Lifetime gifting opportunities under the Tax Relief Act of 2010
By Julius Giarmarco
Giarmarco, Mullins & Horton, P.C.
The 2010 Tax Relief Act brings opportunity, complexity and uncertainty that can only be managed with advanced planning. But, because the provisions of the act are scheduled to sunset on January 1, 2013, this may very well be a “use it or lose it” opportunity. With proper planning, perhaps now more than ever, it is possible to “disinherit” the IRS.
The Tax Relief Act of 2010, signed into law on December 17, 2010, unexpectedly and profoundly changed the rules governing wealth transfer. Perhaps the biggest impact of the act is that it reunifies the estate, gift and generation skipping transfer tax exemptions. The act also brings a new aspect to the estate tax with a portability provision, where a surviving spouse will be able to take advantage of any unused portion of his/her predeceased spouse’s estate tax exemption.
Since the Economic Growth and Tax Relief Reconciliation Act of 2001, the gift tax exemption ($1 million in 2009) has been decoupled from the estate tax exemption ($3.5 million in 2009). But for 2011 and 2012, the estate, gift and GST tax exemptions will be $5 million per person and $10 million per married couple. The exemption amount is indexed for inflation, in increments of $10,000, beginning in 2012. The Tax Relief Act also imposes a top tax rate of 35 percent. However, without further congressional action, on December 31, 2012, the provisions of the act will sunset. As a result, on January 1, 2013, the gift and estate tax exemptions will decrease to $1 million; the GST exemption will decrease to $1.4 million (estimate of inflation adjusted amount); and the top transfer tax rate will increase to 55 percent.
Following is a discussion of some of the lifetime gifting opportunities for wealth transfers under the Tax Relief Act.
After 12 months of uncertainty, the period of certainty is limited to two years. Although the chances of such severe reductions in available exemptions and increases in rates probably will not, as an overriding political matter, be allowed to happen, persons contemplating making substantial gifts should be motivated to do so in 2011 or 2012 to lock in the benefits.
However, if the estate tax exemption returns to $1 million in 2013, the calculation of adjusted taxable gifts in computing the estate tax will result in a clawback of the tax benefits that accrued as a result of using the increased exemption in 2011 or 2012. In other words, in order to prevent two bracket runs, taxable gifts are added back to the base upon which the estate tax is computed (with any gift tax exemption previously used being restored), thus, subjecting tax exempt gifts in 2011 and 2012 to estate tax. As a result, use of the $5 million gift tax exemption in 2011 and 2012 will be beneficial only if the $5 million exemption is extended to 2013 and beyond.
However, despite the risk of subjecting gifts made in 2011 and 2012 to estate tax at the donor’s death, in most cases the gifts should be made. First, there is a chance that the $5 million gift tax exemption will become permanent. Congressional staffers have indicated that a clawback was not intended, and IRS guidance or technical corrections could make that clear.
Second, even if the clawback applies, donors should be no worse off than those who did not make gifts. In either case, the gifts, whether made or foregone, will be included in the decedent’s estate (and subject to estate tax at whatever rates and exemptions are then in effect).
Third, the future growth and income on the gifted assets will not be subject to a clawback, even if the gifts themselves are. Finally, the ability to leverage gift transfers through installment sales to grantor trusts and/or purchases of life insurance (as discussed below) enables donors to transfer far more than their $5 million gift tax exemption.
Following are some examples on how high net worth individuals can use the new $5 million ($10 million for married couples) gift tax exemption:
The ability to transfer $5 million per person without paying gift taxes will encourage many individuals to make gifts to their children and grandchildren (either outright or in trust). Forgiving family loans is another way to use the increased gift tax exemption. The extra gift tax exemption may permit some donors to equalize gifts to all of their children and/or grandchildren when they did not have enough annual gift tax exclusion to do so in the past.
The increased gift tax exemption also opens up significant opportunities for transferring assets between unmarried couples without transfer taxes. If the gifted assets qualify for valuation discounts (which were not touched by the act as many feared), the $5 million/$10 million exemption is further expanded. For example, a gift of an undivided interest in real estate will result in double leveraging, since both the transferred interest and the retained interest will receive a fractional interest discount. If one spouse has most of the marital wealth, the couple can "split" the gift to take advantage of both spouse's exemptions. Grantor trusts
Making gifts to grantor trusts, where the grantor is responsible for paying income taxes on trust income, allows the trust assets to compound free of income tax, while the payment of income taxes by the grantor depletes his/her estate. The grantor’s payment of the trust’s income taxes is essentially a tax-free gift to the beneficiaries of the trust. These wealth transfer benefits can be further enhanced by having the grantor loan up to nine times the equity in the trust with a very low applicable federal rate note payable to the trust.
A seed gift of $10 million by a married grantor to a grantor trust will permit a sale of $90 million of assets to the trust at current historically low interest rates. Further estate tax reduction occurs because the grantor is now paying income taxes on the income generated by the entire $100 million in the trust.
Moreover, if the assets gifted and sold to the trust can be discounted (for lack of control and lack of marketability), the value that can be transferred via the trust is increased. If the grantor retains the power to substitute assets (one of the grantor trust triggers), the grantor can repurchase appreciated assets from the trust to achieve a basis step-up at his/her death.
