Effective January 1, 2011, the federal Estate, Gift and Generation-Skipping Tax (GST) rules have been substantially modified. Of importance to our high net worth clients is the increase in exemptions for estate, gift and GST taxes. These exemptions are now coordinated and are set at a level of $5 million per donor, or $10 million per married couple. Also, the top tax rate has been reduced from 45% to 35% which can result in substantial tax savings. These new rules are in effect only for 2011 and 2012, after which the exemptions are scheduled to revert to $1 million and the top rate will increase to 55%. It is uncertain whether these laws will be changed again to maintain the higher exemptions and lower rates after 2012, and for this reason clients should consider utilizing the new exemptions during this two-year window. This Advisory describes several planning opportunities arising from this new legislation and also from the current low interest rate environment.  

SELECTED PLANNING OPPORTUNITIES

Use of Additional Gift and GST Exemption

The gift tax exemption has increased substantially from $1 million to $5 million per donor, thus permitting additional tax-free gifts. If you previously utilized your $1 million exemption, you now have an additional $4 million that can be gifted, prior to December 31, 2012, without incurring a gift tax. These transfers could involve many types of assets, and might also include forgiveness of existing indebtedness. One tax advantage of making gifts during a donor's lifetime (and the earlier the better) is that future income and growth potential will benefit the gift recipient and will not be includable in the donor's estate, thus reducing estate taxes. While there is some uncertainty how a 2011 or 2012 gift will be taken into account in the donor's estate, there is assurance that such a gift will not attract a gift tax.

The GST tax is an additional tax on gifts and bequests to grandchildren, and the exemption has been similarly increased from $1 million to $5 million. Gifts to grandchildren, as with all gifts, can be made directly to the recipient or in trust for their benefit. For the reasons stated above, such gifts should be considered prior to December 31, 2012.

Benefits of Using Trusts in General

Gifts made in trust have several advantages over outright transfers. A primary advantage is that, if properly drafted, a trust can provide some protection against future claims of the beneficiary's creditors (including ex-spouses). For beneficiaries who are young or may not yet be responsible enough to handle large sums of money, a trust can provide a vehicle to manage assets and assure prudent decision making. Moreover, by allocating a donor's GST exemption to gifts in trust, the trust property and appreciation can pass for multiple generations (even in perpetuity) without estate or GST tax. In some instances the donor could be a beneficiary of such a trust, but several limitations would apply.

Use of Grantor Trusts

Clients who make gifts to use their increased exemption amounts should consider making those gifts to a so-called grantor trust. Grantor trusts contain special provisions that cause the income taxes normally imposed on the trust assets to instead become the obligation of the donor. This means that while the trust receives the income and/or gains from its assets, the donor must pay the associated tax -- in effect a tax-free gift that relieves the trust from the recurring economic drag of income taxes. The long term benefits of such an arrangement can be meaningful.

Transactions With a Grantor Trust

Grantor trusts offer an additional advantage of permitting transactions between the donor and the trust without income tax consequences. This feature is often used to effectuate tax-free sales of assets from the donor to the trust, as well as permitting loans to finance such transactions. Clients should review their holdings to determine whether such a transaction would be beneficial. In light of the additional $4 million of gift and GST tax exemption available during 2011 and 2012, coupled with the potential for use of leverage, a grantor trust transaction could involve very substantial values.

Trust for Spouse

A variation of this concept involves a transfer of assets to a trust held for the donor's spouse. If properly drafted, such a trust could allow the income and other benefits of the trust to remain available to the donor's household (assuming a continuing marriage), but for estate tax purposes the trust assets would not be part of the donor's or the spouse's taxable estate. This concept is not new, but the amounts that can be placed in such a trust without a gift tax are now greater (up to $5 million per donor).

Loans to Family Members

Interest rates remain at unconventionally low levels, including the minimum rate that must be charged among family members in order to avoid an unintended gift. This presents an opportunity for clients to make beneficial loans to their children or other family members. Often, these funds are used to make other investments, thus allowing the income and growth of those investments, in excess of the interest rate on the loan, to benefit younger generations. These loans can be structured as interest-only, with a balloon payment in the future, and there is no limit on the amount that can be loaned.

Additionally, existing family loan transactions can be refinanced at these lower rates, again increasing the benefits to younger generations. For those families who instead prefer to eliminate existing loan transactions, the increased gift exemption creates new flexibility to forgive additional amounts without payment of gift tax.

PORTABILITY

The new laws include a welcome provision for married individuals: the "portability" of a spouse's $5 million estate and gift tax exemption. This has the potential to eliminate the penalty for imperfect planning in cases where the two spouses' assets are not titled to take maximum advantage of their respective exemptions. It is still recommended that spouses carefully title their assets, including balancing their estates in certain situations, and plan for minimal probate of assets at death. The GST exemption, however, is not portable.

OTHER SUGGESTIONS

  • Review existing life insurance policies, or consider additional life insurance, to make use of increased gift exemptions.
  • Review existing estate plan documents to insure that "formula" funding provisions do not have unintended consequences under the new laws.  
  • Avoid state estate taxes by making substantial lifetime gifts if you live in a state which does not impose a gift tax (but which does impose an estate/inheritance tax).