Now that the Presidential Election is behind us, the talk everywhere – from inside the Beltway to around our kitchen tables – has turned to the “fiscal cliff.” One driver toward that “cliff” is the sunset on December 31, 2012, of the Bush-era tax cuts within the Economic Growth and Tax Relief Reconciliation Act of 2001, as extended by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. For months, the financial news media has been reporting on the looming tax increases and touting strategies to capture the benefits of the favorable tax laws before they disappear. But many individuals have held off doing anything significant because they are unwilling to take the risks that some of the strategies entail, hopeful that high exemptions and low rates will stay in place, reluctant to give up control over substantial assets, or simply waiting to see who will occupy the White House and Congress before choosing a course of action.
With a variety of tax measures scheduled to expire at the end of 2012, this advisory will focus solely on the changes impacting federal estate and gift taxes, highlighting those factors that individuals concerned about the burden of future estate tax should consider when deciding whether to take action now, so transfers can be completed before the end of the year.
CURRENT TAX AND ECONOMIC ENVIRONMENT
The current structure of the estate and gift tax, as well as recent economic conditions, favor making gifts this year for the following reasons:
- High Lifetime Exemption.
The individual lifetime exemption for gifts increased to $5.12 million in 2012 ($10.24 million for a married couple). The $5.12 million amount is scheduled to expire at the end of 2012 and return to $1 million. If that occurs, some portion of the $5.12 million exemption available in 2012 may be “wasted” if not used to make gifts before the end of the year. The Obama Administration proposed a return to a $3.5 million estate tax exemption ($7 million per married couple), but some pundits believe both Congress and the Administration could agree to extend the $5.12 million estate tax exemption beyond the end of 2012. The gift tax exemption may be treated differently, however. No one can predict what the two branches will actually do.
- Valuation Discounts.
Current gift and estate tax law allows appraisers to utilize valuation discounts for assets such as partial interests in real estate and interests in closely-held business entities. Legislation has been proposed to restrict or eliminate the use of discounts in the future. If such legislation passes and it is not retroactive, there would be a benefit to making gifts of such assets this year.
- Depressed Values of Certain Assets.
Certain real estate, closely-held business interests, or other assets continue to reflect depressed values due to economic conditions over the past few years, but nevertheless have good long-term growth prospects. These assets may be ideal for gifts.
- Low Interest Rates.
Some gift strategies involve “leverage.” Instead of making a gift of, for example, one million dollars, a parent might sell a $10 million asset to a trust for the benefit of children in return for a $9 million installment note. Although there would still be a $1 million gift taking place, all earnings and growth on the $10 million of assets is removed from the estate except that which is needed to pay interest on the note. The lower the interest rates, the more value can be transferred using techniques like this.
OVERALL ADVISABILITY OF GIFTS
Despite the favorable conditions described above, there are some important countervailing factors to consider.
One factor is the income tax treatment of gifts. Under current law, there is a significant difference in the treatment of income tax basis between lifetime non-cash gifts and transfers at death. A gift of an asset results in the recipient keeping the donor’s original cost basis. The same asset retained until death receives a “step-up” in basis to the asset’s value on the date of death. Thus, the gift of an appreciated asset carries with it a potential capital gains tax for the donee of the gift. In contrast, if the donor retained the appreciated asset until death, there would be no capital gains tax to pay upon a sale at date-of-death value. This year’s 15 percent long-term capital gains tax rate is scheduled to expire at the end of the year, which means a potentially higher tax bill in the future.
Second, there has been speculation that those who make gifts of the full $5.12 million could face an extra tax at death that “claws back” the benefit obtained. The 2010 Act is less than clear on this point; however, members of Congress have stated that no such claw back was intended. Nevertheless, because of the way estate tax calculations worked on instructions from prior years’ estate tax returns, some have suggested that the estates of decedents who make large lifetime gifts in 2011 and 2012 could find they owe additional estate tax to compensate for the zero gift tax that was payable when the transfers occurred. If the exemption drops dramatically and the claw back comes to pass, a taxpayer would be no worse off for having tried to benefit from the $5.12 million exemption – the gifted assets would have been subject to estate tax anyway and lifetime gifts would still exclude future appreciation from the tax base – so long as sufficient assets remain in the estate to pay the extra tax. If, on the other hand, the exemption holds steady or only drops slightly, the taxpayer’s family could lose the benefits of the basis step-up described above for having tried to capture the $5.12 million exemption this year.
Most importantly, no one should make gifts so large that they would disrupt needed cash flow or jeopardize long-term financial security. Therefore, in addition to accepting the risks outlined above, you should make significant gifts only if: (1) you want your children or other heirs to benefit from potential estate tax savings, (2) you know your children well enough that you are comfortable making transfers for their benefit at this time, whether outright or in trust, (3) you are confident that your estate is larger than you could foreseeably need during your lifetime, (4) you understand that Congress may act to keep the estate tax exemption at $3.5 million or more, and (5) you are comfortable with the expense and complexity that this type of planning may entail.
Planning will need to move forward quickly in the month of November. In particular, gifts of assets other than marketable securities will need high quality professional appraisals. The overall design of any gift transaction, including the terms of trusts to receive gifts, will need to be fleshed out in the very near future.