We are approaching one of the most important—and unusual—year-ends in memory. Income tax rates are set to rise dramatically. The federal estate and generation-skipping transfer taxes, after a one-year suspension, are about to reappear with a vengeance. The economy remains choppy; interest rates are at historic lows; and the midterm congressional elections augur fundamental political changes— or even greater gridlock. All of this change and uncertainty create big headaches for investors, business owners and families who want to preserve their wealth.
Our prescription to remedy the migraine? Remember the three “Ps”:
- Don’t Panic
- Don’t become Paralyzed.
While there are many issues, we see meaningful opportunities for savvy taxpayers during the remaining days of 2010. This alert spotlights key 2010 year-end tax planning points—both expiring tax breaks and techniques for softening future blows.
- Income tax rates are set to increase in 2011.
Unless Congress acts, the top federal tax rate on ordinary income (such as compensation, interest and rents) will rise from 35% to 39.6% on January 1. The top federal tax rate on long term capital gains will increase from 15% to 20%. Most dramatically, dividends will once again be taxed as ordinary income, resulting in a rate increase from 15% to 39.6%! Tax rates are being hotly debated, but the reality is that the federal government desperately needs revenue. From 2001 through 2009, federal budget deficits totaled approximately $3.5 trillion and the government is forecasting an additional $2.7 trillion in deficits through 2011. Mandatory spending, such as Social Security and interest on the federal debt, makes up approximately 60% of the budget, so it is unlikely that spending cuts will have a meaningful impact on deficits.
Consider the following strategies to deal with the rise in rates:
- Accelerate income into 2010.
If you have the opportunity to decide when to take income, think about recognizing it in 2010 when rates are lower. Discretionary bonuses, distributions from retirement plans, exercising stock options—wherever you have the ability to control the timing of income recognition—you should consider doing that now. To the extent you have a regular IRA or qualified plan, you should consider converting some or all of that IRA or plan to a Roth IRA.
Whether or not to accelerate income is a complicated decision. Studies show that the longer income tax is deferred, the better off you are, even if rates are higher in future years. On the other hand, if there are funds that you will need over the next few years, taking those funds into income and paying the tax now may be a good course of action. Nonetheless, it’s important to “crunch the numbers” with your legal, accounting and tax advisors to decide the right course.
- Pay dividends in 2010.
If you own stock of a C corporation (or a subchapter S corporation with accumulated earnings), think about declaring a dividend before year-end. Consider taking income in that fashion rather than paying yourself additional salary or a bonus. Since dividends are taxed at only 15% in 2010, this could be your last opportunity to extract funds from your business at this low rate.
- Take capital gains this year.
If you have unrealized capital gains, consider taking them before yearend— but only if harvesting gains makes sense as an investment strategy. If you are considering or are in the process of selling a business, do your best to close the deal by December 31 to take advantage of the historically low 15% capital gains tax rate.
- Estate tax returns in 2011.
On January 1, the federal estate tax comes back into the law, with a top tax rate of 55% and an exemption of only $1 million per decedent. Compare this with 2009, when the top rate was 45% and the exemption was $3.5 million per decedent. This dramatic tax increase creates powerful incentives to engage in sophisticated estate planning (assuming you intend to survive 2010).
- Think about creating GRATs.
As we’ve discussed in prior alerts, a GRAT is a trust, specifically allowed by the tax law, in which you contribute assets and receive an annual payment stream for a period of years. The value of the payment stream roughly equals the original gift plus a "hurdle rate" set by the IRS, resulting in a very, very small taxable gift (literally a few dollars in most cases). If the assets in the trust grow at a higher rate than the IRS-established hurdle rate, the excess assets pass to your beneficiaries without any estate or gift tax. Because interest rates are so low, the hurdle rate is also at an historic low (only 2%, for GRATs created in November). GRATs are a wonderful way to transfer appreciating assets (such as interests in a valuable business, or securities and real estate that are temporarily depressed in value because of the current economy) at virtually no gift tax cost.
Because GRATs are such a powerful planning tool, tax writers have proposed limits on GRATs. In fact, the House of Representatives passed a bill requiring a 10-year minimum GRAT term. (The Senate hasn't passed it, at least as of this alert's publication). President Obama is scheduled to discuss tax changes with Congressional leadership during the "lame duck session" on November 18. While continued gridlock may result, a quickly negotiated compromise—possibly including the GRAT restriction as a revenue raiser—remains a possibility.
A 10-year minimum term would make GRATs more risky, because the creator of the GRAT must survive the GRAT term for the strategy to succeed. So you should be thinking about creating GRATs now.
- Consider making annual gifts before the end of 2010.
You can give up to $13,000 per year ($26,000 for married spouses) to each family member or other individuals you select. By making a set of gifts before the end of 2010 and another set at the beginning of 2011 you can “double up” on the estate and gift tax savings created by annual gifting. You can also still make gifts in unlimited amounts to pay for tuition and medical expenses of another individual so long as you make the payments directly to the school or medical provider.
- Consider more complex strategies.
Think about sales to grantor trusts and charitable gift planning. Consider split dollar insurance arrangements and other insurance related strategies to create funds to pay estate taxes in a tax efficient way. Any or all of these strategies may be limited or eliminated if and when Congress and the President finally get around to dealing with the estate tax on a permanent basis.
- Consider making large taxable gifts in 2010.
Unlike the federal estate tax, the gift tax remains in effect during 2010— but at a maximum rate of 35%, as compared to a top rate of 45% during 2009 and a scheduled top rate of 55% in 2011. Making taxable gifts now also shelters any future appreciation and, in many cases, the gift tax paid from estate taxes, saving the donor's family even more money.
You should consider structuring taxable gifts of property as “net gifts,” so that the recipients, rather than the donor, pay the gift taxes. That strategy reduces the effective gift tax rate from 35% to 26%.
- Think about generation-skipping planning.
There is no generation-skipping transfer (GST) tax in 2010 for transfers to grandchildren or more remote descendants. The GST tax returns on January 1, 2011, together with the estate tax, at a rate of 55%. Thus, there is an extra incentive to make taxable gifts to grandchildren this year, since such gifts bear a reduced gift tax rate and completely avoid the onerous second level GST tax.
While outright gifts to adult grandchildren are "safe" from a GST tax perspective, you should be very careful about creating trusts for grandchildren this year. Although there will not be a GST tax in 2010 on gifts in trust, post-2010 distributions from trusts to any "skip person" (a grandchild, greatgrandchild, etc.) could get hit by the GST tax. It's simply not clear right now. Be sure to speak with your advisors before making such gifts.
There is still time to take advantage of the opportunities available in 2010, but the clock is ticking. You should consult with your tax advisors as soon as possible so that you will be able to select and put into effect the right strategies for you.