Significant tax law changes are scheduled to take effect on January 1, 2013. Individuals should take advantage of unprecedented opportunities to transfer up to $5.12 million ($10.24 million for married couples) to family members (or others) free of federal gift tax and federal generation-skipping transfer (“GST”) tax.
The Economic Growth Tax Reconciliation and Relief Act (EGTRRA) is scheduled to sunset on December 31, 2012, ending Bush-era tax cuts. EGTRRA was originally scheduled to expire on December 31, 2010; however, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (Tax Relief Act) extended EGTRRA. The Tax Relief Act also increased the Applicable Exclusion Amount (AEA) for the federal gift and estate tax and the exemption amount for the federal GST tax.
Pursuant to the Tax Relief Act, the AEA for federal gift and estate tax purposes is $5.12 million ($10.24 million for married couples) for the remainder of 2012, and amounts transferred in excess of the AEA are subject to a 35 percent tax rate. However, the AEA is scheduled to fall to $1 million in January 2013, and amounts transferred in excess of such exclusion amount will be subject to a top tax rate of 55 percent (estates greater than $10 million will be subject to an additional five percent surcharge).
Additionally, the GST tax law, which assesses a tax on transfers to grandchildren and more remote generations, is scheduled to revert to pre-Bush-era law. Pursuant to the Tax Relief Act, for the remainder of 2012, the GST tax exemption amount is $5.12 million, and amounts transferred in excess of such exemption amount are subject to a 35 percent tax rate. However, the GST exemption is scheduled to fall to $1.43 million ($1 million indexed for inflation) in January 2013, and amounts transferred in excess of such exemption amount will be subject to a top tax rate of 55 percent.
Therefore, December 2012 presents a limited window of opportunity for individuals to make large gifts free of any federal gift and GST tax. Gifts may be made outright; however, certain strategies can maximize the tax savings opportunities.
The following highlights some estate planning strategies frequently used to leverage opportunities available under the current federal gift, estate and GST tax law.
Irrevocable Life Insurance Trusts (ILITs): ILITs are formed for the purpose of acquiring life insurance on the grantor’s life. Because the ILIT owns the life insurance, for federal estate tax purposes, the death benefit will be outside the grantor’s estate upon his or her death.
During the grantor’s lifetime, he or she may make gifts to the ILIT that, in turn, the trustee will use to pay the life insurance premiums. The ILIT will be structured so that gifts to it qualify for the Annual Gift Tax Exclusion (currently $13,000 per donee for a single person and $26,000 per donee for a married couple). Gifts to the ILIT in excess of the Annual Gift Tax Exclusion will use part of the grantor’s $5.12 million AEA for federal gift tax purposes to offset any gift tax. At the time of the grantor’s death, the death benefit will pass to the ILIT beneficiaries free of any federal estate tax.
As a result, the current AEA and GST tax exemption amounts offer individuals a significant opportunity to make large upfront premium payments to the ILIT free of federal gift and GST tax.
Grantor-Retained Annuity Trusts (GRATs) And Qualified Personal Residence Trusts (QPRTs): GRATs are particularly effective estate planning tools in the current economic climate where interest rates and asset values are generally low. When creating a GRAT, the grantor makes a gift to the GRAT in exchange for an annuity for a set term of years. The value of the grantor’s gift is equal to the value of the remainder interest in the GRAT when the GRAT is funded. Ideally, the gift of the remainder interest should be as small as possible so that the grantor minimizes use of the federal gift tax AEA. At the conclusion of the GRAT term, leveraging of the AEA is realized when the appreciation of the assets in the GRAT (i.e., the amount in excess of the IRS “hurdle rate” set at the time of the GRAT’s creation) passes to the beneficiaries, free of any additional federal estate or gift tax. For the GRAT to be effective, the grantor must survive the term of the GRAT. If the grantor dies during the term, the assets in the GRAT are includable in the grantor’s estate for federal estate tax purposes.
The Obama administration proposed certain limitations on GRATs that may significantly reduce the effectiveness of this strategy. For instance, the administration proposed introducing a law that would require all GRATs to have at least a 10-year minimum term, which would prevent the use of short-term rolling GRATs (short-term GRATs lessen the risk of the grantor dying during the term and can be very effective in moving highly appreciating assets to the next generation). The administration also proposed introducing a law that would disallow zeroed-out GRATs, where the value of the remainder interest (the measure of the gift) at the time of the GRAT’s creation is zero. This change in the law would result in a gift at the time the GRAT is created and, thus, the grantor would most likely be forced to use part of his or her AEA. The administration also proposed limiting the ability to use valuation discounts for lack of marketability and minority interest for transfers between family members, which would dramatically affect the valuation of assets transferred to GRATs (as well as other planning strategies).
Similar to GRATs in operation, QPRTs may be an attractive option for individuals owning a high-value personal residence or vacation home. The QPRT involves the grantor transferring his or her personal residence or vacation home to the QPRT and retaining a right to live in the property for a term of years. Upon the expiration of the term, the property passes to the children (outright or in further trust). The grantor may then lease back the property, thus still getting the use of it but having removed it from his or her estate.
