In our last Legal Update issue, we advised that on December 15, 2010, the House and the Senate agreed to a compromise on the estate and gift tax until the end of 2012. We are now moving into 2012, it is an election year and the temporary compromise we have enjoyed over the past few years will end December 31, 2012. We are still certain that the estate and gift tax are not going away any time soon and we will see another temporary compromise or, if we are lucky, a permanent change.
Current Law
The Federal unified credit shields property from tax, regardless of whom such property passes to. The amount shielded by the unified credit is known as the “applicable exclusion amount.” The current legislation provides a $5,000,000 applicable exclusion amount with a 35% Federal tax rate for 2011 and in 2012 this amount adjusted for inflation to $5,120,000 or $10,240,000 for a married couple in 2012. It is advantageous for property to pass tax free as part of the applicable exclusion amount because the applicable exclusion amount escapes Federal estate tax at death. So we must plan for this amount, even if it is currently temporary until the end of 2012 and will change again. The new legislation also reunified the gift tax exemption with the applicable exclusion amount and our clients have been able to transfer up to $5,000,000 in 2011 and $5,120,000 in 2012 during their lifetime without paying a gift tax. Absent Congressional legislative action, the lifetime gifting opportunity is only effective until the end of the year.
It seems unlikely that the lifetime gifting exemption will remain as high as it is; therefore, anyone in a position to make gifts should do so while the larger exemption is still available. You can take advantage of the current exemption amount by making direct gifts, gifting partial interests in real estate or family entities or creating certain types of trusts.
On the Horizon
Starting January 1, 2013, the Federal exemption of gift and estate taxes will be reduced to $1,000,000 for an individual and $2,000,000 for a married couple. At this time, the estate tax rate will increase from 35% to 55%. This results in a lower exclusion amount and much higher taxes. 2013 also is the beginning of higher capital gains (20%) and dividend rates (39.6%), up from the 15% ceiling. 39.6% is also the rate for ordinary dividend and the highest ordinary income tax rates.
Our Predictions and Recommendations
We believe that the estate tax will remain in place for the foreseeable future for both Federal and State estate tax purposes. We also believe that a limit on lifetime giving will remain in effect as well and may be lower than the Federal estate tax exemption as it was before 2011. Given the changes that are now on the horizon, the need to address your estate tax planning is necessary in your lifetime planning as well as in your documents that take effect at your death. The fact that this is an election year only increases the chances that a compromised change could adversely affect your estate planning goals.
The following are some recommended planning techniques:
A Qualified Personal Residence Trust (QPRT) is designed to reduce your taxable estate by using your primary or vacation residence and removing the retained interest in the residence(s) from your estate and removing any future appreciation of the home(s) after the transfer. This planning technique is very attractive given the current low value of the real estate market. Valuation discounts on the property may also apply. Given the discounts afforded this type of planning technique, you can make good use of the lifetime gift tax exemption.
A Grantor Retained Annuity Trust (GRAT) is a gift of a remainder interest in a trust. In other words, the gift is of the right of one or more remaindermen (either individuals or one or more trusts) to receive the GRAT assets at the end of a trust term. The Grantor (the person who makes the gift to the GRAT) retains an interest in the GRAT in the form of an annuity for a term of years (e.g., ten years). Typically, the annuity is equal to a fixed percentage of the value of the assets transferred to the GRAT, but a GRAT can be designed with increasing annuity payments. The annuity must be paid out to the Grantor, at least annually, during the GRAT term. The value of the annuity is determined by reference to an IRS interest rate (the “7520 rate”) which is set each month. The rate for the month in which the transfer to the GRAT is made is utilized. The 7520 rate for February is 1.4%. The value of the annuity is subtracted from the value of the property placed in the GRAT and the difference is the taxable gift. If the growth of the assets in the GRAT exceeds the 7520 rate your GRAT will be successful. Given the historically low interest rates, this planning technique continues to be very effective in your estate planning.
A sale of assets to an Intentionally Defective Grantor Trust (IDGT) in exchange for an installment Note. Interest rates are at all-time historic lows. The increase in the lifetime gift tax exemption discussed above allows for far larger tax-free gifts to the IDGT than before. These gifts provide the asset base needed to support a loan (in the form of a Note in favor of the Grantor) used by the IDGT to purchase additional assets. Marketable discounts may also apply depending on the type of assets gifted to the trust. The higher gift tax exemption provides a much larger cushion to absorb IRS audit adjustments while still not incurring estate tax.
It is important for you to be much more receptive to attending to your estate planning even though many uncertainties exist in the law. We predict that it is very unlikely that the estate and gift tax will be fully repealed and that perhaps certain doors of opportunity in lifetime giving are closing. The recent recession created much trauma for many people, but it also resulted in the lower valued real estate market and lower interest rates that created a better planning environment. The above planning techniques are a few of the most effective options available to you now. There are others. Please call us to discuss these opportunities at this unique time and in an election year when the politicians may close many of the planning doors we are describing above.