$5 Million Gift and Generation Skipping Transfer (“GST”) Tax Exemptions
Under new legislation enacted late last year, the 2011 and 2012 estate, gift and GST tax exemptions were increased to $5 million — the highest exemptions in history. With just 15 months left until the exemptions are scheduled to revert back to $1 million as a part of the expiration of the extended Bush tax cuts (absent further legislation), now is the time to act if you have not yet already used your full gift and GST exemptions and are interested in doing so.
The gift and estate tax exemptions are unified under current law. This means that if you use your $5 million exemption today, your exemption remaining at your death will be $0. That said, there are several benefits to using your gift and GST tax exemptions to make a large lifetime gift now, rather than waiting until death:
- Possibility that the exemptions will decrease in the future;
- Any post-transfer appreciation is removed from your taxable estate;
- Current depressed asset values may provide opportunities for substantial post-gift appreciation; and
- Lifetime gifts are especially useful in saving state estate taxes, particularly if you live in a jurisdiction that imposes an estate tax but not a gift tax (such as Massachusetts or New York).
However, there are also some drawbacks:
- You may not want to gift low-basis property (donees receiving gifted property take the donor’s “carryover basis,” whereas, under current law, the basis of an asset received at death is “stepped up” to the asset’s fair market value);
- Gifted asset values may decrease, resulting in a waste of a portion of your exemption; and, most importantly,
- The risk that you may need the money at some point in the future.
When making a large gift, you should seriously consider the use of a trust. Making a gift in trust allows you to separate the timing of the gift (which is often driven by tax motivations) from the timing of the distributions (driven by family and financial factors). In addition, using a trust can provide income and GST tax benefits, and you can structure the trust so that it gives your beneficiaries significant (although not total) control.
Sell/Loan Assets to Trusts While Interest Rates Are Low
If giving away a significant amount of wealth makes you uneasy, but you still wish to take advantage of current gifting opportunities, you may consider selling or loaning property to a trust for the benefit of your family members. As long as the transferred asset appreciates more than the interest rate you charge, you will have removed the future appreciation from your taxable estate while maintaining the current value of the asset for yourself. For this reason, this approach is often called an “estate freeze” technique.
These techniques are especially attractive given today’s interest rates. The IRS just announced the following minimum rates for October: 0.16% for short term loans of less than 3 years; 1.19% for mid-term loans between 3 and 9 years; and 2.95% for loan terms exceeding 9 years. These are the lowest rates in history.
Under this approach, you would sell assets to a trust (or lend money to the trust) and take back a note at a minimal interest rate. The trust could be structured in such a way that a sale of assets does not trigger any income taxes as a result of the sale. At the end of the loan term, any appreciation in excess of the interest rate remains in the trust for the benefit of your family members.
GRAT Interest Rate Lowest in History
Like the sale technique discussed above, the GRAT (Grantor Retained Annuity Trust) is another gift tax-efficient mechanism to shift future wealth to your heirs. Under this strategy, you would create a trust under which you would retain the right to receive annual annuity payments for a fixed period (usually two to five years). After the annuity payment period expires, your interest in the trust would terminate, and your family members (or a trust for their benefit) would receive the balance free of gift tax.
The October interest rate used for GRATs dropped to an all-time low of 1.4%, making it easier than ever before to transfer wealth through the use of this mechanism. For example, if you transfer a $1 million asset to a three-year GRAT, and that asset appreciates 15% annually over the three year period, your heirs will receive approximately $350,000, free of any gift tax, and you will have received approximately $1,030,000 back in distributions.
There are several downsides to a GRAT, including the inability to allocate your GST exemption to the gift (meaning that distributions to your grandchildren from the resulting trust could incur a tax), and that you must survive the term in order to realize any tax benefits. In addition, several bills severely limiting the effectiveness of GRATs have been proposed in Congress.
Under the right circumstances, however, the GRAT can be an ideal way to transfer significant wealth to your heirs with very little downside risk.
Annual Exclusion Gifts
Even if you do no other planning this year, please be sure to use your 2011 annual exclusions. Under current law, you may give $13,000 per person, or $26,000 if you are married, to or for the benefit of any number of beneficiaries. Annual exclusion gifts do not reduce your gift and estate tax exemptions, and can be made directly to your beneficiaries, or indirectly through trusts or college savings plans. In addition, you may pay tuition or medical expenses on behalf of a beneficiary without any gift tax consequence, as long as the payments are made directly to the school or medical provider.
Time to Act
The confluence of increased tax exemptions, low asset values and low interest rates make this the ideal time to consider gifting strategies. The increased estate, gift and GST tax exemptions are scheduled to sunset at the end of 2012 and legislation may soon limit the effectiveness of GRATs. With the uncertainty in Washington, the future of the tax system is anyone’s guess. What we do know for certain, however, is that these opportunities are available now.