As 2011 comes to a close, clients, their advisers, and fiduciaries should examine possible estate planning techniques and steps to undertake in 2012. Next year, hopefully, will be less challenging than 2011, but in these uncertain times for tax legislation, one simply never knows. For example, in 2011, many expressed the concern that Congress might eliminate one of the most beneficial provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “2010 Tax Act”), the $5 million exemption for lifetime transfers, as of November 23, 2011. Many believed that the deficit-reduction super committee might, as part of its efforts to craft a plan to reduce federal budget deficits by $1.2 trillion over the next 10 years, eliminate the $5 million lifetime exemption. The collapse of the super committee’s efforts alleviated this concern, but only to replace it with more uncertainty about the course Congress and the President might take to address the country’s enormous fiscal problems.

This uncertainty mandates that clients and their advisers pay attention to their estate planning and that fiduciaries examine the trusts they are administering, all with a view to taking advantage of techniques that may have a limited lifespan. This is because the favorable estate, gift, and GST tax provisions of the 2010 Tax Act are in place only through December 31, 2012, unless Congress acts to extend them in the coming months. A current review of estate plans by clients, their advisers, and fiduciaries will ensure that estate plans will produce the desired results and minimize the exposure to the estate, gift, and generation-skipping taxes no matter what action Congress may take or fail to take in 2012 and thereafter.

With the 2010 Tax Act, Congress made significant changes to the estate, gift, and GST tax laws for 2010, 2011, and 2012. These changes present both challenges and opportunities for individuals and fiduciaries and their advisors. Among these changes:

  • A reduction of the estate, gift, and GST tax rates to 35%.
  • An increase of the estate tax and GST tax exemptions to $5 million.
  • An increase in the gift tax exemption to $5 million for 2011 and 2012.
  • Indexing of the estate tax, gift tax, and GST exemptions for 2012 so that the exemptions will be $5,120,000 in 2012.
  • A reunification of the estate and gift tax exemptions so that an individual can give away during life or at death up to $5,120,000 through 2012.
  • An introduction of portability, which permits the estate of the second spouse to die to take advantage of the unused exemption of the first spouse to die for 2011 and 2012.

If Congress fails to take action sometime in 2012, or even in 2013, the estate, gift, and GST tax laws in existence before the 2001 Tax Act will return in 2013 with a $1 million exemption for estate and gift tax purposes, a 55% maximum rate, and a $1.36 million GST exemption.

Lifetime Gifts

The 2010 Tax Act, by reunifying the estate tax and the gift tax and increasing the amount of the gift tax exemption from $1 million to $5 million, has greatly expanded the ability of individuals to make large gifts and thereby remove significant amounts of property and post-gift appreciation on that property from their estates. In 2012, individuals who have the resources to do so should carefully consider taking advantage of this favorable environment for lifetime gifts.

Reducing estate tax through lifetime gifts is one of the most effective methods of decreasing transfer taxes. An individual can give away substantial amounts of property without incurring gift tax. For wealthy individuals, making large taxable gifts almost always is advantageous from a tax standpoint. The challenges in planning for lifetime giving often are non-tax factors such as:

  • Impact of the gift on the beneficiary.
  • Concerns about the adequacy of the donor’s remaining resources after the gift.
  • Perceptions about the inflexibility of irrevocable transfers, such as the inability to significantly change the future trust terms when gifts are made in trust.

The sophisticated and well-advised donor will follow a particular sequence in making gifts, starting with those that have the least tax impact and are the easiest to implement, and then moving to gifts that have permanent tax consequences or involve more complex planning. That sequence typically is:

  • Annual exclusion gifts through which an individual can give $13,000 to any one or more recipients that he or she chooses.
  • Education and medical exclusion gifts.
  • Lifetime exclusion gifts, including leveraged and split-interest gifts (such as grantor retained annuity trusts; qualified personal residence trusts; and gifts with sales for a promissory note; loans; charitable remainder and lead trusts).
  • Gifts that require payment of gift tax.

Annual Exclusion Gifts. The Internal Revenue Code currently provides an exclusion from gift tax for the first $10,000 (indexed for inflation) given to any donee in any year. The annual exclusion amount is indexed in $1,000 increments. Because of indexing, the annual exclusion has been $13,000 since 2009 and will continue to be $13,000 in 2012. Thus, an individual currently can make annual gifts of up to $13,000 to any number of people, without any gift tax on the transfers or use of gift tax exemption. A married individual can double the annual exclusion by gift-splitting — using one spouse’s funds and having the non-donor spouse consent to treat gifts made as being made one-half by each of the spouses.

The benefits that can be derived from making $13,000 annual exclusion gifts should not be underestimated. In substantial estates, simple cash gifts of $13,000 can generate a federal estate tax savings of $4,550 for every transferee involved, assuming a 35% estate tax rate.

