As December 31 approaches, Congress may be acting more like the ancient Mayans than current tax professionals.
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The Mayan "Long Count" calendar, beginning over 5,000 years ago, comes to an abrupt end on Dec. 21, 2012. Those who study ancient civilizations are left to guess what comes next. The same is true with regard to the status of the estate tax. There are those in Congress who call for the repeal of the estate tax, while others simply argue over the amount of the exemption. What will ultimately happen by year's end is anyone's guess.
If no action is taken, the current $5,120,000 lifetime estate and gift tax exemption reverts to its prior level of $1,000,000 per individual on January 1. The rate of tax goes from its current level of 35 percent to 55 percent. Given the uncertainty regarding tax policy prior to year's end, individuals having significant estates should consider the opportunities that may not be available after December.
The simplest plan is to make outright gifts to children and grandchildren. Lifetime gifts having a cumulative value of up to $5,120,000 (per donor) can be made currently without incurring gift tax. Any future growth on the transferred assets would be outside of the reach of the donor's taxable estate.
The use of trusts to receive gifts provides additional benefits. Trusts can be designed to last several generations without the assets being subject to gift, estate or generation-skipping tax. Assets held in trust are also protected from creditors of the beneficiaries, including ex-spouses in the event of a divorce. If a donor cannot determine the ideal assets to transfer by year's end, special provisions can be included in the trust agreement allowing the donor to give cash this year and then swap out the cash for other assets next year.
To further leverage the benefits of trusts, a donor may gift assets to a trust commonly known as a "grantor trust" that is designed to be excluded from his taxable estate, but remain responsible for the income taxes on trust income and gains. The assets in the trust could then grow outside of his estate without being depleted by income taxation. Currently, there are proposals by the government to limit the benefits of grantor trusts. Therefore, high-net-worth individuals updating their estate plans should consider creating a grantor trust prior to year's end (if they do not already have an existing one).
DON'T TRUST THE KIDS?
In certain cases, individuals may wish to take advantage of the current exemption amount, but are reluctant to give access to a significant amount of wealth to the children or grandchildren. There are a couple of options to deal with such concerns.
In the case of a married couple, each spouse can create a trust for the primary benefit of the other spouse. The children and grandchildren would also be discretionary beneficiaries of the trusts. During the life of each spouse, they would have access as a beneficiary to trust assets, at the discretion of a trustee (who should be an unrelated party). At death, the assets would escape estate taxation in both spouses' estates. In order to avoid certain technical tax rules and what is called the "reciprocal trust doctrine," which would have the effect of unwinding the transactions, the terms of the trusts for husband and wife should be substantially different from one another. The differences may involve giving certain powers to one spouse in his trust but not giving the other spouse the same powers in her trust, and delays in the timing and creation of the trusts.
Another option, particularly in the case of unmarried individuals, is the use of a self-settled trust created in one of several states that provide for such vehicles. Such states include South Dakota, Nevada, Alaska and Delaware, which are the most popular. In such a case, the individual would convey assets up to the amount of their remaining exemption to a trust for the benefit of family members. However, he would also retain a beneficial interest in the trust, either as a current or a potential beneficiary. At least one of the trustees would be a trust company in one of these favorable jurisdictions. The institutional trustee would generally be given the power and authority over distributions to the beneficiaries.
This vehicle does not come without risks; however, as the law is not entirely clear with regard to the estate tax consequences of self-settled trusts. To reduce the risk, the grantor would generally not be named an initial beneficiary, but rather an individual or institution unrelated to him would have the power to add him (or his spouse) as a beneficiary.
To shift significant wealth, an intra-family sale is an effective technique. In this case, the senior family member sells an interest in a family entity holding substantial wealth (such as an LLC or limited partnership) to a grantor trust for the benefit of family members. In return, he would typically receive a promissory note from the trust having a principal amount based on a valuation discount and an interest rate based on Internal Revenue Service tables. These rates tend to be significantly lower than market rates. The promissory note would be payable interest-only for a term of years. After the term, a final payment of principal would be due, although the note could be refinanced or otherwise renegotiated at such time. The interest payments would not be subject to income tax, nor would capital gain be recognized upon sale because of the grantor trust status. All future income and growth in excess of the note value and interest obligation would be outside of the grantor's estate and in the trust.
It is conventional wisdom in estate planning circles that, prior to sale, the grantor should make a gift to the trust of at least 10 percent of the value of the assets expected to be sold. This is to give the trust at least some financial independence. The first and possibly second interest payment on the note can be made from the gifted assets. Some practitioners use the gifted amount to make a downpayment on the note. The current high level of gift tax exemption provides the opportunity to make a larger initial gift. This translates to a larger amount capable of being sold at a discount (up to $100 million for a married couple).
There are further opportunities that can be explored based on the use of the exemption amount for 2012, and high-net-worth individuals should consider all options available to them.
Seth R. Kaplan is a partner in the Florida business law firm of Berger Singerman, focusing on personal tax and estate planning for high-net-worth individuals and families. Reach him at firstname.lastname@example.org.