Where to from here?
Excerpted from The 2012 Essential Tax and Wealth Planning Guide
Prior to the 2010 Act, how best to utilize the $1 million gift tax exclusion amount was the basis for a substantial part of most taxpayers’ gift planning. The significantly increased $5 million exclusion amount provides an unprecedented range of possibilities. We have organized transfer considerations around five broad classes of individual circumstances: 1) leveraging gift transfers, 2) tuning up prior planning, 3) thinking big, 4) waste not, want not, and 5) basic blocking and tackling.
For more details on the classes for planning circumstances outlined below, including examples and more details on planning tips, read The 2012 Essential Tax and Wealth Planning Guide.
Class 1: Leveraging gift transfers
Prior to the 2010 Act, the $1 million exclusion amount was often used in leveraged transactions, such as a gift to a grantor trust, followed up by a purchase of assets from the grantor at some reasonable multiple of the amount of the gift made to the trust. Thereafter, because the exclusion amount had been utilized, grantor retained annuity trusts (GRATs, discussed later) were frequently used to transfer the appreciation on property away from the estate of the grantor. GRATs, appropriately executed, are ideal for this purpose because they result in very small taxable transfers.
If you wish to move assets in excess of the $5 million exclusion amount ($10 million per couple) through inter vivos transactions, using the increased exclusion amount as seed capital to engage in similarly leveraged transactions is an option. It is important to note that, to be respected, the debt obligation must be serviced pursuant to its terms.
Planning tip: Compare the projected wealth transfer over time between an outright gift using the $5 million exclusion and a transaction that leverages the $5 million exclusion amount.
Class 2: Tuning up prior planning
“Tuning up” in this regard involves more than just addressing prior transfer tax transactions that may not have developed as modeled (e.g., those that might have been adversely affected by the recession); it also means dealing effectively with risks that arise as a natural outcome of the development of the tax law.
Planning tip # 1: In light of recent developments, it may be advisable for you to consider disposing by sale or gift of an initial contributing partner’s entire interest in the partnership or, alternatively, terminating the entity. Since 2004, the IRS has waged a profoundly successful campaign against family investment entities, including family-controlled investment partnerships and LLCs. Prior to 2004, taxpayers had won the preponderance of such cases. It is now common audit practice for the IRS to examine, in depth, the circumstances behind the creation and the business and investment activities of any family controlled investment partnership or LLC in which the decedent was an initial contributing partner and in which the decedent owned an interest at death.
Planning tip # 2: Highly leveraged sales of interests in family-controlled entities are not uncommon wealth transfer transactions. The recent recession has damaged the financial fortunes of many such entities, often reducing entity distributions and flagging them for debt service. Failure to act when a note is in default raises issues regarding the propriety of the original sales transaction. In situations where the entity’s fortunes are not likely to recover, accelerating the notes and foreclosing against the trust’s assets (e.g., the purchased entity interest) is often the better course of action. In situations where the entity’s fortunes are likely to recover but not in a fashion that permits the original terms of the note to be met, however, you may consider renegotiating the formal terms of the note including, perhaps, forgiving the note in whole or in part. Alternatively, you might consider gifts of assets to the purchasing party that may be used to satisfy the note.
Planning tip # 3: It is quite common for parents to extend credit either directly to children and trusts for descendants or indirectly to businesses or investment entities owned by descendants or trusts for descendants. It is also common for such loans to become nonperforming. As noted previously, the failure to act when a note is in default raises transfer tax concerns. In these situations, you may want to consider forgiving some or all of any nonperforming notes. Your particular circumstances will influence the prudent course of action.
Planning tip # 4: Sometimes the rental arrangements necessitated by a successful gift to a qualified personal residence trust (QPRT) are uncomfortable or administratively burdensome for the parties involved, specifically where the QPRT has terminated and the grantor’s children now own the residence. The parents must rent the residence from the children. The children could consider a gift back to the parent(s) of the life interest in the residence. Such a transfer would negate the need for rent payments. Under the current, low prevailing interest rates, such a life interest is quite modestly valued, depending on the parents’ ages.
