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A Once in a Lifetime Opportunity: Taking Advantage of Increased Gifting Exemptions

By November 28, 2011June 16th, 2016Advanced Planning

Only one year remains for the greatest gift giving opportunity since the gift and estate tax laws were enacted. Have you made plans yet to take advantage of it?

As most of you know, in December 2010 Congress shocked almost everyone by increasing the exemption from federal gift taxes from $1 million to $5 million. This law is scheduled to expire on January 1, 2013 when the gift tax exemption is supposed to return to $1 million. Assuming that we return to gift and estate tax rates of 50%, and a gift and estate tax exclusion of $1 million, as currently scheduled, failing to use your exemption by the end of 2012 could cost your family over $4 million in taxes. This cost doesn’t even take into account any income and appreciation on the gifted assets.

Getting Started with Planning

How do you get started with a gifting plan? Here’s a suggestion – meet with your financial advisor (FA) as soon as possible. If your FA provides financial planning services, all the better. Work with your FA to make some reasonable assumptions about future investment returns and figure out how much of your net worth you need to retain access to for the rest of your life without jeopardizing your standard of living. You should consider gifting all or a part of any excess to your children or other heirs before the law expires on December 31, 2012.

After you and your FA decide what you can afford to gift, meet with a lawyer who is an expert in estate planning and the federal income, gift, estate and generation skipping transfer tax laws. Working together with your FA and your CPA, ask your lawyer to develop a gifting plan that you can implement before the end of 2012. As you develop your plan, think about the following:

  • Do you want to continue to use any of the assets you are considering gifting, such as a vacation home?
  • Should the gifts be outright so that the recipient has unlimited access to the funds, or should the gifts be in trust so that they can be shielded from creditors, including spouses?
  • Should the gifts be structured to benefit multiple generations of your family, or just your children?
  • Who should pay the taxes on the income earned by the gifted assets?

Depending on the answers to these and other questions, your lawyer should be able to provide you with several different options for achieving your goals. Once you have decided on the structure of the gifts, you will need to select the specific assets to be gifted. Ideally, the assets you gift will have these attributes:

  • Significant potential for appreciation or income production, or both.
  • High income tax basis – meaning that the asset has not appreciated significantly since you acquired it.

A benefit of gifting, in contrast with transferring assets at your death, is that the appreciation and income earned on the gifted assets are also removed from your estate. With estate tax rates historically around 50%, this means that every dollar of appreciation and income associated with the gifts you make could save you fifty cents in death taxes.

The Power of the Grantor Trust

One way to turbo charge your planning is to make your gift to a trust known as a “grantor trust”. A grantor trust is a trust designed to remove assets from your estate for estate tax purposes, while continuing to treat you as the owner of the assets for income tax purposes. This makes you responsible for the income tax on the assets owned by the trust. It also permits the assets in the trust to grow free of taxes, while you further reduce your estate by the income taxes associated with the trust’s assets. Moreover, under current law, paying the income taxes associated with assets in a grantor trust is not considered a gift from you to the trust.

Let’s look at a simple example of the grantor trust at work. Assume you make a gift of $1 million to a grantor trust. Further assume that the gifted assets are invested, return 5% per year in interest income and that your marginal income tax rate is 35%. At the end of ten years, the amount in the trust has grown to $1,628,895. The total income tax associated with the interest earned on the gifted assets is $220,113 ($628,895 multiplied by 35%). Because the trust is a grantor trust, you are responsible for the income tax liability, but the IRS does not view your payment of the tax as a gift to the trust. By structuring the trust as a grantor trust you have permitted the gifted assets to grow faster (and outside of your taxable estate) and reduced your own taxable estate by paying the income tax on the gifted assets. Your CPA or financial planner can help you better calculate the power of the grantor trust as an estate planning technique, but suffice it to say, over time the federal estate tax savings can be extraordinary.

Locking in the Exemption and Retaining Access: Spousal Access Trusts

You might be reading this article thinking that you have enough money to worry about estate taxes, but not enough money to start gifting assets to your children. Recent difficulties in the economy and uncertain investment returns have many people concerned that they are not sufficiently wealthy to gift their assets away, yet the risk that gift and estate tax exemptions may revert back to $1 million concerns them.

