In 2011 and 2012, the gift, estate and generation-skipping transfer tax exemptions are all $5 million and the tax rate is 35%. If Congress does not act again, in 2013 the exemption will be $1 million and the top tax rate will be 55%. This is the current law and must be considered in all planning. The portability of the gift and estate tax exemption between spouses was also introduced, but only for spouses who both die between January 1, 2011, and December 31, 2012.
We also have lower income tax rates for the next two years, but President Obama has made it clear he wants higher tax rates in 2013. Unless there are changes in the next two years, in 2013 the long-term capital gains rate will increase to 20%, the maximum tax on qualified dividends will go back to 39.6%, and the additional 3.8% surtax will be introduced.
Tax Planning Opportunities in 2011 and 2012
With the gift tax exemption at $5 million per person, we can expect a huge transfer of wealth over the next two years. Those who have already used their $1 million exemption now have an additional $4 million to use for gifts. And while we cannot be absolutely certain that the $5 million gift tax exemption will be honored if it returns to $1 million in 2013, it would certainly make sense for Congress to do so. Let's look at some of the planning opportunities that will immediately maximize these transfers.
Spousal Access Trusts
The general concept of a Spousal Access Trust is that one spouse can transfer up to $5 million in trust for the benefit of his/her spouse, children and future generations. Benefits include asset protection, estate tax protection, direct descendent protection (property stays within the bloodline) and income shifting. Risks are the reciprocal trust doctrine and grantor trust rules. In U.S. Estate of Grace, 395 US 316 (1969), the Supreme Court developed a two-part test to determine whether trusts will be ignored because they are "reciprocal": a) the trusts must be inter-related and b) the trust creation and funding must leave the grantors of the trusts in essentially the same economic position as they would have been in if they had created the trusts naming themselves as life beneficiaries. If both parts are met, the IRS and/or the courts will uncross the trusts and include the value in each of the grantor's gross estate, nullifying their careful planning.
Gifts to an Irrevocable Life Insurance Trust
Life insurance can be used to provide income for a family, pay estate taxes, and as an income tax shelter. If structured properly so that the trust maker does not have any incidents of ownership, none of the assets (policy proceeds) of an irrevocable life insurance trust (ILIT) will be included in the trust maker's taxable estate, making them free of both income and estate taxes. ILITs will become more popular as income tax rates increase, in 2013, from the current 35% rate to39.6% or even to 43.4% for clients subject to the 3.8% surcharge. The general concept is that the ILIT is the owner and beneficiary of the policy on the trust maker's life. The trust maker makes gifts to the trust to cover the insurance premiums, and the trustee makes the premium payments. At the trust maker's death, the proceeds are paid to the trustee who can use the funds to purchase assets from the estate and provide liquidity for estate taxes and other expenses.
Generally, a dynasty trust is one that benefits multiple generations, and none of the trust assets are included in the trust maker's or any of the beneficiaries' taxable estates. Not being taxed at each generation (historically at 45-55%) allows the assets to grow tremendously over the years. However, there is a generation-skipping transfer tax that applies when a transfer is made by the grantor to a "skip person" (grandchild, great-grandchild, or other person more than 37.5 years younger than the grantor). Currently, each grantor is allowed a lifetime GST exemption on the first $5 million of taxable transfers directly to a skip person or to a trust that could benefit a skip person. A husband and wife can combine their GST exemptions. This perhaps temporary GST exemption increase will make dynasty trusts even more popular over the next two years. The dynasty trust established in the right jurisdiction can theoretically go on forever.
After the $5 million exemption has been used, it may be advantageous to give away more and pay the gift tax at the current 35% gift tax rate. Also, the gift tax is "tax-exclusive" while the estate tax is "tax-inclusive." A taxable gift of $1.00 makes the donor liable for a $0.35 gift tax, for a total of $1.35. On the other hand, $1.35 in a decedent's estate taxed at 35% nets only $0.88 to the heirs.
Intentionally Defective Grantor Trusts (IDGT)
An IDGT is a trust that is a grantor trust for income tax purposes, but not for gift, estate, and GST tax purposes. IDGTs are especially powerful right now for wealthy clients because of the $5 million gift and GST tax exemptions and historically low interest rates. Using an IDGT, a married couple can currently gift up to $10 million in undivided interests in highly appreciating assets, then sell additional interests in the same assets to the IDGT. The value of both the donated and the sold assets can be discounted due to minority interest. If the assets are wrapped in an LLC or limited partnership, their value may also be adjusted for lack of marketability and lack of control. The trust then pays an installment note back to the trust maker. Also, because the IDGT is a grantor trust (i.e., "defective" trust for income tax purposes), no capital gains tax is due on the installment sale, the interest income on the installment note is not taxable to the grantor.
Estate planning professionals have an exceptional window for transfer opportunities in 2011 and 2012 with the $5 million estate, gift, and GST tax exemptions; lower income and estate tax rates; and still-depressed property values. And, as is often the case, these opportunities provide excellent opportunities to work with a team of advisors to provide the best possible results for mutual clients.