On December 17, 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the "2010 Act") was signed into law, making significant modifications to the estate, gift and generation-skipping transfer ("GST") taxes. The 2010 Act:
- reduced the estate, gift and GST tax rates to 35%.
- increased the estate tax exemption from $3.5 million to $5 million.
- increased the GST tax exemption from $1 million to $5 million.
- reunified the estate and gift tax exemptions so that an individual can gift up to $5 million during life.
Unfortunately, these favorable provisions of the 2010 Act will remain in effect only through December 31, 2012, when the act is scheduled to sunset. Unless the law changes, in 2013, the law reverts to the 2001 law, and the top gift and estate tax rate will be 55% and the estate and gift tax exemptions will be $1 million. In addition, the GST tax rate will revert to 55% and the GST tax exemption will be $1 million (indexed for inflation). Moreover, certain favorable provisions in the GST tax laws that were enacted in 2001 would no longer apply. Thus, in order to avail yourself of the maximum benefits under the temporary new law, you may wish to consider one or more of the following planning techniques, each of which can significantly reduce your taxable estate at death by taking advantage of the provisions of the 2010 Act prior to 2013.
Use Your Exemption to Make Non-Taxable Gifts
With the increase in the gift tax exemption from $1 million to $5 million per person, you now have the ability to reduce your estate by simply making direct gifts to your descendants or anyone else you wish to benefit (or to trusts for your descendants or anyone else, as discussed below). In fact, a married couple can gift $10 million to their descendants without paying gift tax. Even if you used your entire gift tax exemption in prior years, the additional $4 million increase in the gift tax exemption is available to you ($8 million for a married couple).
Additionally, in the event that you made loans to your children or grandchildren, you may wish to consider using your new gift tax exemption to forgive those notes.
Making gifts during life not only reduces your estate by the amount gifted, but also by all the appreciation on that gift over time. For example, if you make a $5 million gift this year and die twenty-five years from now, the value of that gift, including appreciation, will be over $21 million, assuming 6% growth (or over $10 million, assuming only 3% growth).
Gifts in Trust
Although it is simple to make a direct gift of cash or marketable securities to various individuals, there are many advantages to using your new exemption amounts to make gifts of property in trust instead of outright gifts to individuals. Gifts to trusts for the benefit of your descendants allow you to allocate your GST tax exemption to that trust. Allocating your GST tax exemption to the trust enables the funds in the trust, plus all future growth, to pass to your descendants without the imposition of any estate or GST tax at each beneficiary's death.
Gifts in trust also provide an additional opportunity for the trust's income to be taxed to you instead of to the trust or the trust beneficiaries. This lets you, in essence, make additional tax-free gifts to the trust of the amount of the tax that the trust otherwise would pay. This type of trust is known as a grantor trust.
Furthermore, gifts in trust are protected from claims by the beneficiary's creditors, including spouses, and ensure that the assets do not pass outside the family bloodline. These benefits apply at every generation for the longest period allowed under law.
Leveraging Your Gifts
Leveraging your gift tax exemption provides you the opportunity to get more bang for your buck from your gift. For instance, an alternative to making a gift of cash would be to form a partnership or limited liability company ("LLC") and give away part of that partnership or LLC to a trust for the benefit of your descendants. The advantage of gifting interests in a partnership or LLC is that such interests may be able to be valued in such a way that discounts would be available on account of the gift being a minority interest in the partnership or LLC and/or due to restrictions on transfer in the partnership or LLC agreement. Assuming a 30% discount, a gift of a partnership or LLC interest with an underlying value of $14 million would still be under the $10 million combined gift tax exemption of you and your spouse. Additionally, as mentioned above, GST tax exemption could be allocated to the trust, enabling both the interest transferred to the trust and all future growth to pass to your descendants without the imposition of any estate, gift or GST tax.
Tax Rates for Taxable Gifts (those above the $5 million exemption amount)
In 2011 and 2012, the gift tax rate is 35%. In 2013, that rate is scheduled to revert to 2001 rates (ranging from 41% to 55% for gifts over $3 million). Thus, to the extent that you wish to make taxable gifts (those in excess of $5 million, the current individual lifetime gift exemption), you may wish to consider making such gifts in the next two years. In addition to paying tax at a lower rate, the gift tax paid is removed from your estate (assuming you live for three years or more from the date the gift is made) and all the appreciation on the gifted asset is removed from your estate.
