The Tax Relief, Unemployment Insurance Authorization And Job Creation Act, signed into law in December 2010, provides some magnificent short-term planning opportunities, particularly for those who would like to make substantial gifts in 2011 and 2012. For two years only, the Act increases the gift, estate and generation-skipping tax exemption to $5 million while reducing the respective tax rates to a relatively low 35%.
What the 2010 Tax Relief Act does not do, however, is provide any long-overdue permanence in the transfer tax arena. Simply put, from today’s vantage point, it is impossible to know what the law will be on January 1, 2013.
If Congress fails to act before 2013, affluent families will find themselves facing a return of 2001 transfer tax law, with exemptions limited to $1 million and rates as high as 55%. Alternately, Congress might enact a more liberal regime – or perhaps repeal the estate tax altogether. In the face of this continued uncertainty, advisors are urging clients to return to fundamentals. The mantra is, “Look to your personal objectives first, not the tax law.”
“The elective repeal of estate taxes in 2010 and the increased exemptions in 2011 have moved clients and their advisors away from tax minimization formulas and toward non-tax-driven wealth transfer planning,” says Raymond C. Odom, director of wealth transfer services for Northern Trust in Chicago. “The old way of thinking was, ‘You can’t give away more than the exclusion amount because you’re going to be heavily taxed.’ The new thought is, ‘If you want to give, you shouldn’t be intimidated by tax law because the tax law might change.’”
This does not mean clients should avoid seeking sophisticated tax advice. Even the new law is not without its perils. For example, many commentators have noted the potential for clawback, the possibility that gifts in excess of $1 million made in 2011 and 2012 might be taxed in the estates of decedents who die in a year when the estate exemption is less than $5 million.
Goal-Based Wealth Transfer Planning
The Act’s creation of a two-year tax exemption window coming off a year when estate taxes were completely repealed has some subtle implications. “On one hand, you can give away $5 million over the next two years and not worry about the appreciation from those gifts being subject to transfer tax in the future,” Odom says. “On the other hand, since executors could opt out of estate tax in 2010, some clients may say, ‘I’m not in a rush – the $5 million exemption today may be increased to a $10 million exemption tomorrow, or perhaps the tax might even get repealed.’”
As tax law constantly changes, the wiser strategy is to make wealth transfer decisions because they align with personal goals rather than unknown future tax law.
A married individual in a second marriage with $40 million in assets might desire to transfer wealth to adult children from a first marriage. “Now could be a great time to make a gift to the children from the first marriage and eliminate the ‘expectation tension’ between the second spouse and the children,” Odom says. A married couple, together, can transfer $10 million to family or friends in 2011 and 2012. The remaining $30 million could then be earmarked for the surviving spouse alone. “Now everyone is a little happier,” he says.
Identifying personal goals and intentions – and selecting the right techniques based on them – is even more crucial when passing wealth to grandchildren and great-grandchildren through generation-skipping transfers, says Hugh Magill, Northern Trust’s chief fiduciary officer. Considerations include:
- Whether the recipients are mature enough that the wealth won’t rob them of self-initiative or the desire to continue their education;
- Whether transfers will hurt relationships between the grandchild and his or her parents; and
- How transfers may influence successive generations in the future.
“Too often, trusts are drafted with the standard language found in a trust form book, which doesn’t reflect the personal views of the grandparents,” Magill says. “The more trusts can reflect the grandparents’ view, the more effective they will be in ensuring the wealth achieves its purpose.”
Stretching Your Tax Exemption
If you have assets in excess of $5 million, you can maximize the effectiveness of your gifting strategy by employing techniques to stretch the gift, generation-skipping and estate tax exemptions. Magill advises beginning with techniques that do not use the $5 million tax exemption:
- Annual exclusion gifts: Everyone can transfer up to $13,000 a year to as many recipients as they choose. Together, a married couple can transfer $26,000 to a recipient; one married couple can transfer $52,000 to another married couple.
- Qualified tuition and medical transfers: You can pay for qualified medical expenses (including health insurance and long-term care insurance premiums) and tuition without using any gift or generation-skipping transfer tax exemption if you make the payments directly to the provider.
