Saturday, May 21, 2011

A Window of Opportunity

The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 which was passed and signed into law in December of 2010 gives affluent individuals a gift, estate and generation-skipping tax exemption of $5M for the tax years 2011 and 2012. On December 31, 2012, these exemptions are scheduled to expire. The new amounts going forward could be as low as $1M. At the same time, the present estate tax rate of 35% is scheduled to increase to a whopping 55%!

Savvy planners are telling clients that there is currently an 18 month "Window of Opportunity" to shift wealth to the next generation on an extremely tax advantaged basis.

  1. What happens if someone gives away $5M in 2011 and dies in 2013 when the estate tax is only $1M?

The answer is "We don't know?" The way the Tax Act was written in 2010 there is a possibility that Congress could attempt to "claw back" into the taxable estate gifts made in 2011 and 2012 that were in excess of the estate tax basic exclusion amount then in effect (i.e. $1M). Other commentators are convinced that this will not happen. The way we look at it, even if the claw back were to occur, the appreciated earnings of the gifted amounts would escape estate tax taxation at a potential 55% and the taxpayer would be no worse off if he or she had done nothing.

2. If I give my money away have I lost all control over the assets of the gift?

There are two basic ways one can make a gift: (1) outright; or, (2) in trust. Outright gifts are just that....a donor writes a check to a child and proceeds become the child's outright as soon as the check clears. The child can do whatever he or she wishes with the proceeds. Outright gifts are cheap and easy. But, they offer no asset protection or oversight of the gifted funds. A gift into a trust is a gift with strings attached to it. The donor can condition how the proceeds are to be used by placing the proceeds with a Trustee for the benefit of the child who is known as a beneficiary, i.e the one who "benefits" from the trust. A trust can be crafted to be as "liberal" or "restrictive" as the donor wishes. The main advantage to a gift in trust is that the proceeds can be protected from a beneficiary's predators, creditors and spouses. This asset protection of the gift is a huge benefit. It is even possible with proper drafting to make the donor one of a class of beneficiaries (the donor, the donor's spouse, the donor's children and grandchildren) of an Irrevocable Trust.

3. If I make a gift of appreciated securities doesn't the donee get the donor's income tax basis in the assets that are transferred?

If one's estate is less than $1M dollars there is no need to make gifts for estate tax purposes as the heirs will receive a "step-up" in the basis of the inherited property to the full fair market value as of the taxpayer's death. When one makes a gift of appreciated securities or real estate, the donee of the gift does get the donor's lifetime income tax basis along with the gift. That is why it is always better to gift cash than highly appreciated securities that would get the step-up at the time of the owner's death. Another option is to make a transfer of appreciated securities to what is known as an "intentionally defective grantor trust" a/k/a as an "IDGT". Why would anyone want a defective trust? It is a quirk in the tax code that one can make a gift for gift tax purposes of property transfered to an IDGT; but, for income tax purposes the donor continues to pay the income taxes on the property inside the IDGT. Why would a donor want to to do this? Because, every time the donor pays the tax on the IDGT it is the same as making a transfer for value to the grantor trust; but, the payment of the income taxes is NOT deemed to be a gift for gift tax purposes. In essence, the proceeds inside the IDGT can appreciate on a "tax free basis" because the IDGT is not paying the income tax on the growth inside the IDGT with its assets. If the Trustee of the IDGT sells stock, the capital gains tax on the sale is paid by the donor of the securities and reported on the donor's income tax return. Often the amount of wealth transferred in this manner will more than offset the capital gains taxes paid by the donor even if the children did not receive a "step-up" tax basis.

4. What is the effect of gifting to a "Dynasty Trust"?

When a donor gifts assets into a "Dynasty Trust" for the benefit of children, grandchildren and future children yet to be born by allocating their Generation Skipping Tax Exemption to such a gift, the benefit of avoiding taxes as each generational level is leveraged. If a taxpayer does not use one's Generations Skipping Tax ("GST") exemptions, the exemptions are generally wasted. The government gives these exemptions to everyone. It truly is a case of use it or lose it.

Let's say Taxpayer X does NOT use his GST exemption when he dies with a $5M estate in 2011. There will be no estate tax on the transfer of his wealth to his son Y at the time of his death . But, let us say son Y dies in 2013 when the estate tax rate is 55% over everything over $1M. The tax on the son's estate is 55% of $4M = $2,200,000; which in turn passes to Y's daughter Z. Z dies the following the year with a taxable estate of $2,800,00 [$5M - federal estate taxes of $2,200,000] at which time her estate owes $990,000 in Federal Estate Taxes on her taxable estate which passes to her children. So to pass Taxpayer's X original $5M estate down to two generations, his heirs will have paid a whopping $3, 190,00 in Federal Esate Taxes.

Use the same fact pattern with Taxpayer X as above. However, this time Taxpayer A creates a $5M dynasty trust with his estate at the time of his death and allocates his GST exemption to the dynasty trust so that there is no tax. When his son B dies in 2013 there is NO estate tax on the dynasty trust because the son B does not own the Dynasty Trust! Instead, the entire proceeds of the Dynasty Trust are held for the lifetime of Son B's daughter, C. If daughter C dies a year later, again the entire $5M (plus earnings) of the Dynasty Trust will pass estate tax free to C's children inside the Dynasty Trust. The tax savings over three generations can be as high as 65%. While it is true that Taxpayer A will have to pay some professional fees to create the Dynasty Trust, the tax savings pale in contrast to any expenses of administration of such Dynasty Trusts. Dynasty Trusts can be great "rainy day" fund to protect future beneficiaries from the effect of predators, creditors and spouses.

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