Tuition and Medical Expenses. Tuition payments made directly to an educational organization on behalf of a person and payments for a person’s medical care made directly to the provider also are not treated as taxable gifts. This can be an important exclusion for planning purposes. For example, grandparents who already take full advantage of the annual exclusion for gifts to grandchildren can make additional tax-free transfers by paying their grandchildren’s tuition for private school or college.

Taking Advantage of the $5 Million Exemption for Lifetime Gifts. With the gift tax exemption increased to $5 million for 2011 and $5.12 million for 2012, and the possible return to a $1 million exemption in 2013 because of the sunsetting of the 2010 Tax Act, wealthier individuals who can afford to make larger gifts have a wonderful opportunity in 2012 to remove a larger amount of assets from their estates without tax than might be possible after 2012.[1]

Even if the current estate and gift tax law is extended beyond 2012, making large gifts now to take advantage of the $5 million gift tax exemption can be beneficial. The sooner the gifts are made, the sooner the assets are removed from taxation, and the sooner the appreciation on the assets after the date of the gift is removed from taxation in the donor’s estate. And a husband and wife have a combined gift tax exemption of $10.24 million.

The best assets to use for taxable gifts are assets with a high return and a high basis. Because the value of the taxable gift itself is usually not excluded from the estate tax calculation, the primary benefit of an outright taxable gift is removing the future appreciation of and earnings from the gifted property from one’s estate.

We cannot count on the transfer tax being eliminated or the $5 million exemption being increased or even lasting beyond 2012. Careful estate planning therefore requires thoughtful use of this limited exclusion. In addition to identifying high basis assets and trying to identify assets with good growth potential, the exclusion will be most effective if used with techniques that reduce the current taxable value of transfers in one or more ways. This includes most of the techniques used in sophisticated planning.

The exemption amount is a limited resource. It pays to use it with techniques that maximize its benefit. For the wealthiest individuals, it is not enough just to transfer $5 million of property and start it growing outside the estate. Instead, these individuals should consider one of the following techniques:

  • Valuation discounts for closely held business interests.
  • Valuation discounts for limited partnerships and limited liability companies.
  • Gifts of fractional interests, with fractional interest discounts.
  • Grantor retained annuity trusts.
  • Sales to intentionally “defective” grantor trusts.
  • Qualified personal residence trusts.
  • Augmenting gifts with loans at the applicable federal rate or sales in exchange for a note.

Charitable Gifts. For clients with charitable intentions, certain charitable techniques are particularly attractive in the current low interest rate environment. The historically low section 7520 rates favor certain planned giving techniques, such as charitable lead annuity trusts and gifts of remainder interests in residences or farms. But, the low section 7520 rates may make certain other charitable techniques, such as charitable remainder trusts, inaccessible for certain younger donors and will reduce the donor’s income tax charitable deduction for certain planned gifts. Thus, care must be taken in making charitable gifts.

Testamentary Planning

One major change for 2011 and 2012 is the introduction of the concept of portability for 2011 and 2012 only. Portability of a predeceased spouse’s exemption to the surviving spouse could simplify estate planning for some married couples, especially those with combined estates in excess of the exemption but not larger than twice the exemption. It could eliminate the need for those spouses to have a complicated will with a “credit shelter trust” that escapes estate tax at the survivor’s death. And it could reduce the need for married couples to keep an eye on how much property each spouse owns, because portability of the exemption will be available whether or not the predeceased spouse owned enough property to have used any exemption (or owned any property at all). For example, portability will work just fine if a married couple holds all their assets as joint tenants with right of survivorship.

  • But a credit shelter trust will still offer advantages over portability, especially in larger estates. These advantages include:
  • Providing professional management and asset protection during the surviving spouse’s life.
  • Protecting the expectancy of children from diversion by the surviving spouse, especially in cases of second marriages and blended families.
  • Sheltering intervening growth in value and accumulated income from estate tax.
  • Permitting use of the predeceased spouse’s GST exemption, because portability applies only to the gift and estate tax exemption.

The decision to rely on the portability regime or continue with the traditional “credit shelter” trust regime must be made by considering the relationship between the top estate tax rate, the top capital gains tax rate, the rate of inflation, and the rate of return on assets. Currently, the top estate and capital gains tax rates are separated by only 20% (15% top capital gains tax rate and 35% top estate tax rate). This is the closest together these rates have been in 90 years. Only in the initial years of the tax system (1917-1921) did the capital gains tax rate ever exceed the estate tax rate. Throughout the rest of the history of the transfer tax system, the top estate tax rate has been double, and at times triple, the top capital gains tax rate.

These techniques, their structure, and their advantages and disadvantages are all discussed in more detail in the McGuireWoods White Paper on the Impact of the 2010 Tax Act.

Many commentators have observed that the estate tax (as well as the gift tax and GST tax) is a voluntary tax. Those who plan do not pay the tax. Those who fail to plan do pay the tax. While planning cannot always completely eliminate exposure to the estate, gift, and GST taxes, appropriate planning can minimize those taxes. This is especially true of planning techniques that may be available only for 2012 if Congress permits the 2010 Tax Act to sunset on December 31, 2012.