Is there anything that can be done to take advantage of this historic window of opportunity for estate planning without losing access to your assets? One possibility worth considering is to make a gift to a trust that benefits your spouse during your spouse’s lifetime and uses your lifetime gifting exemption. Your spouse can be named as a trustee along with an adult child or someone else friendly with your spouse and you can permit distributions to your spouse or for your spouse’s benefit for any reason considered appropriate by the non-spouse trustee.

Like any estate planning technique, this idea is not without possible downsides. If your spouse dies before you, you lose the indirect access you had to the gifted property through your spouse. Similarly, if you and your spouse have marital difficulties, your indirect access will also be cut off.

If these risks do not concern you and you are intrigued by the possibility of locking in the benefits of the exemption, then you might also want to consider the possibility of your spouse creating a similar trust for your benefit. The IRS has a rule prohibiting you and your spouse from attempting to derive an estate tax benefit by creating reciprocal trusts, but it is possible to navigate around that obstacle. A skilled estate planning lawyer should be familiar with this issue and should be able to help you find a solution for it that is acceptable to you.

Relying on Portability Can be Dangerous

No discussion of the new tax law would be complete without a brief mention of “portability”. Simply put, portability means that if your spouse dies and fails to use any portion of his or her estate tax exemption, then the unused amount is available to you as the surviving spouse.

Prior to the 2010 law, gift and estate tax exemptions were personal, so if they were not used during your lifetime the exemptions were lost. This meant that a person who failed to properly plan his affairs, either by not having his lawyer prepare the correct documents or not having his assets properly titled, could lose the benefit of his exemption from federal death taxes.

The purpose of portability is to allow the use of both spouses’ exemptions even in cases where a couple failed to do proper estate planning. As an example, assume Joe and Mary each have $5 million of assets and Joe dies in December, 2011 with a Will that leaves all of his assets to Mary. Further assume that Mary dies in December, 2012. Without portability, Mary would have a $10 million estate, but only a $5 million exemption from federal estate taxes. The $5 million by which her estate exceeds her exemption would be taxed at the current 35% federal estate tax rate and her estate would owe the government $1.75 million in federal estate taxes.

Portability permits the executor of Joe’s estate to make Joe’s $5 million unused exemption available to Mary at her death. The result is that Mary’s $10 million estate is protected from federal estate taxes because portability makes Mary’s exemption of $5 million and Joe’s unused $5 million exemption available to Mary when she dies.

Although one would think that portability makes estate tax planning unnecessary in many cases, relying on portability is risky. First and foremost, like all aspects of the 2010 law, portability expires on December 31, 2012. As a result, it only benefits a married couple if both spouses die after January 1, 2011, and before January 1, 2013. In addition, the example of Joe and Mary above assumes that the $5 million Mary inherited from Joe at his death did not appreciate or produce income. If Joe had engaged in traditional estate tax planning and, at his death, left his $5 million in trust for Mary’s benefit, then the $5 million and all appreciation and income on that gift would be exempt from federal estate taxes at Mary’s death. Relying on portability before it becomes a permanent part of the tax law is not advisable.

Start Your Planning Now!

If you are at risk to pay federal estate taxes, call your financial advisor soon. Ask your FA to get the ball rolling on organizing your advisors to help you take advantage of an opportunity that may prove to be “once in a lifetime”. When 2013 rolls around, you’ll rest easy knowing that your assets will end up benefitting your heirs while potentially saving millions of dollars in taxes.

[author] [author_image timthumb=’on’][/author_image] [author_info]Michael J. Maransky is a partner with the firm of Fox Rothschild LLP. Michael’s practice involves a broad range of matters, many of which are tax related including, estate and gift tax planning, estate and trust administration, and resolution of tax controversies. Michael is the Managing Partner of the firm’s Blue Bell office and is a member of the firm’s Executive Committee. For more information click here.[/author_info] [/author]