Class 3: Thinking big
While it is true that the $5 million exclusion amount might be beneficial for highly leveraged transactions, for a great many taxpayers the $5 million exclusion ($10 million per couple) for gifts made in 2011 and 2012 is large enough that simple outright gifts, whether direct or in trust, may be the most efficient mechanism to transfer wealth. Minority interests in closely held businesses, fractional interests in real estate, interests in entities owning distressed assets (e.g., significant real estate holdings), interests in private equity funds or other investment entities, and perhaps even interests in family-owned investment entities (e.g., family limited investment partnerships or family investment LLCs) may prove the most effective candidates for gift transfers by virtue of how they are valued.
A minority interest in a closely held enterprise generally is valued at less than its proportionate share of going concern value (for a business enterprise) or net asset value (for an investment entity) because of lack of control and/or lack of marketability discounts. This valuation outcome has been the government’s primary motivation in attacking the veracity of family-owned investment entities. Thus, successful valuation outcomes depend, as discussed above, on the determination that any closely held entity is demonstrably motivated by reasons other than tax efficiency and that the entity operates in business-like manner. Still, even if the taxpayer prevails with respect to discount valuation determinations, such discounts simply lower the threshold required for a wealth transfer to be successful or, in the alternative, reduce the tax cost of the transfer if the enterprise is not ultimately successful. Notwithstanding the compelling features of transferring property that can be discounted, remember that the success of a gift transfer is fundamentally a function of an asset’s post-transfer growth and earnings prospects — not its current value.
Thinking outside the box
Valuation considerations in conjunction with the prevailing low interest rates have made the economics of renouncing a surviving spouse’s interest in all or a part of a marital trust a much more viable prospect. The reason to consider renouncing an interest in a marital trust is that the assets of a marital trust will always be included in the estate of the surviving spouse. The most popular form of marital trust is the qualified terminable interest property trust (QTIP trust). When a surviving spouse renounces his or her interest in a QTIP trust, the surviving spouse is deemed to have made a gift of (and is obligated to pay gift tax on) the value of the trust’s assets. Regulations, however, require that the donees (the QTIP trust remaindermen) reimburse the surviving spouse for the gift tax apportioned to the actuarial value of the remainder interest. Because prevailing interest rates remain at record lows (the § 7520 rate in September 2011 is two percent) the relative amount of tax that is charged directly to the surviving spouse is disproportionately low, particularly if the surviving spouse is of advancing years.
The regulations also prescribe that this required reimbursement to the surviving spouse will be treated as consideration received with respect to the transfer. The consideration received is subtracted from the value of the QTIP trust’s net assets to arrive at the amount of the taxable gift. At a minimum, the consideration to be received is measured by the statutory requirement, a formula that reimburses the donor for any gift tax associated with the actuarial value of the remainder interest in the trust; however, it is not unusual for the formula to reimburse the donor for any tax (i.e., GST, income, and even post-transfer estate taxes arising from a transfer) and even, absent state law restrictions to the contrary, a little pocket money as well. For example, the surviving spouse could make the transfer for an amount that will leave a nest egg after the payment of all related taxes.
Because QTIP trusts are generally characterized by an extraordinary mix of assets (from heirloom art and the family home to blue-chip stocks and individual retirement accounts), it is important to note that one need not renounce the whole of the QTIP trust or even an undivided interest in the whole QTIP trust. If supported by state law or the provisions of the trust instrument, a QTIP trust can be severed into two or more identical trusts that are funded disproportionately. One such trust would be funded with the assets the surviving spouse is interested in retaining. The surviving spouse would then renounce his or her interest in the remaining trust or trusts.
Planning tip: If you are a spouse who is a beneficiary of a marital trust established by your deceased spouse, consider whether a gift of all or part of your interest in such trust might accomplish your wealth transfer objectives in a more tax efficient manner.
