On December 17, 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the "2010 Act") was signed into law, making significant modifications to the estate, gift and generation-skipping transfer ("GST") taxes. The 2010 Act:
- reduced the estate, gift and GST tax rates to 35%.
- increased the estate tax exemption from $3.5 million to $5 million.
- increased the GST tax exemption from $1 million to $5 million.
- reunified the estate and gift tax exemptions so that an individual can gift up to $5 million during life.
Unfortunately, these favorable provisions of the 2010 Act will remain in effect only through December 31, 2012, when the act is scheduled to sunset. Unless the law changes, in 2013, the law reverts to the 2001 law, and the top gift and estate tax rate will be 55% and the estate and gift tax exemptions will be $1 million. In addition, the GST tax rate will revert to 55% and the GST tax exemption will be $1 million (indexed for inflation). Moreover, certain favorable provisions in the GST tax laws that were enacted in 2001 would no longer apply. Thus, you may wish to consider one or more of the following planning techniques before the current law expires at the end of 2012.
Use Your Exemption to Make Non-Taxable Gifts
With the increase in the gift tax exemption from $1 million to $5,120,000 per person ($5,000,000 adjusted for inflation), you now have the ability to reduce your estate by simply making direct gifts to your descendants or anyone else you wish to benefit (or to trusts for your descendants or anyone else, as discussed below). In fact, a married couple can gift $10,240,000 to their descendants without paying gift tax. Even if you used your entire gift tax exemption in prior years when it was limited to $1,000,000, the additional $4,120,000 increase in the gift tax exemption is available to you ($8,240,000 for a married couple).
Additionally, in the event that you made loans to your children or grandchildren, you may wish to use your gift tax exemption to forgive those loans.
Making gifts during life not only reduces your estate by the amount gifted, but also by all the appreciation on that gift over time. For example, if you make a $5 million gift this year and die twenty-five years from now, the value of that gift, including appreciation, will be over $21 million, assuming 6% growth (or over $10 million, assuming only 3% growth).
Gifts in Trust
Although it is simple to make a direct gift of cash or marketable securities to various individuals, there are many advantages to using the current exemption amounts to make gifts of property in trust instead of outright gifts to individuals. Gifts to trusts for the benefit of your descendants allow you to allocate your GST tax exemption to that trust. Allocating your GST tax exemption to the trust enables the funds in the trust, plus all future growth, to pass to your descendants without the imposition of any estate or GST tax at each beneficiary's death.
Gifts in trust also provide an additional opportunity for the trust's income to be taxed to you instead of to the trust or the trust beneficiaries. This lets you, in essence, make additional tax-free gifts to the trust of the amount of the tax that the trust otherwise would pay. This type of trust is known as a grantor trust.
Furthermore, gifts in trust are protected from claims by the beneficiary's creditors, including spouses, and ensure that the assets do not pass outside the family bloodline. These benefits apply at every generation for the longest period allowed under law.
Leveraging Your Gifts
Leveraging your gift tax exemption provides you the opportunity to get more bang for your buck from your gift. For instance, an alternative to making a gift of cash would be to form a partnership or limited liability company ("LLC") and give away part of that partnership or LLC to a trust for the benefit of your descendants. The advantage of gifting interests in a partnership or LLC is that such interests may be able to be valued in such a way that discounts would be available on account of the gift being a minority interest in the partnership or LLC and/or due to restrictions on transfer in the partnership or LLC agreement. Assuming a 30% discount, a gift of a partnership or LLC interest with an underlying value of $14 million would still be under the $10,240,000 combined gift tax exemption of you and your spouse. Additionally, as mentioned above, GST tax exemption could be allocated to the trust, enabling both the interest transferred to the trust, and all future growth to pass to your descendants without the imposition of any estate, gift or GST tax.
Tax Rates for Taxable Gifts (those above the $5 million exemption amount)
In 2012, the gift tax rate is 35%. In 2013, that rate is scheduled to revert to 2001 rates (ranging from 41% to 55% for gifts over $3 million). Thus, to the extent that you wish to make taxable gifts (those in excess of $5,120,000, the current individual lifetime gift exemption), you may wish to consider making such gifts this year. In addition to paying tax at a lower rate, the gift tax paid is removed from your estate (assuming you live for three years or more from the date the gift is made) and all the appreciation on the gifted asset is removed from your estate.