Finally, additional leverage of the gift and GST tax exemption can be accomplished by having the trust use a portion of its cash flow to purchase life insurance on the life of the grantor or the joint lives of the grantor and the grantor’s spouse (see below). Even without a sale, a simple gift of $5 million or $10 million to a grantor trust will have a huge impact on the amounts that can be transferred over time, which amounts can serve as the seed money for a sale to the trust in the future.
Even though the Tax Relief Act did not touch zeroed-out grantor retained annuity trusts (as some in Congress proposed), the sale to a grantor trust has several advantages over GRATs, including no mortality risk and the opportunity to allocate GST exemption to the seed gift. In contrast, GST exemption cannot be allocated to GRATs until the end of the retained annuity term. But, unlike zeroed-out GRATs, a sale to a grantor trust requires a seed gift equal to 10 percent of the sale price. The act's increased gift tax exemption makes this less problematic for sales to grantor trusts. Split-dollar plans
In a split-dollar arrangement, one party provides the majority of the funding, while the other party (usually a trust) controls most of the death benefit. The party that provides the funding is entitled to receive back the greater of the cash outlay or the cash surrender value of the life insurance policy. Because the trust gets any death benefit over and above the cash outlay or cash surrender value, there is an economic benefit to the trust.
Each year this is measured by the cost of one-year term insurance (IRS Table 2001). This cost gets expensive as the insured gets older, so a mechanism is needed to unwind the arrangement. As a result of the act, a large gift can be made to the trust to enable it to "exit" from the split dollar arrangement.
Life insurance transfers
Using the $5 million ($10 million per couple) gift tax exemption – to make a single gift to an irrevocable life insurance trust to purchase a single-premium policy (keeping in mind the potential problems with a modified endowment contract) or to pay future premiums that are due after 2012 – can help individuals with illiquid estates solve their liquidity problem. It is simple and clean. The increased exemption will be particularly useful to grantors whose gifts were limited to their available crummey powers and $1 million/$2 million lifetime exemption.
Life insurance is also an excellent way to leverage the grantor's GST exemption. For example, a married couple can fund an ILIT (designed as a dynasty trust) with $10 million; deposit the $5 million into a second-to-die life insurance policy; and secure $50 million of coverage guaranteed for life. Even though the GST exemption may be reduced after 2012, by allocating the grantor’s GST exemption to the $10 million gift in 2011 or 2012, it will not be taken away or reduced after 2012.
The other $5 million can be invested in other assets (the "side fund"). If the ILIT is also designed as a grantor trust, the $5 million side fund compounds free of income tax, and the grantor's payment of the ILIT's income taxes further depletes the grantor’s estate. At the death of the surviving spouse, the $50 million of insurance plus the amount in the side fund are all GST exempt.
Thus, there is no estate or GST tax as the trust assets pass from one generation to the next (for the maximum period permitted under state law). Under many states' laws, trusts may have perpetual terms or extended terms (i.e., 360 – 1,000 years). Persons with non-taxable estates may forgo the complexities of an ILIT (i.e., crummey letters, annual income tax returns (Form 1041), etc.) and simply own their life insurance policies personally. An added advantage of doing so is that the owner-insured can thereby retain direct access to the policy's cash value.
GRATS and valuation discounts
Equally key to what is in the Tax Relief Act is what is not in the act. Valuation discounts are often used with various estate planning techniques (such as family LLCs). For example, as discussed above, valuation discounts can be used to enhance the benefits of a sale to a grantor trust.
While it had been rumored that the new tax law would limit the ability to discount the value of assets in estate planning transactions, the act does not include such limits. As a result, valuation discount planning continues to be an effective estate planning tool, and individuals may want to take advantage of such techniques in case Congress changes its mind in the future.
In addition, prior legislative proposals would have instituted a minimum 10-year term for GRATs. This would have greatly reduced the planning opportunities associated with GRATs. However, no such provision is included in the Tax Relief Act. Thus, short-term zeroed-out GRATs (e.g., two to three years) appear likely to be viable, at least for the immediate future.
A GRAT can also be used to assist in funding an ILIT. By distributing the assets remaining in a successful GRAT to an ILIT, funds are provided to finance premiums or to create an exit strategy for a split-dollar or premium financing arrangement.
In summary, the 2010 Tax Relief Act brings opportunity, complexity and uncertainty that can only be managed with advanced planning. But, because the provisions of the act are scheduled to sunset on January 1, 2013, this may very well be a “use it or lose it” opportunity. With proper planning, perhaps now more than ever, it is possible to “disinherit” the IRS.
CIRCULAR 230 DISCLAIMER: NONE OF THE ARTICLES IN THIS NEWSLETTER ARE INTENDED OR WRITTEN BY THE VARIOUS AUTHORS OR GIARMARCO, MULLINS & HORTON, P.C., TO BE USED, AND THEY CANNOT BE USED, BY YOU (OR ANY OTHER TAXPAYER) FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON YOU (OR ANY OTHER TAXPAYER) UNDER THE INTERNAL REVENUE CODE OF 1986, AS AMENDED.