Net gifts generally
A net gift is a gift that is conditioned on the donee’s payment of the gift tax. It is called a net gift because the amount subject to tax is the value of the property transferred net of the amount that the donee will reimburse the donor. There are several observations that are useful when considering whether a net gift transaction makes sense.
A net gift is recommended when a significant transfer is called for but the donor either lacks the liquidity to pay the resulting tax or is unwilling to bear the tax burden. A net gift requires the donee to either have the required liquidity to pay the tax or, in the alternative, be willing to make arrangements to provide the funds to pay the resulting tax.
With respect to a transfer of a specific amount or a specific asset, net gifts operate to reduce the gift tax obligation, as was the case in the QTIP renunciation example discussed already. In that sense, net gifts are more tax efficient (i.e., the effective tax rate for $1 of transferred wealth is lower). Consequently, they can serve as a mechanism to leverage available liquid resources — particularly if it is the donee with the liquid resources. Logic and math, however, will tell you that the maximum amount of wealth that can be transferred with respect to a specific tax liability is going to be the same whether the transfer is a simple gift or a net gift. Shifting the “source” of the funds for the payment of the transfer taxes arising from the transfer does not affect this outcome.
Planning tip: Although perhaps counterintuitive, a net gift transaction is most tax effective when the top tax rates are low. This is because more wealth can be transferred for a stated amount of tax when the maximum gift tax rate is lower without regard to the existence of consideration.
Class 4: Waste not, want not
It is a rare individual who does not feel some disquiet when relinquishing control over assets that have significant value. Rarer still is the willingness to pay a tax for the opportunity to make such a transfer. It is human nature, after all, to accumulate wealth, not to part with it. For many, making large wealth transfers would be easier if they could be comfortable that they could access the transferred assets in times of need. In certain states this is now possible; otherwise, such access can only be contingent and/or indirect if the transfer is to be effective for tax purposes. Nevertheless, contingent and indirect access is often sufficient to bring a donor peace of mind.
The inter-vivos credit shelter trust
Planning tip: In order to use the $5 million exemption through a lifetime gift while still retaining contingent or indirect access to the gifted property, consider a gift to a trust for the benefit of one’s spouse.
Resident asset protection trusts
An alternative to using an inter vivos credit shelter trust is funding a trust in a state that permits self-settled trusts, where the grantor can be a discretionary beneficiary. Because of this discretion, all such trusts must utilize an independent trustee resident in the state whose laws will govern the trust. The key to the success of these trusts as estate planning vehicles is the denial of access to the trust’s assets by the grantor’s creditors. At the time of publication, there are 12 states that permit such self-settled, creditor-protected trusts: Alaska, Colorado, Delaware, Missouri, Nevada, New Hampshire, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, and Wyoming. It is generally understood that these trusts will protect trust assets against the grantor/contingent beneficiary’s creditors if the grantor is a resident of one of the respective states noted above. There is considerable controversy over whether the asset-protection features of such trusts extend to grantors who are nonresidents of the respective states noted above. Several bankruptcy cases have denied a discharge to grantors of a self-settled trust in a nonresident state because the laws of the grantor’s home state did not permit such trusts.
The IRS has ruled favorably that the establishment of such trusts will be regarded as a completed transfer for gift tax purposes. It has refused to rule regarding the estate inclusion of the assets of the trust in the grantor’s estate, however, as such a determination would require scrutiny of the trust’s operations. By implication, then, if the trust has, in fact, conveyed significant benefits to the grantor, asset inclusion may well result if such operations imply an indirect understanding between the grantor and the trustee such that the grantor effectively retained dominion and control over the trust assets. The moral of the story is thus — self-settled trusts could be great rainy-day funds, but if the fund is tapped, the risk of estate inclusion will increase dramatically.