By way of example, a gift of $5 million made in 2012 by an unmarried individual who had used his $5 million gift tax exemption in 2011 would result in a gift tax payable of $1,750,000. In 2013, the same $5 million dollar gift would result in a gift tax payable of $2,750,000. Moreover, assume that the individual dies in 2020 and that there is 5% growth, the gift tax of $1,750,000 and the appreciation of $2,387,277 (compounded annually over eight years) would be removed from the estate tax-free.
Non-Reciprocal Trusts Created by Married Couples – Having Your Cake And Eating It Too
Let's suppose you really do not want to make a gift at this time, but you also do not want to waste the savings available by the increased exemption amount available in 2012. You can have your cake and eat it too by creating a trust for the benefit of your spouse. By doing so, the assets transferred to the trust (and any growth on those assets over time) would be removed from your taxable estate. However, if you need to use some of the funds in the trust, your spouse can simply receive a trust distribution. If you add your descendants as potential beneficiaries of the trust, the Trustee also could make a distribution to one or more of them, which will also occur free of gift tax. This flexibility would allow (but not necessarily require) distributions to be made to your spouse or descendants. Since trust distributions are not required, the funds also could accumulate in the trust and not be subject to any further estate, gift or GST tax. It is possible for each spouse to create trusts for each other, if desired.
Each spouse (the "grantor-spouse") would establish a trust for the other spouse (the "beneficiary-spouse"). The trusts would be mutual but would contain some differences to avoid the trusts being deemed "reciprocal," which could cause adverse estate tax consequences. For example, one trust would be for the benefit of the spouse and descendants, while the other trust would be only for the benefit of the spouse. Or the trusts can have different Trustees, with one beneficiary-spouse acting as sole Trustee of one trust and the other beneficiary-spouse acting with another individual as co-Trustees of the other trust. In addition, in one, but not both of the trusts, the spouse can be given a limited power to appoint trust property upon his or her death to any one or more of your descendants and charity.
The beneficiary-spouse can be Trustee of the trust for all purposes except to make distributions to himself or herself during the grantor-spouse's lifetime. During the grantor-spouse's lifetime, any such distributions to the beneficiary-spouse must be made by the non-spouse Trustee, and distributions for the beneficiary-spouse's "support" must be prohibited. However, the grantor-spouse may retain the power to remove and replace the non-spouse Trustee. After the grantor-spouse's death, the beneficiary-spouse, as Trustee, may make distributions to himself or herself for his or her support. If your descendants are also beneficiaries of the trust, either the beneficiary-spouse or the non-spouse Trustee may make distributions to your children, grandchildren and further descendants.
In addition, each trust would be structured as a "grantor trust" for income tax purposes. When a trust qualifies as a "grantor trust" for income tax purposes, all of the trust's income is taxed to the grantor, as opposed to the trust. In addition, even though the grantor pays income tax on the trust's income, any gifts to the trust by the grantor are complete for estate and gift tax purposes and, thus, the trust should not be included in your estates upon your deaths for estate tax purposes. The main benefit in structuring a trust as a "grantor trust" for income tax purposes is that the payment of income tax by the grantor on behalf of the trust should not be considered a gift for gift tax purposes. Therefore, if you pay income tax on income received by the trust, you would be removing additional assets from your estates. Because you would be in the 35% estate tax bracket, for every dollar of income tax you pay on behalf of the trust, an additional $.35 of tax is saved.
Upon the death of the survivor of both spouses, the remaining trust property would be divided into equal shares for your children (or your grandchildren) and held in continuing trusts for them. The terms of those trusts would mimic the terms of the trusts for your children (or grandchildren) in your revocable trusts or Wills. In addition, if you allocate your GST exemptions to the trusts, the property would be held in trust for the lifetime of your children, then grandchildren and future generations. Those trusts are sometimes referred to as "dynasty trusts" or "perpetual trust" because they continue in perpetuity. For as long as the assets are held in trust, there is no estate or GST tax imposed and the assets are protected from creditors. Accordingly, wealth can be transferred from generation to generation tax-free.
A Potential Pitfall: The Clawback
Some practitioners have raised the concern that if a donor uses the increased exemption of $5,120,000 during 2012, and, in 2013, that exemption is reduced back to $1 million, then, upon the death of the donor, there could be a potential clawback of the gifts made in excess of that reduced exemption when determining the estate tax owed by the donor's estate. However, there is nothing in the current law to suggest that the government would take this approach.
We feel that individuals should take full advantage of the current exemption amounts and rates while the opportunity is still there. Gifts always have the advantage of transferring future growth out of one's estate, in addition to removing the assets that have been transferred. We recommend that you contact your personal planning attorney to discuss the best way to utilize your increased exemption amounts.