The remaining months of 2012 provide an unprecedented opportunity for higher-net-worth individuals and families to transfer wealth to future generations without incurring federal gift tax. Under tax rules scheduled to expire at the end of this year, individuals can make tax-free gifts of up to $5,120,000 (married couples can gift twice that amount). Unless Congress acts, the exemption will drop to $1 million in 2013. Taking advantage of this unique gifting opportunity before the end of the year could save a tremendous amount in your clients’ future estate taxes. See: RIAs don’t get rich clients’ surprising altruism says Fidelity Charitable study — and it’s costing them.
Understanding federal gift and estate tax rules
Gift and estate taxes are excise taxes imposed by the federal government on the transfer of assets during lifetime, or at death. These taxes are incurred only if the value of the property transferred exceeds the applicable exclusion amount.
In the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, the applicable exclusion amount was increased to $5 million per person beginning in 2011. The inflation-adjusted exclusion amount increased further to $5,120,000 for 2012, giving us the highest exclusion amount since the modern estate tax was enacted in 1916.
The 2010 act also lowered the tax rate on transfers above the exclusion amount to a flat 35%, giving us the lowest gift and estate tax rate since Franklin Roosevelt was president. Finally, the 2010 act “reunified” the exclusion amount for both gift and estate tax purposes, meaning the exclusion can be used to make lifetime gifts, or to make transfers that take effect only at death. All of these changes to the federal gift and estate tax rules were welcomed as being very favorable to U.S. taxpayers.
Unfortunately, the favorable rule changes established by the 2010 act are set to expire automatically at the end of 2012. Unless new legislation is enacted (which will require an agreement by both houses of Congress, as well as the president), the exclusion amount reverts to $1 million and the top tax rate rises to 55%, for 2013 and beyond.
The fate of these and other Bush-era tax cuts will hinge to a large degree on the outcome of next week’s election. While no one can predict with any certainty what will happen on election day, one of these three scenarios seems likely to have an impact on future gift and estate tax rules. See: Cheat sheet for recent SEC regulatory changes and amendments.
• More gridlock. If Congress and the White House remain divided, with parts of the government controlled by Republicans, and parts by Democrats, 2013 could begin with what some commentators are calling “Taxmageddon.” All Bush-era tax cuts will automatically expire after Dec. 31 and many tax rules will revert to pre-2001 levels. The gift and estate exclusion amount will decrease to $1 million, the top tax rate will increase to 55%, and the cost of transferring wealth will rise dramatically. (As a caveat, Congress may enact legislation any time during 2013 that could be made effective retroactively to the beginning of the calendar year.) See: Here’s a 15-item checklist of low-hanging tax tips for financial advisors.
• The Democrats retain the White House and control the House and Senate. President Obama’s 2013 budget proposal recommended lowering the gift tax exemption to $1 million, but restoring the estate tax rules to their 2009 levels, with a $3.5 million estate tax exclusion amount and a top tax rate of 45%.
• The Republicans gain control of the White House and the Senate and retain control of the House. Congress could extend the current gift and estate tax exclusion amount of $5,120,000 and the 35% tax rate, or the estate tax could be abolished altogether.
Who should take advantage of this unique gifting opportunity?
First, it is extremely important to point out that the vast majority of U.S. taxpayers will never owe federal estate taxes. For most individuals and married couples, the No. 1 financial planning objective should be securing a comfortable retirement. A lifetime gift is a permanent and irrevocable transfer of property, and you should never give away what you cannot afford to be without.
Second, there is no one-size-fits-all in financial and estate planning. A single person in advanced age and declining health with a net worth of several million dollars might decide to make tax-free gifts to children or grandchildren in 2012 while the exclusion amount is high. On the other hand, a healthy married couple who has recently retired with a net worth of several million dollars might decide against making large gifts in 2012 because they do not want to risk running out of resources in their later years. Every situation should be evaluated on a case-by-case basis before deciding whether to make large gifts in 2012.
Basic block and tackling of making gifts
If after careful evaluation you decide to make a substantial gift in 2012, there are many ways to transfer wealth to children and more remote beneficiaries.
• Outright gifts. You can make an outright gift of cash, securities, real or personal property, art objects and collectibles, etc. The gift must be complete and unconditional. Transferring assets with higher potential for appreciation might result in even greater estate tax savings. Although no gift tax will be incurred unless the cumulative value of all your gifts exceeds the current $5,120,000 exclusion amount, gifts exceeding the $13,000 annual gift exclusion amount must be reported on a U.S. gift tax return.
• Gifting a business interest. There may be an extra advantage of making gifts of an interest in a closely held business. The gift tax value of an interest in a closely held business may be reduced by discounts for lack of control and lack of marketability.The combined discount can often be as much as 35% to 45%. You should consult with a qualified business valuation expert before reporting such gifts.
• Gifts in trust. If you are making gifts to younger beneficiaries, you might consider creating a gift trust for them. You can structure the trust to provide for the beneficiary’s health, education, maintenance and support in a trustee’s discretion. You may also allocate a portion of your generation-skipping-tax exemption to gifts in trust that could exempt the trust assets from all future estate taxes.
• Insurance trusts. An effective way to leverage a transfer of wealth is to make a gift to an Irrevocable life insurance trust. If the trustee purchases life insurance on an individual or a married couple, the insurance proceeds payable to the ILIT will be excluded from the insured’s estate for federal estate tax purposes. The trustee of the ILIT can purchase a single premium, paid-up life insurance policy, or invest the trust corpus and pay annual insurance premiums out of income derived from the investments. Existing life insurance policies also can be gifted to individuals or to an ILIT. See: Is Hartford Financial’s market exit a death knell for the annuity crowd or just more Hartford haplessness?.
• Loan forgiveness. If you have made a loan to a child or other beneficiary, the forgiveness of the loan amount may be treated as a gift.
• Charitable remainder trusts. A CRT can be structured to provide an income stream to a noncharitable beneficiary for a specified number of years, or for the life of the beneficiary, followed by a gift of the remaining trust assets to one or more qualified charitable organizations. The donor receives a current charitable income tax deduction equal to the actuarial value of the remainder gift to charity. See: Fidelity Charitable courts advisor business — and competes with Schwab — by making alternative assets OK in its donor-advised fund.
• More advanced gifting strategies include: grantor-retained annuity trusts, Qualified personal residence trusts and family limited partnerships.
Rich Behrendt is director of estate planning for Robert W. Baird & Co.'s Private Wealth Management group. Prior to joining Baird in 2006, Rich was an estate tax attorney with the Internal Revenue Service for 12 years. His responsibilities at the IRS involved auditing estate, gift, and fiduciary income tax returns. Rich earned his law degree from Brooklyn Law School in 1994. He is a member of the State Bar of Wisconsin, Milwaukee Bar Association and Milwaukee Estate Planning Forum. Rich is also an adjunct professor of Law at the University of Wisconsin Law School, where he teaches a course in advanced estate planning.