By way of example, a gift of $5 million made in 2012 by an unmarried individual who had used his $5 million gift tax exemption in 2011 would result in a gift tax payable of $1,750,000. In 2013, the same $5 million dollar gift would result in a gift tax payable of $2,750,000. Moreover, assume that the individual dies in 2020 and that there is 5% growth, the gift tax of $1,750,000 and the appreciation of $2,387,277 (compounded annually over eight years) would be removed from the estate tax-free.
Non-Reciprocal Trusts Created by Married Couples
Let's suppose you really do not want to make a gift at this time, but you also do not want to waste the savings available by the increased exemption amount available in 2011 and 2012. You can have your cake and eat it too by creating a trust for the benefit of your spouse. By doing so, the assets transferred to such trust (and any growth on such assets over time) would be outside of your estates. But if you felt like you needed to use some of the funds in the trust, your spouse could simply receive a distribution from the trust. If you added your descendants as potential beneficiaries of the trust, the Trustee also could make a distribution to one or more of them, which would also occur free of gift tax. This flexibility would allow (but not necessarily require) distributions to be made to your spouse or descendants. Since distributions are not required, the funds also could accumulate in the trust and not be subject to any further estate, gift or GST tax. It is possible for each spouse to create trusts for each other, if desired. This sort of trust could be viewed as a protective device to be used against the exemption amount being lowered in the future.
Domestic Asset Protection Trusts/Single Individuals
A similar approach that should work if you are a single individual would be for you to create a domestic asset protection trust ("DAPT"), of which you can be a beneficiary. Such a trust must be formed in a jurisdiction that has "DAPT" legislation, such as Delaware. By creating a DAPT, the assets transferred to the trust are outside your estate, but remain available for your use (as long as a Delaware resident or trust company acts as your co-trustee and is in charge of making the distributions to you). As with the trusts for spouses described above, there would be no requirement that you take distributions (unless you need them), so, to the extent that you don't, the trust principal and growth can accumulate within the DAPT free of any future estate, gift or GST tax. Best of all, Delaware's strong asset protection statutes protect the assets of the DAPT from your creditors, and the creditors of any remainder beneficiaries for whom the trust assets are ultimately meant to benefit.
Gifts of Real Property
An especially useful planning technique for those who own a residence or a vacation property is transferring that property to a trust for the benefit of your descendants (or other beneficiaries) and then leasing the house back from the trust. Because the gift of the property is made in trust, GST tax exemption can be allocated to the trust, enabling the property, plus all future appreciation, to pass to your descendants without the imposition of any estate or GST tax at the beneficiary's death. Furthermore, if you have more than one descendant whom you wish to benefit, you can create multiple trusts and transfer partial tenancy-in-common interests in the property to each trust, which will enable you to discount the value of the property transferred on account of each trust receiving a fractional undivided interest in the property. Finally, if the trust(s) is structured as a grantor trust, your payment of rent to the trust for your use of the gifted property will not constitute taxable income to the trust, essentially allowing you to make additional tax-free gifts to the trust.
In addition to the above technique, the use of a qualified personal residence trust ("QPRT") continues to be a great option for transferring real property out of your estate and to your descendants at a reduced gift tax cost. To create a QPRT, you transfer title to your personal residence (either a principal home or a vacation home) to a trust that contains certain provisions required by the Internal Revenue Code. The trust provides that you, as grantor of the trust, retain the exclusive right to live in the residence for a specified term of years (which you must outlive to avoid estate tax inclusion), during which you continue to be responsible for paying property taxes and other expenses to maintain the residence. Upon expiration of the term, the personal residence, including any appreciation in its value, passes pursuant to the terms of the QPRT (i.e., to your children, or trusts for their benefit) without any further exposure to gift tax. Upon creation of the QPRT, you make a taxable gift equal to the fair market value of the residence at the time of the transfer less the actuarial value of your retained right to live in the residence. As the trust term increases, the value of your retained interest also increases, resulting in a decrease in the amount of the gift. Thus, for older clients, the increased $5 million dollar exemption gives you the opportunity to create a shorter term QPRT and still be able to shelter the gift of the remainder interest. It is also possible to transfer partial interests in a residence to a QPRT to obtain fractional interest discounts in the value of the property transferred.
