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.

2011-2012: The Time to Plan

Congress has given those who plan estates a wonderful 2 year window before the possible return of the estate tax in 2013. The 2010 Tax Act kicked the can of Bush tax cuts down the road for two years. In addition, Congress increased the size of the exemptions from tax. The new limits are set to expire on December 31, 2012. But, in the meantime, here are the current limits:

1. Gift Tax Exemption: Individuals can now make lifetime gifts up to a $5M and exclude the transfer from tax by filing a Federal Gift Tax return allocating one's lifetime gift tax exemption.
2. Generation Skipping Transfer ("GST") Tax Exemption: Individuals can now set up trusts for younger beneficiaries and use a $5M GST lifetime exemption. This is a "use it" or "lose it" exclusion. Once a person dies, this exemption disappears.
3. Annual Exclusion Gifts: In addition to the use of one's lifetime exemptions, an individual can also make annual exclusion gifts of up to $13,000 per year per donee without any adverse tax consequences.
4. Estate Tax Exemptions: An individual can die in the next 2 years and not pay any Federal tax on estates of less than $5M. In addition, for spouses dying in 2011 and 2012 it will now be important for the personal representative of a deceased person's estate to file a gift tax return passing along a deceased spouse's Unused Spousal Exclusion Amount to one's spouse. Effectively, the surviving spouse could then have up to $10M worth of estate tax exemption. However, the GST tax exemption cannot be transferred in this manner.

This means that families with wealth who wish to plan ahead can do some extraordinary things to benefit future generations. The use of an Irrevocable Life Insurance Trust ("ILIT") which can be funded with life insurance creates opportunities for tremendous tax leverage for future generations. Clients who have illiquid assets, such as a family business or a farm, can use an ILIT to balance out distributions between multiple beneficiaries.

Another strategy that received a reprieve was the use of the Grantor Retained Annuity Trust ("GRAT"). This strategy coupled with an ILIT can make intergenerational wealth transfers a significant part of giving what one has, to whom one wishes, the way one wishes, at the lowest possible tax impact. Those who choose to plan in the next two years will benefit their families significantly over those who do nothing.

The time to do this planning is now! Every day one waits you run the risk of losing these opportunities.

Planning for College

As kids get ready to go off to college it is that time of year when parents swallow hard to pay for tuition, fees and expenses of a child's college education. For a child in Missouri the cost of a public education is approximately $17,000 per year. For a private school costs can exceed $50,000 per year. Few people can afford to pay for this out of their regular income. It takes a lifetime of savings and planning for this expenses.

What are the options for saving?

1. Parents can try to save money in their name. The plus of this is that the investment is in the parent's name and there is no loss of control. The downside is that the return on the investment is currently taxable at the parent's rate.

2. Specialized savings accounts in the child's name, i.e. Uniform Transfer to Minor's Account ("UTMA") and Uniform Gift to Minor's Account ("UGMA") are popular accounts at banks, savings institutions and investment firms. The advantage of these type of accounts are that they cheap and easy to set up. The investments in these accounts are taxed to the minor (subject to kiddie tax). The downside to these accounts is that when the child turns 21 in Missouri (in some states it is 18) the investment belongs to the child. For example, if your child wants to buy a motorcycle on his or her 21st birthday and take their significant other to Alaska you will not be able to do anything about it. For this reason, I do not recommend these accounts unless they are for very small amounts.

3. Section 529 College Savings Plans. Almost every state offers these accounts which are similar to an IRA. The main attraction is that the investment grows tax free inside the 529 Plan. If used for "Qualified Educational Expenses" the amounts expended for college are not taxable income. The parent (or better yet the parent's living trust) can be the owner of the 529 plan so that there is no loss of control. If the child does not go to college, the owner of the 529 plan can name a new beneficiary. Contributions are limited to $13,000 per year. A five year gift of $65,000 can be made up front; but, no other contributions can be made for a five year period.

4. An Irrevocable Trust. Another way to create a fund for future use is to set up an Irrevocable Trust. Let's say a Grandparent sets up an Irrevocable Trust naming the Parent as the Trustee for the benefit of a Grandchild (the "beneficiary") The Trustee can invest in anything that is fiduciallary appropriate. Grandparent can contribute up to $13,000 per year (the "annual exclusion gift"). If Grandparents want to make a joint contribution to such an Irrevocable Trust the maxiumum amount of the gift could be as much as $26,000 per year ($13,000 x 2 = $26,000) . In addition, a Grandparent could choose to make a lifetime gift up to $1M as part of their lifetime gift tax exemption amount to "supercharge" such a trust in addition to annual exclusion gifting. If Grandparent wishes to do so the trust can be made "defective". This means that for estate and gift tax purposes the Irrevocable Trust is outside of the estate of the Grandparent. But, for income tax purposes the earnings of the Irrevocable Trust can be picked up by the Grandparent and put on the Grandparent's income tax return. Why would a Grandparent might want to do this? Because, so far paying the income tax for someone else is not deemed to be a gift. In essence, the Grandparent's payment of the Irrevocable Trust's income tax is another way to transfer more wealth to the next generation. Meanwhile the Irrevocable Trust grows "tax free" so to speak. The earnings are compounded and re-invested in the trust each year. If the Irrevocable Trust could earn 7% a year for 10 years it would double in value. This is a wonderful way to create a supercharged savings plan for a grandchild. The trust can offer asset protection planning from the grandchild's creditors, predators and spouses for their lifetime if so desired.