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.

Generation Skipping Issues in 2010

Like the federal Estate tax, the federal Generation-Skipping Transfer ("GST") tax is currently repealed for 2010. If Congress continues on its "do nothing" approach to tax reform, the GST tax will reappear on January 1, 2011 at a top rate of 55%.

Unlike the estate tax where one has to die in 2010 to benefit from the repeal, there are some options this year for those who are planning on living until 2011. By way of background, the GST tax was implemented by Congress in 1976 as a way to stop rich people from passing wealth down to future generations tax free. It was designed to tax distributions that did not get passed down from one generation to the next (i.e. parent to child) by taxing distributions that "skipped" a generation. Thus, in addition to income tax, estate tax, and gift taxes Congress leveled a new tax (the GST tax) for transfers that are classified as "generation skipping transfers" to or for the benefit of a "skip person". This system was so complicated that Congress decided in 1976 to give every taxpayer a $1M dollar exemption from GST taxes. In 1976 $1M was a lot of money. From 1976 to 2001 the GST exemption was increased to $1, 060,000. Suddenly, people who had never heard of the GST tax [Chapter 13 of the Internal Revenue Code] were paying more in taxes. Congress ratcheted the exemption up to $3,500,000 by 2009. We are now poised for the return of the GST tax on January 1, 2011 at the base rate of $1M with perhaps some minor inflation adjusted amount.

A skip person is generally a person more than one generation removed (think grandchild and beyond) from the transferor. A skip person can also include a trust for the benefit of beneficiary or beneficiaries of a skip person(s). A generation skipping transfer can be either:

1. a "Direct Skip" which is an outright transfer to a skip person or a trust for a skip person;
2. a "Taxable Distribution" from a trust to a skip person; or
3. a "Taxable Termination" of a trust or non-skip person's interest in a trust that vests property in a skip person, which could include the termination of all non-skip persons' interests in the trust, leaving only skip persons as beneficiaries.

Certain trusts may be "GST Exempt" trusts because they were set up before the date of the enactment of the GST tax (i.e. they are "grandfathered") or the maker of the trust allocated his or her GST exemption on a validly filed GST tax return to allow the GST Exempt trust to have an inclusion ratio of "0".

Several planning opportunities present themselves in 2010. For example, a donor can make direct gifts to grandchildren without any GST tax in 2010. However, the federal Gift tax still remains in effect. The highest federal Gift Tax rate for 2010 is 35%. Gifts that are less than $13,000 per donee per calendar year are exempt from gift tax. In addition, a person may allocate any part of their $1M dollar lifetime gift tax exemption to such gifts. Note that the gift tax rate is down 10% from last year (45%) and will be 20% less than the projected current gift tax rate of 55% for next year.

If a grandparent who has exhausted all of one's annual exclusions and gift tax exemption were to gift $1,000,000 to a grandchild this year, the transfer tax would be $350,000. That same gift if made in 2011 would incur a combined gift tax and GST tax liability of $1,100,000! That is a tax rate of 110%! If a grandparent were to make gifts to great-grandchildren, such gifts would skip two generational levels.

Many grandparents have established gift trusts for grandchildren. Each calender year the grandparent would gift $13,000 into such a trust for the benefit of the grandchild. Normally Section 2611 (b)(2) of the Code would protect future distributions from such trusts from GST tax in the future since the original transfer to the trust was subject to GST. A transfer to such a trust in 2010,however, would NOT be subject to GST. There fore, the protection of Section 2611 (b)(2) may not apply. Accordingly, grandparents should not make annual exclusion gifts to gift trusts in 2010. Instead, one may wish to consider either direct transfers to skip persons or to a Uniform Transfer to Minors Account for such a grandchild in 2010. Consideration needs to be given to the appropriateness of such gifts to a grandchild outright.