Intentionally Defective Grantor Trusts (IDGTs): Like GRATs and QPRTs, IDGTs are “estate freeze” strategies that freeze the value of contributed assets. Through a combination of gifting and selling assets to an IDGT, the grantor may remove assets from his or her estate for federal estate tax purposes yet continue to be treated as the owner of the transferred assets for federal income tax purposes. As a result of this contrast in treatment, the grantor (not the IDGT) recognizes the IDGT’s taxable income during the grantor’s lifetime (essentially, tax-free gifts to the trust beneficiaries); however, at the grantor’s death, the assets in the IDGT pass to the beneficiaries free of any federal estate tax. The grantor trust status also eliminates capital gains tax on the initial sale of the assets to the IDGT because the grantor is treated as having sold assets to him or herself.
The mechanics of the IDGT involve the grantor prefunding it with “seed money” (typically, 10 percent of the amount to be sold) and, thereafter, selling business interests (or other assets likely to substantially appreciate) to the IDGT in exchange for a promissory note. After the sale, the value of any remaining balance on the promissory note is included in the grantor’s estate for federal estate tax purposes; however, the business interests (or other assets) and any appreciation thereon above the IRS “hurtle rate” are not included in the grantor’s estate for federal estate tax purposes. Such assets instead pass to the remainder beneficiaries free of any additional federal gift or estate tax.
As with GRATs, the Obama administration proposed certain limitations that would diminish the effectiveness of IDGTs and other grantor trusts. For instance, the administration’s proposal would include the assets of a grantor trust in the grantor’s gross estate for federal estate tax purposes, subject to federal gift tax any distribution from a grantor trust to beneficiaries during the grantor’s lifetime, and subject to federal gift tax assets remaining in a grantor trust if the grantor (during lifetime) ceases being treated as the trust owner for federal income tax purposes. The administration’s proposal to limit the use of valuation discounts (described above regarding GRATs) would also dramatically affect the valuation of assets gifted and sold to IDGTs.
Dynasty Trusts: Dynasty trusts are designed to exist for multiple generations and, in some instances, in perpetuity. A dynasty trust can exist in the form of, inter alia, an ILIT or an IDGT. It is a very powerful strategy in that it leverages not only the federal gift tax AEA, but also the federal GST tax exemption amount.
A typical dynasty trust involves the grantor gifting assets to the trust using part or all of his or her federal gift tax AEA (to offset gift tax) and allocating part or all of his or her GST tax exemption to the amount gifted (because such assets will benefit multiple generations). After the exemption is allocated to the gifted assets, all such assets, including any appreciation thereon, will be forever sheltered from GST tax. In addition to the tax advantages, assets held in a dynasty trust can be protected from beneficiaries’ creditors for multiple generations.
The Obama administration proposed limiting the use of the GST tax exemption amount to 90 years.
Spousal Lifetime Access Trusts (SLATs): SLATs are designed to address the concern individuals might have regarding losing future access to assets gifted to an irrevocable trust. A SLAT involves a grantor-spouse creating an irrevocable trust for the benefit of a beneficiary-spouse, typically also naming their descendants as additional beneficiaries. The terms of a SLAT will provide the beneficiary-spouse with access to the gifted assets pursuant to certain distribution standards; the beneficiary-spouse may then use those assets for his or her benefit or for the benefit of the grantor-spouse. The assets are contributed to the SLAT utilizing the federal gift tax AEA, and the assets remaining in the SLAT would not be subject to federal estate tax in either spouse’s estate at the time of death. Moreover, each spouse may allocate his or her GST tax exemption to the contributed assets to protect such property for future generations.
Each spouse could create a SLAT for the benefit of the other spouse, with sufficiently distinguishable terms so as to avoid the “reciprocal trust doctrine” (which prevents individuals from creating identical or nearly identical trusts for the benefit of each other with the effect of escaping taxation under the precise language of the tax law).
The manner in which the federal estate tax is calculated creates the potential for what has been referred to as “clawback.” Specifically, upon death, to calculate the federal estate tax, all lifetime gifts are pulled back into the donor’s estate for federal estate tax purposes; however, only the AEA for federal estate tax purposes in effect at the time of death (and not the prior AEA for federal gift tax purposes) is used to offset any tax generated.
Many commentators believe that clawback is an unintended result of the legislation, and they predict that a technical correction will be made to the law to eliminate it. In any event, even if clawback applies, clients may still benefit by making large gifts in 2012 because doing so freezes the value of the gifted assets at the 2012 value – i.e., any increase in the value after the date of the gift (quite possible, given the current economic climate) would avoid federal estate tax in the donor’s estate.
The time to act is now. Significant changes in the tax law are scheduled to take effect on January 1, 2013. What remains of 2012 may present a once-in-a-lifetime opportunity for individuals to transfer up to $5.12 million ($10.24 million for married couples) completely free of any federal gift and GST tax. Also, a number of estate planning strategies might soon lose some or all of their effectiveness if the Obama administration’s proposals become law.
As year-end rapidly approaches, individuals should make their Annual Gift Tax Exclusion gifts for 2012. The 2012 exclusion allows each individual to give $13,000 ($26,000 for married couples) to an unlimited number of individuals without triggering federal gift (and GST) tax consequences. The Annual Gift Tax Exclusion is noncumulative, meaning that any unused exclusion does not roll over to following years. For 2013, the Annual Gift Tax Exclusion is scheduled to increase to $14,000/donee ($28,000 for married couples).
Interested individuals should be seeking advice regarding these unique and time-sensitive estate planning opportunities before it is too late.
Russell J. Ressler is the Chair of the Trusts, Estates & Personal Planning practice group at Stradley Ronon Stevens & Young, LLP.