Purchasing Additional Life Insurance in Trust
The proceeds from a life insurance policy owned in your own name will be subject to estate tax at your death. In contrast, the proceeds from a life insurance policy owned by an irrevocable life insurance trust ("ILIT") will generally pass free of estate taxation. Thus, ILITs have been, and continue to be, a very useful and basic estate planning device. One of the past difficulties of administering an ILIT was how to transfer funds to an ILIT without incurring gift tax, particularly if an individual did not have many children and grandchildren to count as beneficiaries of an ILIT. This problem was particularly applicable to funding large insurance policies. On account of the increase in the lifetime gift tax exemption to $5 million, it has become much easier to fund trusts to purchase life insurance. Individuals with existing ILITs may wish to purchase additional life insurance or keep policies that they were thinking of terminating.
You may wish to consider making a large gift to an ILIT now, to protect against the exemption amount being decreased in the future, instead of merely making transfers to the ILIT when premiums are due. Since the gift occurs when the funds are transferred to the ILIT (as opposed to when life insurance premiums are paid), a large gift to an ILIT while the $5 million exemption is in place will allow the trustee of the ILIT to pay premiums for many years without worrying about the gift tax exemption being decreased.
Some individuals may think that they no longer need life insurance to provide liquidity to pay estate tax since the estate tax exemption is $10 million for a married couple. But with the uncertainty of the estate tax system after 2012 (only a $1 million estate tax exemption and a 55% tax rate), it may be more important than ever to include life insurance as part of your estate plan. Waiting to see what happens in 2013 before purchasing life insurance has the risk that you will not be as healthy then as now, precluding the purchase of life insurance. Furthermore, even if qualifying for additional life insurance in the future will not be a problem, funding the ILIT may be more difficult with a lesser gift tax exemption amount.
A Sale to an Intentionally Defective Grantor Trust
A sale to an intentionally defective grantor trust is used to "freeze," for estate tax purposes, the value of the assets you sell to the trust by exchanging them for a promissory note with a stated interest rate and principal amount. Any and all appreciation on the assets after the sale to the trust is not included in your estate, and if the asset is an interest in a limited partnership, limited liability company or a closely held corporation, a discount should apply to the sales price.
- To employ this technique, you would first create an irrevocable trust that would be a "grantor trust" for income tax purposes (the "Grantor Trust"). A grantor trust is a trust where all of the income of the trust is taxed to you and any transactions between you and the trust are disregarded for income tax purposes. This is created by your retaining certain powers in the trust. The Grantor Trust would be structured so that the assets in the trust at your death would not be included in your estate for estate tax purposes.
- You would then sell assets to the Grantor Trust in exchange for a promissory note, which could be drafted so that you receive interest only and principal in a single balloon payment at the expiration of the note (for example, in nine years). The annual interest payments you would receive from the Grantor Trust under the note would not be taxable income to you because it is a grantor trust for income tax purposes (and thus, it would be treated as if you were paying yourself interest which is not considered taxable interest).
- Most practitioners believe that, in order for the sale transaction to be respected by the IRS, the Grantor Trust should be funded, before the sale takes place, with at least 10% of the value of the assets the Grantor Trust is purchasing (the "seed money"). One way to satisfy this requirement is by a gift to the Grantor Trust of the seed money prior to the sale. With the recent increase of the gift tax exemption to $5 million ($10 million for married couples), you can make a significant tax-free gift to a Grantor Trust to enable it to purchase additional assets from you (up to $90 million for married couples), the appreciation on which will escape future estate taxation.
- A further advantage of utilizing a sale to a defective grantor trust is that you can allocate a portion or all of your GST exemption to the irrevocable Grantor Trust that is created to purchase your assets. Since, in addition to your lifetime gift exemption, your GST exemption also has been increased to $5 million ($10 million for married couples), you have a higher amount of GST exemption to allocate to the Grantor Trust, the result of which would be to shelter the appreciation in the trust from the future imposition of GST tax.
A Potential Pitfall: The Clawback
Some practitioners have raised the concern that if a donor uses the increased exemption of $5 million during 2011 and 2012, and, in 2013, that exemption is reduced back to $1 million, then, upon the death of the donor, there could be a potential clawback of the gifts made in excess of that reduced exemption when determining the estate tax owed by the donor's estate. However, there is nothing in the current law to suggest that the government would take this approach.
We feel that individuals should take full advantage of the current exemption amounts and rates while the opportunity is still there. Gifts always have the advantage of transferring future growth out of one's estate, in addition to removing the assets that have been transferred. We recommend that you contact your personal planning attorney to discuss the best way to utilize your increased exemption amounts.