It’s also a prime time to transfer assets with depressed values, such as real estate. “If you think your property will have a value that is two to three times more than its current value – and you don’t need it and want to transfer it to your beneficiary – then it’s an ideal time to do that,” Odom says.
Likewise, shares of stock in a family company that has gone through some challenges during the recession also may have a lower value right now, Magill says.
The current low-interest rate environment makes certain techniques particularly tax-efficient, says Grace Allison, tax strategist for Personal Financial Services at Northern Trust. For instance, if you have a concentration of stock in a family-owned business that you want to give to your child, but you still need some cash flow from it, you might consider a bargain sale. Today’s interest rates are so low that you could loan your child the money to purchase the stock, charging him or her a tax-approved rate that is still relatively minimal.
Charitable lead annuity trusts also take advantage of the current low interest-rate environment. “They allow you to fund gifts to charity and pass on wealth to children,” Allison says. “With this type of trust, an annuity interest goes to your chosen charity, which could be a private foundation that your family uses to pre-fund charitable donations. Or, you could set up a private foundation that your kids control, enabling them to be active in the philanthropic community.” After a specific number of years, the remainder of the trust goes outright to children or to a new trust for the children. Because gifts are in the future – and because current interest rates are so low – the current (and taxable) value of that remainder interest is minimal.
Another technique to stretch the gift or generation-skipping tax exemption is the creation of a family limited partnership or limited liability company into which assets are transferred, Magill says. Interest in the company or partnership can be gifted to a trust for grandchildren, for example. Since the asset being transferred is not a marketable asset, the transfer may be eligible for certain valuation discounts for lack of marketability and being a minority interest.
But Magill cautions that these types of planning techniques must be used very carefully because the IRS may question the transfers as a substitute for transfers of the underlying property.
Estate Planning Considerations
The 2010 Tax Relief Act also dictates the need – particularly for those with estates of $10 million or less – to reassess what beneficiaries will receive at your death.
Existing estate planning documents likely contain formulas based on pre-2010 rules, which don’t take into account the significant increase in tax exemptions. “There is a danger that existing formulas will lead to results that the client did not intend,” Allison says.
For instance, a woman with an estate worth $10 million might have estate-planning documents drafted at a time when the generation-skipping tax exemption was $3.5 million. Under those documents, a generation-skipping trust would be created for her grandchildren at her death, to be funded with “an amount equal to the GST tax exemption.” If she dies in 2011 or 2012, instead of giving $3.5 million to her grandchildren, she would give $5 million – 50% of her estate – to them.
As a second example, consider a man with estate-planning documents drafted many years ago when his estate was valued at $12 million. He hasn’t reviewed the documents since he remarried, and the value of his assets has since decreased to $5 million. Within the original document are instructions to create a credit shelter trust for the benefit of his descendants – children from the first marriage – and a qualified terminable interest property (QTIP) trust for his surviving spouse. If the man were to die in 2011 or 2012, all $5 million in assets would go to the credit shelter trust for the children, with nothing to the marital trust for the spouse.
“In blended families where assets have decreased but exemptions have increased, or with estates of $10 million or less, the tax law changes can create formula problems,” Allison says.
For couples transferring wealth at death, the Act also includes portability of the unified gift and estate tax exemption for those who die in 2011 or 2012. Under prior law, a married couple would lose the benefit of the first-to-die’s available estate tax exemption if the exemption exceeded the first-to-die’s taxable estate. Under the new law, if the first-to-die spouse dies in 2011 or 2012, his or her unused exemption can pass to the surviving spouse. The surviving spouse can make gifts with the first-to-die spouse’s unused exemption in 2011 or 2012, or use it to increase available estate tax exemption – if he or she dies before 2013 when the new law expires.
What the Act doesn’t do is eliminate the need for an estate plan. “It’s unwise to conclude that because you have a $5 million exemption and don’t have assets in excess of $5 million, you don’t need an estate plan,” Allison says. “The purpose of an estate plan is to see that assets are disposed of in the way you intend.”
The 2010 Tax Relief Act offers a variety of new opportunities and advantages for transferring wealth both during life and at death. But keep in mind that the new law doesn’t undermine the need to plan strategically and consult your financial advisors for guidance.