The enactment of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the "Act") on December 17, 2010 provides taxpayers with a number of estate planning opportunities never before available to them. These new opportunities, combined with the current low interest rates and asset values, enhance the effectiveness of many previously available planning techniques. However, these opportunities will not last forever, because the Act is designed to "sunset," or expire, on December 31, 2012. This Alert provides a brief summary of the Act and describes multiple planning opportunities that, if appropriate, should be utilized as soon as possible, since it cannot be assumed they will be available after 2012.
What did the Act change?
The most significant changes under the Act are the increase of the per-person estate, gift and generation-skipping transfer ("GST") tax exemptions to $5,000,000, the reduction of the maximum estate, gift and GST tax rate to 35% and the unification of the estate and gift tax exemptions so they may be used during lifetime or at death. The increased exemptions enable you to transfer a total of $5,000,000 to any beneficiary, including grandchildren, before incurring any transfer taxes. This means that even if you had previously utilized all of your $1,000,000 lifetime gift tax exemption, you now have a two year "window" in which to make transfers of an additional $4,000,000 gift tax-free. This presents what may be a once-in-a-lifetime opportunity to transfer significant wealth using any one or more of the techniques discussed below.
What opportunities are available?
All of the following examples of various gifting opportunities are based on the premise that you have not used any of your $5,000,000 lifetime gift tax exemption. The examples also assume that your children or grandchildren (and/or trusts for their benefit) will be the ultimate beneficiaries of the gifts (with any gift that will ultimately pass to a grandchild or more remote descendant also utilizing the donor's separate $5,000,000 GST tax exemption).
- Outright Gifts – If you are married, you and your spouse can now gift assets valued up to $10,000,000 outright to your children, grandchildren or other individuals without incurring gift or GST tax (in addition to gifts of up to $13,000 per recipient per year, which are excluded from the gift tax). These outright gifts can include the forgiveness of outstanding loans or mortgages you have made to children or other family members in previous years.
- Leveraging the Gift Tax Exemption With Valuation Discounts – Assets subject to valuation discounts may be used in combination with some of the techniques described below to increase the tax savings from a gift. The Act does not restrict the ability of taxpayers to avail themselves of valuation discounts in connection with a gift, including gifts of interests in real estate, family limited partnerships ("FLPs"), S corporations, limited liability companies and other hard to value assets. For example, assume that you own a 100% interest in an FLP worth $10,000,000. You want to make a gift of 30% of the FLP to your child. The "value" of the share of the FLP's underlying assets is 30% of $10,000,000 or $3,000,000. However, for gift tax purposes, the reportable value may be much less, reflecting discounts to reflect the lack of marketability and voting control associated with the 30% interest. Assuming a combined 25% discount, the reportable value of the 30% interest in the $10,000,000 FLP is only $2,250,000.
- Sale to Intentionally Defective Grantor Trust – The sale of assets to an intentionally defective grantor trust ("IDGT") is structured so that the assets of the trust are excluded from the grantor's estate for estate tax purposes, but not for Federal income tax purposes. A sale of assets to an IDGT requires the initial funding of the trust with enough liquidity to legitimize the subsequent sale transaction, typically in the form of a gift of 10 - 15% of the transaction value (commonly referred to as "seed money"). The seed money is then used by the trust as a downpayment for the purchase of the asset from the grantor. This technique makes it possible for you to remove an asset expected to appreciate greatly, such as an interest in a closely held business, from your estate for its current value. With the increased exemption, you and your spouse can gift up to $10,000,000 in seed money to a trust, which could support a purchase price of up to $100,000,000 (5 times the amount possible under prior law). No Federal income tax is payable with respect to the sale.
- GRAT – A GRAT is a technique whereby property is transferred into a trust in exchange for an annuity, the value of which is determined with reference to the term of the trust and current interest rates set by the IRS. The assets remaining in the GRAT after the annuity payments are made pass to the beneficiaries of the GRAT gift tax free. The Act does not adversely affect the utility of a GRAT, at least until 2013. A good way to visualize this technique is to view the transfer as a loan by you to the GRAT for a term of years. During the term, you are paid back the principal, plus interest at the IRS rate (only 2.8% for February 2011). Any appreciation on the property during the term of the GRAT in excess of the principal and interest passes gift tax-free to your beneficiaries. The lower the hurdle rate, the easier it is for a GRAT to be successful.
- Life Insurance Planning
- Insurance death benefits, either from single life or second to die policies, can be used to provide estate liquidity or as an excellent investment tool to provide additional wealth for future generations. The death benefits can provide for a significant return free of both estate and income tax.
