Estate planning opportunities under the Tax Relief Act of 2010, Pt. 1
By Julius Giarmarco
Giarmarco, Mullins & Horton, P.C.
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 bill is that it “reunifies” the estate, gift and generation skipping transfer (GST) tax exemptions. The tax package 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 (EGTRRA), 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 bill also imposes a top tax rate of 35 percent. However, without further Congressional action, on December 31, 2012, the provisions of the tax package sunset. As a result, on January 1, 2013, the gift and estate tax exemptions decrease to $1 million; the GST exemption (which is currently adjusted for inflation) will decrease to $1.4 million (estimate); and the top tax rate will increase to 55 percent.
Following is a discussion of some of the planning opportunities for wealth transfers under the 2010 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 substantial gifts should be motivated to do so in 2011 or 2012 to lock in the benefits.
Following are some examples on how high-net-worth individuals can use the new $5 million ($10 million for married couples) gift tax exemption.
Simple gifts — 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. If one spouse has most of the marital wealth, the couple can "split" the gift to take advantage of both spouse's exemptions. If the gifted assets qualify for valuation discounts (which were not touched by the tax package, 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. Installment sales to grantor trusts — A "seed" gift of $10 million by a married grantor to an intentionally defective irrevocable trust (IDIT) will permit a sale of $90 million of assets to the IDIT 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 IDIT. The grantor's payment of the IDIT's income taxes is essentially a tax-free gift to the beneficiaries of the IDIT. Moreover, if the assets gifted and sold to the IDIT can be discounted — for lack of control and lack of marketability — the value that can be transferred via the IDIT is increased.
Finally, additional leverage of the gift and GST tax exemption can be accomplished by having the IDIT 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. Even without a sale, a simple gift of $5 million or $10 million to an IDIT will have a huge impact on the amounts that can be transferred over time – amounts that can serve as the seed money for a sale to the IDIT in the future.
Even though the act did not touch zeroed-out Grantor Retained Annuity Trusts (“GRATs”) (as some members of Congress proposed), the sale to an IDIT 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 an IDIT requires a seed gift equal to 10 percent of the sale price. The bill's increased gift tax exemption makes this less problematic for sales to IDITs.
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 Tax Relief 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 (ILIT) 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 a $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).
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 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 legislation. 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 Tax Relief 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.
Part two will discuss portability vs. family trust, disclaimer trusts, the Tax Relief Act's impact on charitable planning, and look ahead to other potential effects.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.