January 1, 2013 will almost certainly bring substantial changes to the federal estate tax rates. Planning is needed to avoid the harsh result of the 55% estate tax rate. Sadly, most people that would benefit from the planning needed will fail to do so. 2012 may very well provide one of the most favorable opportunities ever for family wealthtransfers. These planning opportunities are available and needed by many people, not just the ultra-wealthy. These opportunities will almost certainly end on December 31, 2012.

The Existing Law Imposes Harsh Changes. The current estate tax exemption is 5.12 million dollars while the current estate tax rate is 35% on an estate in excess of 5.12 million dollars. The existing gift tax exemption is also 5.12 million dollars and the gift tax rate is 35%. This means that a married couple can transfer 10.24 million dollars without incurring estate or gift tax.

January 1, 2013, will bring a dramatic reduction from 5.12 million dollars to 1 million dollars for the estate, gift and generation skipping tax rate exemption and an immediate increase in the estate tax rate from 35% to 55%.

President Obama proposed a 45% tax rate and a 3.5 million dollar exemption. However, President Obama has also proposed other changes seeking to prohibit traditional estate planning techniques such as valuation discounts between family members and certain grantor retained annuity trusts (“GRATs"). These proposed changes make President Obama’s position far less reasonable than President Obama’s proposed exemption and tax rate would suggest. We have no way of knowing whether any change might be enacted before January 1, 2013. This uncertainty also represents a great opportunity that should not be ignored. After January 1, 2013, estates in excess of 1 million dollars are subject to estate tax. However, that same person can transfer 5.12 million dollars in value before December 31, 2012 without incurring any gift tax.

Planning Considerations. Each estate plan should be custom tailored to the individual’s or family’s specific situation, goals, and family relationships. A revocable trust is designed to avoid probate and reduce estate taxes. Many people also benefit from a variety of irrevocable trusts which provide substantially greater estate tax savings, insulate future growth or appreciation from estate or gift tax, and provide significant asset protection. The following is a list of only a few of the alternatives to consider:

The Irrevocable Life Insurance Trust. Many people are surprised to learn that life insurance owned by an individual is included in his or her estate for estate tax purposes. The effect is substantial for a 1 million dollar policy owned by an individual with a taxable estate; $550,000 of the death benefit goes to the IRS (based upon the 2013 rates) with only $450,000 going to the family. A life insurance trust is an irrevocable trust established to own a life insurance policy on the life of the settlor or creator free of estate tax. The settlor establishes the trust terms, but the trust is irrevocable and cannot be amended except under very limited circumstances. The tax savings can be substantial removing a $1,000,000 death benefit from a taxable estate would save $550,000 in estate tax at the 2013 estate tax rates.

Qualified Personal Residence Trust (“QPRT"). A Qualified Personal Trust (“QPRT") provides both substantial estate tax savings and enhanced asset protection shielding the residence from creditor claims and law suits. The QPRT provides the grantor or creator the right to live in the residence for a predetermined number of years. Because the grantor or creator retains the right to live in the residence, the value of the gift to the QPRT must be reduced to reflect the interest retained by the grantor or creator. The QPRT permits the grantors or creators the ability to sell the residence through the trust and move to a new home. If structured properly, the QPRT will not trigger a change of ownership for property tax purposes. This technique is particularly effective in today’s economy with low home values and the expectation of future appreciation or increases in future home values.

Intentionally Defective Irrevocable Trust (“IDIT"). One of the most powerful irrevocable trusts is the Intentionally Defective Irrevocable Trust (“IDIT"). An IDIT is an irrevocable trust that exists for estate tax purposes but is a disregarded or nonexistent entity for income tax purposes. Zero tax plans often feature IDITs because the IDITs provide an efficient use of your gift and estate tax exemption. A $500,000 gift can be made to the IDIT which is outside your taxable estate. The IDIT can then buy 5 million or more dollars of other assets such as securities, real estate or business from your taxable estate in exchange for a Note. Appreciating assets can be transferred to an LLC before the sale and the entity may provide a discount to “squeeze" or reduce the value. When your taxable estate sells the asset for a Note, the value can be frozen to the Note value insulating future appreciation from estate tax. The Note can even be drafted to have no value after a specified period of time (a “Self-Cancelling Note"). This squeeze and freeze technique decreases the value of the taxable estate substantially while shifting wealth and increasing values in the irrevocable trust that is not subject to estate tax.

The most unique aspect of the IDIT is that the trust is recognized for estate tax purposes but ignored for income tax purposes. This unique characteristic provides four (4) tax benefits as follows:

  • You move assets out of your taxable estate to appreciate and grow without estate tax.

  • Capital gains on the sale of the asset are avoided because the trust is disregarded for income tax purposes.

  • Gift taxes are avoided from the sale of the assets to the IDIT which is not a gift.

  • The Note received in the sale to the IDIT provides you with lifetime income. These payments are often taxed at capital gains rates.

Grantor Retained Annuity Trusts. The settlor or creator establishes a special type of irrevocable trust called a Grantor Retained Annuity Trust (“GRAT"). The settlor contributes funds to the GRAT and the GRAT pays you an annual annuity payment for a predetermined period. After the term expires, the assets remaining in the GRAT are distributed to the beneficiaries. The tax savings arise because the sum of the specified annuity payment is part of the principal plus interest. The trust is designed with the premise that the principal will appreciate or increase in value and that the minimum interest paid to you is less than the future appreciation plus any interest earned by the GRAT. The remaining assets or values are then distributed to the designated beneficiary, free of gift or estate tax. The GRAT is specifically designed to avoid estate tax. As a bonus, the assets within the trust are insulated or shielded from your creditors.

Family Limited Partnerships and Limited Liability Companies. A family’s limited partnership (“FLP") or limited liability company (“LLC") can create an organizational structure to manage the assets by children or grandchildren. The FLP or LLC also provides a vehicle to make discounted or leveraged gifts to children or other family members. The FLP or LLC creates a partnership enabling the senior members to maintain substantial control over the partnership property or business while still making gifts to the junior family members. Discounts are typically applicable under current law to reduce the value of interest retained by the parent. This technique or strategy is often used for real property interests. Those discounts can be as high as 30-40% of the value retained by the senior family members after the interest that is transferred to the junior family members. For example, for a $1,000,000 interest in which 20% is transferred to the junior family members, the parents’ or senior family members’ retained interest would be valued at $520,000. This provides a substantial estate tax savings upon the death of the parents or senior family members.

These are just a few of the more advanced techniques that are available to protect you and your family from the estate and generation skipping tax. Your estate plan should be designed to satisfy you and your family’s specific goals, needs and circumstances.