New Tax Law Provides Opportunities to Make Gifts to Grandchildren Before Year End

The new tax legislation significantly changes the federal estate, gift and generation-skipping transfer tax laws for 2010 through 2012 and provides taxpayers with valuable wealth transfer opportunities. If you wish to make gifts to grandchildren, some action may be necessary before January 1, 2011.

Action Points

Gifts to Grandchildren

Through year end, you may make gifts to grandchildren, outright or in trust, without the imposition of any generation-skipping tax. However, you would pay a 35% gift tax on any gift in excess of your $1 million gift tax exemption.

Gifts to Children

In 2011 and 2012, each person will have a $5 million gift tax exemption. You should consider deferring taxable gifts to children until next year in order to take advantage of this exemption. The gift tax rate is 35% for 2011 and 2012.

Gifts from Existing Trusts

Through year end, distributions can be made from existing trusts that are not exempt from the generation-skipping transfer tax (e.g., Grantor Retained Annuity Trusts, Qualified Personal Residence Trusts and most life insurance trusts) outright to grandchildren (and in some instances, in further trust for grandchildren) free of gift and generation-skipping transfer tax.

Summary of Tax Legislation

Gift Tax

For 2010, the exemption from federal gift tax remains at $1 million, but it will increase to $5 million in 2011 and will be adjusted for inflation in 2012. Because of the increase in the federal gift tax exemption, you should consider deferring your 2010 year-end gifts (other than annual exclusion gifts and gifts to grandchildren and more remote descendants as discussed below) until 2011 since you will be able to shelter $5 million of the gift (reduced by any of the $1 million existing exemption already used by you) from gift tax. Even if you have made prior taxable gifts in excess of the $1 million gift tax exemption, beginning in 2011 you will be able to make additional tax-free gifts of $4 million.

Since we do not know what the gift tax exemption and the gift tax rate will be after 2012, depending on your personal and financial circumstances, you may want to consider making substantial gifts in 2011 and 2012 while the lifetime gift tax exemption is $5 million and the gift tax rate is 35%. The assets you transfer, together with the income and appreciation earned on such assets, will be removed from your estate and will not be subject to estate tax upon your death.

Generation-Skipping Transfer ("GST") Tax

The GST tax is a tax, in addition to the estate tax, imposed on transfers to grandchildren or more remote descendants. The exemption from GST tax in 2010 remains essentially unlimited under the new legislation (since in 2010 the GST tax on generation-skipping transfers is zero). In 2011 and 2012, the GST exemption amount will be $5 million (indexed for inflation after 2011) and the GST tax rate will be 35%. Thus, you should consider making outright gifts to grandchildren and more remote descendants or gifts to trusts exclusively for the benefit of grandchildren before the end of the year. The new legislation gives you a unique opportunity, which may never be available again, to make gifts to grandchildren and more remote descendants in 2010 without incurring any GST tax. Even if the generation-skipping transfer will generate gift tax in 2010, it may be worthwhile to pay the gift tax, since you will not have to pay GST tax and can preserve your $5 million GST exemption for additional gifts to grandchildren in the future.

Estate Tax

For individuals dying in 2010, 2011 or 2012, the federal estate tax exemption amount is $5 million and the maximum federal estate tax rate is 35%. The recipient of property from a decedent will receive a "basis step-up" for the asset, meaning that the income tax basis of the inherited asset will be stepped up (or down) to its fair market value on the date of the decedent's death. However, the executor of an estate of an individual dying in 2010 may elect not to pay any federal estate tax and the tax basis of the bequeathed property will be the decedent's basis in the property (so-called "carryover basis"). An estate making this election will receive a limited basis step-up of $1.3 million for assets passing to anyone and an additional basis step-up of $3 million for qualifying bequests to a spouse. Therefore, if an executor of the estate of a decedent dying in 2010 elects not to pay estate tax and the decedent's property with a carryover basis is later sold, a capital gains tax will be assessed on the difference between the value of the property on the date of sale and the carryover basis in the property.

Estates well in excess of $5 million that do not pass largely to a spouse or charity will generally choose to opt out of the estate tax and forego the full step-up in basis, since the overall capital gains tax which will be owed upon the sale of the assets will be less than the estate tax due.

Portability of Federal Estate Tax Exemption

Under the new legislation, beginning in 2011, a surviving spouse can use his or her deceased spouse's unused federal estate tax exemption amount, so long as the first spouse dies in 2011 or thereafter. The deceased spouse's executor has to make an election on the deceased spouse's estate tax return allowing the surviving spouse to take advantage of this opportunity. Portability of the federal estate tax exemption can be a very useful tool if a spouse dies without sufficient assets in his or her name to take advantage of the federal estate tax exemption, but the surviving spouse has significant assets in his or her name. The reverse is not true: the first spouse to die cannot use the other spouse's federal estate tax exemption. In addition, the GST tax exemption is not portable, so a person cannot use his or her deceased spouse's unused GST exemption.

2013 Sunset

Unless Congress enacts additional legislation which extends or modifies the new law, this legislation will expire on January 1, 2013. As a result, the estate, gift and GST exemptions would revert to $1 million and the tax rate would revert to 55%.

Grantor Retained Annuity Trusts ("GRATs")

Although we had been concerned that Congress would impose a mandatory minimum ten year GRAT term and prohibit so-called "zeroed out" GRATs in which the value of a grantor's retained interest is equal to the value of the property transferred to the trust, resulting in a zero gift tax, the new legislation does not address GRATs. Consequently, for now, GRATs still remain an attractive estate planning tool in this low interest rate environment since they enable you to transfer the appreciation on assets to beneficiaries without estate or gift tax consequences.

Since every person's situation is different and thus may be impacted differently by the new legislation, you will need to consult us or other advisers to determine how the new law affects you in particular.