The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act liberalized many of the rules for gifting and estate planning, at least through 2012.
For example, it increased the lifetime gift tax exemption—the amount of money or other property that you can gift over the course of your lifetime without incurring a gift tax—to $5 million, up from $1 million in 2010.
It did not, as some had speculated, change or eliminate a number of powerful planning techniques that have been the focus of negative attention by the IRS and Congress. However, the beneficial rates and exemption amounts that these techniques leverage are set to expire after 2012, so timing is critical. Less predictably, the techniques themselves may be curtailed or eliminated by upcoming legislation, further increasing the urgency.
As a consequence of liberalized gifting rules and uncertainties about their future, the legislation created an obvious incentive to reduce the size of your taxable estate over the next two years through gifting.
But is a major gifting strategy the right approach for you?
Advantages and Disadvantages of Gifting
There are clear advantages to gifting if you believe you’ll have a taxable estate at the time of your death.
Given the current $5 million lifetime exemption, you can remove considerable asset value-and all subsequent appreciation of those assets-from your estate for federal and state tax purposes through gifting. (Washington State does not have a gift tax, although it does have an estate tax with an exemption of $2 million.)
Currently, you can also employ techniques that leverage the temporarily high lifetime gifting exemption to provide an even greater tax benefit. Some of these techniques are under fire by the IRS and Congress, so they may not be available to you if you delay.
On the other hand, it may not be financially viable to gift a significant portion of your estate at this time-you may need those assets and the related cash flow in the future. You may also have concerns about gifting such large amounts to your heirs.
Gifted assets do not benefit from an increase in tax basis at death, so it’s also important to determine if you have sufficient assets that are appropriate for gifting. In some cases, the amount you save in estate taxes may not outweigh a future increase in income taxes payable by the recipient when the asset is eventually sold. This concern is particularly relevant for assets that are likely to be sold soon after your death.
Finally, absent a technical correction to the new law, it is possible that your estate may owe additional estate taxes-essentially deferred gift taxes-resulting from certain gifts you make in 2011 and 2012. Referred to as a clawback, this scenario arises if the lifetime gifting exemption decreases in the future, as it is currently scheduled to do in 2013, and your gifts in 2011 and 2012 exceed the by-then-reduced exemption. Such a clawback tax obligation was clearly not the intent of Congress when the new law was written, and many expect the technical correction will be made. However you should include the possibility of a clawback among your other considerations when planning your gifts.
Strategies and Techniques to Enhance the Benefits of Gifting
If you maxed out your lifetime gifting at $1 million under pre-2011 rules, you can simply gift an additional $4 million before the end of next year without paying federal gift taxes. If you’re married, your spouse can gift a similar amount to double the benefit.
As an alternative, you can make use of a number of special trusts and entities to leverage your gifting through the use of value freezes and valuation discounts. They include family limited partnerships/family limited liability companies, GRATs, IDGTs, QPRTs and intra-family loans.
Presently, the impact of these powerful planning tools is greatly enhanced by the increased lifetime gifting exemption and currently low interest rates and asset valuations.
Family Limited Partnerships/Family Limited Liability Companies
The terms family limited partnership (FLP) and family limited liability company (FLLC), refer to a limited partnership or LLC that is created to hold a family’s business or investment assets and that includes restrictions limiting its ownership to family members.
Typically, senior members of a family transfer the family business or other assets to the partnership in return for general and limited partnership interests—or if it is an LLC, in return for an appointment as manager and member units. Over time they gift limited partnership interests in the FLP or member units in the FLLC to children, grandchildren or other family members. As general partners or LLC managers, they retain much control over the FLP or FLLC and the underlying assets.
Family members who receive limited partnership interests or member units, on the other hand, gain an ownership interest in the FLP or FLLC but have few rights and little control over either the FLP/FLLC or the underlying assets.
The advantage of this strategy from a gifting perspective derives from the fact that there is no ready market for a minority interest in a nonpublic company. This type of minority interest is an inherently illiquid asset, especially when it is a limited partnership interest or member unit that represents little or no control. As a result, the value of the gifted FLP or FLLC interest is significantly discounted—in other words, valued at much less than the fair market value of the underlying assets—for gift and estate tax purposes.
Grantor-Retained Annuity Trust (GRAT)
A GRAT is an irrevocable trust that is established for a predetermined period of time, after which it distributes its assets to designated beneficiaries.
When you establish a GRAT, you transfer assets that you expect to appreciate in value to the trust―potentially including personal or real property. The trust then makes an annual annuity payment to you each year for the life of the trust. The amount of the payment is based on a present value calculation that includes an IRS-mandated interest rate. As a result, GRATS are particularly attractive when asset values and interest rates are low, as they are now.
At the end of the trust term, if the appreciated value of the assets exceeds the sum of your annuity payments, the remaining assets pass to your beneficiaries free of gift tax on the appreciation. If the value of the assets is less than the sum of the annuity payments, the assets return to you with no gift tax implications. As a result, there is little downside to a GRAT. You can simply take the assets that have been returned to you and try again.
If you die before the term of the GRAT expires, the assets are considered part of your estate.
Proposed legislation may lengthen the required term for a GRAT, making them less attractive in certain situations.
Intentionally Defective Grantor Trust (IDGT)
An intentionally defective grantor trust, or IDGT, is a variation on a grantor trust. It breaks at least one of the grantor trust rules such that the trust is not recognized for income tax purposes.
The IDGT uses funds provided by you, as grantor, to purchase assets from you. Generally the purchase includes a down-payment and a promissory note with an interest rate based on the Applicable Federal Rate, or AFR. Since the trust is disregarded for income tax purposes and the interest payment is made by the trust to you, it is disregarded for tax purposes.
Any appreciation in the value of the trust’s assets is retained by the trust for estate tax purposes, thus keeping it out of your estate.
Qualified Personal Residence Trust (QPRT)
A qualified personal residence trust, or QPRT, is a form of grantor trust designed to freeze the value of your home, secondary residence or vacation home for estate tax purposes as of the time it is transferred to the trust. The technique can be used for up to two homes and is particularly valuable in a down real estate market.
When you form the trust, you gift your home to the trust for a predetermined number of years and designate the ultimate beneficiary. The longer the term of the trust, the smaller the gift to your beneficiary. Ideally the term will be long enough to minimize the gift tax and allow you to maintain control of the home for life, but not so long that you die before the term expires.
During the term of the trust, you live in your home rent-free and continue to pay related expenses. Because the trust is generally ignored for income tax purposes, you can deduct the real estate taxes and interest that you pay on your personal income tax return.
Assuming that you outlive the term of the trust, you must relinquish ownership and the home passes to your beneficiary without additional gift or estate taxes. Any appreciation is effectively removed from your estate.
You can, however, further reduce the value of your estate by continuing to live in the home and making lease payments at fair market value to your beneficiary.
If you die before the term of the QPRT expires, the home becomes part of your estate.
If you can’t or would prefer not to provide an outright gift to a family member, you might choose to loan the funds instead. Here, too, a down economy provides a benefit: The IRS’ rate for short-term intra-family lending is at a historic low.
The IRS requires a minimum interest rate on a transaction between family members or other related parties before it considers the transaction to be a loan and not a gift. Assuming the child or other family member that you lend to earns more on the use of the funds than the IRS’ interest rate, these gains are free of gift tax.
Of course, at some future date, you might choose to forgive some or all of the balance of the loan as a gift.
The federal gift and estate tax rules for each of these techniques are inherently complex, so it’s crucial that you give us a call to discuss your situation before taking any action.