- Creating an irrevocable trust ("ILIT") to own a life insurance policy has always been an excellent way to leverage your available gift tax exemption while removing the insurance proceeds from your taxable estate. The increased exemption allows you to gift significantly more to the ILIT during 2011 and 2012 without being limited to the $13,000 per donee annual exclusion amount. Larger gifts can be used to pay for larger policy premiums or can be invested within the ILIT and used to fund premiums due in the future, when the gift tax exemption level is uncertain. This could greatly reduce or even eliminate trust administration costs and the need to use "Crummey" notices annually. In addition, the ability to make larger gifts enables someone who is in less than perfect health to cover the cost of higher premium payments that was impractical under prior law. A large gift to an ILIT can be used to fully pay up an existing insurance policy or purchase a single premium fully paid up policy.
- The higher gift tax exemption may allow you to terminate an existing split dollar agreement to simplify the administration of policy ownership.
- The increased gift tax exemption may be used to acquire large insurance policies through a premium financing technique pursuant to which an ILIT purchases the insurance policy with borrowed funds. Cash gifted to the ILIT can then be used to cover the loan payments which are typically less than the full premium.
- As with any well drafted trust, the assets in an ILIT are protected, to the extent permitted by law, from claims of creditors of the beneficiaries, including claims of a beneficiary's spouse in the event of divorce.
- If you have existing policies which were originally secured to cover any estate tax exposure you should carefully analyze your personal financial situation before deciding to reduce or eliminate your life insurance portfolios. Many of you will come to the conclusion that your policies should be retained. First, the estate tax situation beyond 2012 is far from certain, and the estate tax rate may increase again. Second, growth in your net worth may increase or create estate tax exposure. Finally, depending on the type of policy, the life insurance can be retained as part of a diversified investment portfolio.
- Dynasty Trust – Many of these techniques can be combined with a dynasty trust to further enhance the gift tax benefits. A dynasty trust is an irrevocable trust created to exist during the lifetimes of multiple generations (and therefore requires use of the GST tax exemption), without being subject to estate or GST tax in any generation. In many states, dynasty trusts can have perpetual existence. This type of trust is one way to provide a financial cushion or "safety net" for your children and their descendants protected to the extent permitted by law from claims of creditors, including a spouse in the event of divorce, and to create wealth outside of your taxable estate. If you and your spouse transfer $10,000,000 into a Dynasty Trust in 2011, in 40 years at an estimated net 6% annual growth, the trust assets available to your descendants would be over $102,000,000!
- Spousal Limited Access Trust – This technique may be perfect if you are looking to reduce your taxable estate by using part of your increased gift tax exemption but you are not prepared to completely part with the assets transferred because the assets may still be needed in the future. You can transfer up to $5,000,000 into a Spousal Limited Access Trust or "SLAT" for the benefit of your spouse (and children, if desired) during the spouse's lifetime. The benefit of a SLAT is that the amount transferred (and any appreciation on such amount), to the extent retained in the trust, is no longer included in your estate, but at the same time can be made available to your spouse if necessary in the form of a discretionary distribution approved by an independent trustee.
- QPRT – A Qualified Personal Residence Trust ("QPRT") is a vehicle that allows you to transfer a residence (primary or vacation) into a trust which will ultimately distribute the property to your children or a trust for their benefit after a term of years. The value of a gift for reporting purposes is less than the fair market value of the property transferred because the children do not receive the property until the end of the trust term. The amount of the discount depends upon the term of the trust and current interest rates. You and your spouse could utilize your $10,000,000 gift tax exemption to transfer a property valued at well over that amount, removing the value of the property and any appreciation on it from both of your estates. While the current low interest rates may make this technique somewhat less attractive, this may be offset by generally lower real estate values.
- CLAT – A Charitable Lead Annuity Trust ("CLAT") is an excellent technique if you are charitably inclined and also wish to provide for your children. You transfer assets into a trust which provides for an annual payment for a certain term of years to the public charities or private foundations of your choosing. At the end of the term, the balance in the trust passes to your children. The reportable gift, and therefore the amount of gift tax exemption utilized, is determined with reference to what the remainder of the trust passing to your children at the end of the term would be based on current IRS interest rates, the term of the trust and the payout rate. This technique is best utilized when interest rates are low because: (1) lower interest rates at the creation of the CLAT reduce the value of the remainder interest and therefore the amount of gift tax exemption used, and (2) any growth in the trust assets over and above the annual payments to the charities is transferred to the remainder beneficiaries at the end of the trust term gift tax-free.
These are only a few of the estate planning techniques that can be used to "turbo charge" your estate plan in 2011 and 2012. There are a multitude of opportunities available to transfer significant wealth in a tax free or tax efficient manner. Virtually all clients must undertake a review of their current estate plan in light of this limited two year opportunity. Please contact your Private Client Group attorney to schedule an appointment to review your plan and discuss which of the techniques is compatible with your overall estate planning goals.