Low prevailing interest rates make the use of a QPRT a disproportionately costly proposition because low interest rates act to “inflate” the value of the transferred remainder interest. Yet, because a residence — particularly a vacation residence — is both illiquid and often characterized as an heirloom asset, residences often prove easier to part with than other assets; accordingly, these trusts are utilized frequently. If for no other reason, QPRTs should be a gift of last resort because of the post-termination rental issue previously mentioned. Lacking better gift candidates, however, using the $5 million exclusion amount to move the remainder interest in a personal residence is better than letting the $5 million exclusion go to waste.
Class 5: Basic blocking and tackling
While the unexpected introduction of the $5 million gift tax exclusion amount has greatly increased planning flexibility and opportunity, it need not and should not detract from the use of tried and true estate planning techniques. Quite to the contrary, you should continue to employ these techniques in addition to the new opportunities afforded under the 2010 Act.
Planning tip # 1: You may want to shift wealth down generational lines through an annual gifting program. There is even more benefit if the gifted asset: 1) can be valued on a discounted basis, 2) is likely to appreciate and/or generate income that will be excluded from the donor’ estate, and 3) is given to a grantor trust that permits the trust assets to grow income-tax-free while reducing the grantor’s estate by the amount of any income tax paid.
To demonstrate the power of annual gifting, assume a couple has three children. In 2011, this couple can transfer up to $26,000 per child, or $78,000 to all three children. If each child has a spouse, the maximum amount that can be given to the children and their spouses is $156,000 without incurring a taxable gift. If the couple has grandchildren, the ability to further reduce their taxable estates through annual gifts expands.
Planning tip # 2: If a child or grandchild has earned income, consider making a cash gift. The child or grandchild may use that gift to contribute $5,000 or the amount of the donee’s earned income, whichever is less, to a traditional IRA or Roth IRA. Funds contributed to a Roth IRA will grow tax deferred, and qualified distributions will be tax free for federal income tax purposes. Funds contributed to a traditional IRA may be deductible for income tax purposes.
Planning tip # 3: Remember to make any payments on behalf of others directly to providers of medical and educational services. Direct payments are not treated as taxable gifts to the recipients of these services. For example, a grandmother who wishes to help pay for a granddaughter’s education can write tuition checks directly to the school without making a taxable gift. If she writes the check to the granddaughter, however, she will have made a taxable gift to the extent the amount gifted exceeds the $13,000 annual exclusion. Tuition is not limited to college tuition; any qualified school tuition can be excluded. And medical does not just mean doctors and hospitals; any qualified medical expense, including insurance premiums, can be paid under this exclusion.
Planning tip # 4: Consider funding future educational expenses through gifts into a § 529 educational plan for children and grandchildren. Such plans provide several tax benefits. Using a special election, a donor can fund up to five years of annual exclusions into these plans in one year. Specifically, in 2011, one can contribute $65,000 to one grandchild’s § 529 plan without incurring a taxable gift or a GST tax (discussed in more detail later). If other gifts are made by the donor to that grandchild during 2011-2015, however, those gifts would use some of the donor’s $5 million exclusion amount as well as some of the donor’s $5 million GST tax exemption. By funding these plans in advance, the growth in the fund occurs in an income-tax-exempt environment.
Planning tip # 5: Don’t overlook the additional estate planning advantages that accrue to transfers made in favor of trusts determined, for income tax purposes, to be grantor trusts. Grantor trusts are trusts in which the grantor has retained either an economic interest or powers over trust property that are significant enough to require the income of the trusts to be taxed to the grantor as if the trust were a disregarded entity. Interestingly, the retention of some powers over trust property will not also cause the trust to be disregarded for transfer tax purposes. Properly employed, these powers can cause the grantor to be legally liable for the income taxes arising from the trust’s tax attributes, but not in a manner that causes estate tax inclusion. From an estate tax perspective, such trusts represent the gifts that keep on taking — a situation that can be perpetuated for as long as the grantor is willing to sustain the continuing income tax liability.
For more details on estate taxes and wealth transfer in today’s environment, including potential gift tax changes under President Obama’s budget proposals, read The 2012 Essential Tax and Wealth Planning Guide.
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