To Gift or Not to Gift

As we noted in our December 2010 Estate Planning Update,1 the tax law changes enacted that month increased the unified gift and estate tax exemption to $5 million. This may provide some planning opportunities because an individual can now transfer up to $5 million of assets without incurring gift tax (a married couple can transfer up to $10 million). Making gifts now allows you to remove any future appreciation in these assets from your estate. When combined with valuation discounts, you could achieve significant savings. The $5 million exemption is in addition to the $13,000 each individual may give to any number of persons per year free of gift tax or use of lifetime exemption.

However, the $5 million exemption is only in effect through 2012. This puts a premium on making gifts over the next sixteen months. In addition, there is the possibility that, if the gift and estate tax exemption is set at less than $5 million after 2012, the IRS may attempt to "clawback" the gifts that were made in 2011 and 2012 at the death of the donor such that the amount of any such gifts that exceed the estate tax exemption in effect at the time of death would be subject to estate tax. We agree with many commentators that Congress is likely to fashion any new law in 2012 to prevent the IRS from taking this position. Even though the possibility of a clawback of gifts made in 2011 and 2012 is remote, it should not be ignored. In most cases, there will be no downside to making gifts using the increased exemption when compared to the upside potential of removing the appreciation in value of any assets from your estate. We would be pleased to discuss with you, in the context of your personal circumstances, what may be a temporary opportunity to significantly decrease estate and gifts taxes for your family.

Grantor Retained Annuity Trusts Live On

We discussed in previous Estate Planning Updates2 various bills that have been introduced that would require a grantor retained annuity trust (GRAT) to have a minimum annuity period of 10 years. Essentially, a GRAT pays the donor an annuity for a specified period, which is based upon an interest rate tied to mid-term Treasury rates, and in return, the appreciation of the assets in the GRAT above such rate passes to the named beneficiaries at the end of the period with minimal use of gift tax exemption. A GRAT only works if the grantor survives the annuity period. If he or she does not survive, the value of the property is included in the grantor’s estate. Clearly, a mandate that a GRAT have a minimum annuity period of at least 10 years would reduce the probability of a successful GRAT. It also would diminish the ability to take advantage of short-term upturns in the markets, or to recover from short term downturns.

Luckily, the various proposals to establish a minimum GRAT term have not yet made their way into law, and therefore a GRAT remains a very successful technique to transfer wealth to later generations. This is especially true given the current environment of low interest rates. Consequently, you should consider acting now to create a short-term GRAT to transfer your business interests, real estate, or other assets to family members.

Another technique similar to a GRAT is a sale to a grantor trust. A sale to a grantor trust has the same objective as a GRAT, to remove from the taxable estate that portion of the appreciation in the value of the assets that surpass mid-term Treasury rates. As such, because of the currently low interest rates, a sale to a grantor trust is another extremely effective vehicle to transfer wealth to the next generation with less tax and would not be affected by any legislation that is now pending.

Portability: Good Idea but Don’t Rely on It

Along with setting the estate, gift, and generation-skipping transfer tax exemptions and rates for 2011 and 2012, the 2010 tax law changes introduced a new concept: portability. Portability allows a surviving spouse to take advantage of the deceased spouse’s unused estate tax exemption in addition to his or her own exemption. For example, if a husband dies having only used $2 million of his $5 million exemption, his wife may add his $3 million of unused exemption to her own, potentially allowing her to pass up to $8 million by lifetime gifts or at her death. In order to take advantage of portability, an estate tax return must be filed for the deceased spouse even if one would not be required otherwise.

At first glance, one might think portability would take away the need for more complex planning techniques, such as re-titling assets between spouses and utilizing of trusts to shelter the amount of the estate tax exemption. However, there are reasons not to rely on portability. As with the other provisions of the 2010 tax law changes, portability is only in effect for 2011 and 2012. This means that both spouses would have to die within this two-year period in order to take maximum advantage of portability.3 A decision to leave assets outright to the surviving spouse also may cause you to lose benefits that are provided by trusts. A trust can provide creditor protection, which would not result if a surviving spouse receives assets outright. In addition, a trust allows the deceased spouse to restrict transfers outside the family by the surviving spouse. Perhaps most important from a tax standpoint, a trust funded with the estate tax exemption can be protected from estate tax at the second death, which includes the amount of the appreciation that occurs in the trust assets between the two deaths. Portability does not provide any of these benefits. Finally, portability does not apply to the exemption from generation-skipping transfer tax. This means that while a surviving spouse could shelter $10 million from estate taxes, he or she would only be permitted to transfer $5 million to grandchildren free of tax.