Many years ago, I stopped trying to use a "crystal ball" to determine what Congress would do with estate tax law. I can only counsel my clients about what the current law is and what opportunities are available today.
As many commentators have discussed, one planning opportunity available through the end of 2012 is the ability to make large lifetime gifts to remove significant assets from an estate before death. The Gift and Estate Tax Lifetime Exemptions are currently $5,120,000.00. This means that in 2012, an estate having a net value of $5,120,000 or less is completely exempt from Estate Tax. In addition, this exemption allows individuals to make large gifts during 2012 that are not subject to the Gift Tax. In 2013, the exemption drops to $1,000,000.00 unless Congress decides to extend or modify the current law in some way.
By taking advantage of the higher Lifetime Exemption in 2012, clients can make gifts to children and other beneficiaries without any out-of-pocket cost for Gift Tax. In addition, gifts in 2012 can save future estate taxes by removing future appreciation on the gifted assets. Gifts made to multiple generations (e.g. children, grandchildren, etc.) this year, also can avoid any Generation-Skipping Transfer Tax.
While taking advantage of this strategy has the potential to reduce the taxes imposed upon large estates, the "tax tail should not wag the dog". This means that achieving a client's goals for their estate plan should take priority over the desire to avoid paying taxes. Before the client takes the steps necessary to utilize this strategy, it is important to ask the following questions:
- Can I afford to make a large gift?
- Will I need these funds in the future?
- Am I concerned that my heirs will not be able to manage the assets I give or may have creditor or divorce problems?
- If I make gifts, do I want them to be outright gifts or do I prefer gifts into irrevocable trusts for control purposes?
The client should be careful about gifting any assets they may need to maintain their lifestyle later in life. What is given away cannot be returned without incurring gift tax, income tax and estate tax consequences. The client must be comfortable with giving up control and the use of the asset, subject to restrictions that can be placed on a beneficiary's use.
If the client can afford to make a large gift and is comfortable doing so, it is probably advantageous, especially if the tax rates increase from the current 35% maximum bracket to the 55% maximum bracket, as is scheduled in 2013, and the lifetime credit drops to $1,000,000.00. Presuming appreciating assets, heirs can receive significantly more in assets and appreciation from a large gift in 2012 rather than after-tax distributions at death.
Two words of warning, first under current law, the donee of a gift receives the donor's income tax basis in the gifted property, while the beneficiary of most inherited property will receive a "step up in basis" to the date of death fair market value of the inherited property. While making a gift may avoid Estate Tax, it may also create additional capital gains income tax when the asset is later sold. Consideration of the income tax consequences should be part of the pre-gifting analysis. Second, there is the possibility that there will be a "tax clawback" in future legislation. That is, an added Estate Tax that takes back some of the tax-free benefits of the 2012 gifts. In the current law, it is not clear that gifts made in 2012 using the larger Lifetime Exemption cannot be added back to the estate of a client who made large gifts, resulting in the imposition of a larger Estate Tax burden at death if the exemption is only $1,000,000 at the time of death.
- Outright gifts to beneficiaries of real estate, business interests (corporations, partnerships and LLCs), investment assets and even cash with no restrictions. If the client gives minority interests in entities, the client can maintain control of the entity, and may even be able to take advantage of minority valuation discounts when determining the value of the gifts made.
- Gifts to irrevocable trusts for the benefit of minors or children with creditor issues, suspect marriages, or spending problems with provisions that protect these beneficiaries and distribute assets over time. The only limit on restrictions is the imagination of the grantor. The trust can be designed to provide maximum flexibility for distributions to beneficiaries yet protection of the principal.
- Gifts in trust for a spouse, with the remainder going to children and grandchildren after the death of the spouse. The trust, a "spousal limited access trust", can be designed as a "grantor trust" where the person setting up the trust is considered the owner for income tax purposes, yet is not considered the owner for estate tax purposes. The spouse can receive income and/or principal, which allows the grantor to enjoy the benefits of the trust assets. It may be possible for the beneficiary spouse can even have the right to appoint his or her trust rights back to the grantor at their death without it being considered in the estate of the grantor at the grantor's death. This allows the grantor to continue to have use of the assets
- Gifts to an irrevocable trust can be used purchase life insurance on the grantor. The gift can provide a significant multiple of insurance coverage, thus providing greater benefit to beneficiaries should
- For those trying to ensure the maintenance of a family vacation home for the future, that client may want to consider gifting a 49% interest in the home to children, either outright or in the form of an LLC interest. Using this method the client can maintain control of the home and there will be no change in the status for property tax purposes.
- Gifts of property to "grantor trusts" and then the purchase of assets by the grantor for cash or a promissory note. This type of strategy allows the trust beneficiaries to receive interest income during the repayment of the note, as well as the eventual principal repayment. In addition, because the grantor still owns the assets, they will get a step up in basis for income tax purposes at the death of the grantor.
Before making any large gifts, clients should have a serious discussion with professional advisors to determine if the gifts are appropriate for the client's financial and family situation. Planning for large gifts does take time, which is obviously limited between now and December 31, 2012. If the client is interested, now is the time to start in order to avoid last-minute decisions that are not productive for the client.