The government has put on our plates a once in a million, lifetime gift of a $5,000,000 tax break. Never before has this type of gift been handed to so many Americans. Until the end of 2012, the gift-tax exemption has been raised to $5,000,000, $10,000,000 for couples. Simply put, this means that a couple could give away up to $10,000,000 without paying a nickel in taxes.
In addition to this largess, the government has also bestowed upon us a lowered tax rate of 35% which has been reduced from the scheduled 55% rate due to return at the end of 2012. Before you jump to restructuring your estate plans and retooling the strategies you have in place, there are important considerations, both emotional and financial, that must be taken into account.
The gift tax has been in our history since 1789, and the development of the modern estate and gift taxes occurred in 1916. It was established to prevent the wealthy from giving away their estates prior to their death in an effort to avoid the estate taxes. Today there are multiple options to take advantage of the $5,000,000 exemption granted to each American. We will cover the following strategies as an overview in an effort to provide you with options and ideas in how to reduce your current and future estate tax levy. Some of these strategies are due to expire within the next year or two, thus there is reason to act now as opposed to delaying. Since there is no current indication that the government will extend the current laws beyond 2012, especially since there are so many extenuating and outside events such as our debt crisis which could render the tax breaks temporary.
With the exemption increased from $1,000,000 to $5,000,000 per individual, everyone now has the ability to reduce estate taxes by granting a direct gift to descendants or anyone you choose, including trusts. If you have used your prior exemption of $1,000,000, this opportunity still provides you with the benefit of making a gift of $4,000,000 thus completing the entire $5,000,000 exemption.
Making gifts will not only reduce the estate and thus the estate taxes by the amount gifted, but in addition will remove all future appreciation. As an example, if a $5,000,000 gift were made this year and you died 28 years from now and during that period of time you were able to earn a 5% return, the growth on that $5,000,000 would be the equivalent to $19,600,646 which means that over $14,600,646 would escape estate taxes.
Gifting into a Trust
Although the simplicity of a direct gift sounds good, there are many advantages of making a gift of property into a trust as opposed to outright. Any gift to a trust will allow you to allocate your generation skipping transfer tax exemption (GST) to the trust. This will enable the funds gifted plus all future growth to not only escape estate taxes but also any gift or GST taxes.
In addition the trust can be designed to be taxed to you instead of to the trust beneficiaries. In essence this is a way of making additional, tax-free gifts equal to the tax the trust would have paid. The specific name of this type of trust is known as a grantor trust.
Lastly, gifts made to a trust can be protected from any claims of the beneficiaries’ creditors, including spouses and will ensure that all of the assets will not pass outside of the family blood line if desired. It is possible that these benefits could be applied to every generation for the longest period allowed under the law which varies state by state.
Married Couples Nonreciprocal Trusts
A unique way of protecting the tax exemption without actually giving away the asset is to create a trust for the benefit of your spouse, and, if desired, descendants. The $5,000,000 could be gifted to a spousal trust and those assets plus any growth over time would remain outside of the estate thus no tax. However, if you needed some of the funds then your spouse could receive a distribution from the trust to be used for the benefit of both of you. In addition, if your descendants were beneficiaries, the trust also could make distributions for their use free of gift tax. Since distributions are at the discretion of the trustee and do not have to be made, funds could also accumulate free of future estate, gift, or GST taxes. In addition, this type of trust could also be used as an asset protection strategy and hedge against the exemption being lowered in the future.
One method of reducing the value of one’s gift is by utilizing an entity such as a limited liability company (LLC) and transferring, as part of the gift, the LLC membership units. These units will be valued in such a way that discounts could be applied since the gift being made will normally be a minority interest subject to restrictions on future transfers. By way of example, if an LLC membership unit with an underlying value of $16,000,000 were to be gifted, assuming a 37.5% discount, the gift would still fall within the $10,000,000 combined couple’s exemption. Not only would future estate taxes be avoided on the $16,000,000 being transferred and all future growth but GST tax exemption would be allocated to the trust as well. This would allow the transferred assets and future growth to pass to future generations free of any estate, gift, or GST taxes.
Domestic Asset Protection Trusts
There are certain jurisdictions, such as Delaware, Nevada, and Alaska to name a few, which allow assets to be transferred to the trust outside of your estate but at the same time remain available for your use. There are naturally certain restrictions and rules that must be followed. Since there are no requirements forcing distribution, assets could remain and accumulate within the domestic asset protection trust (DAPT) free of any future estate tax, gift, or GST taxes. As an ancillary benefit, depending on the jurisdiction chosen, the DAPT will provide very strong asset protection from your creditors and the creditors of your beneficiaries.
Gifting Real Estate
There are two methodologies to gifting a residence or a vacation home. The simpler of the two is to set up a trust and gift the property to that trust for the benefit of your descendants or other beneficiaries. You in turn would then lease the house back from the trust. Since the gift was made to a trust, GST tax can be allocated to the trust so that all the future appreciation will pass without estate or GST tax. A further benefit of this approach is, if there are multiple beneficiaries you can create multiple trusts, enabling discounts to apply to the properties transferred through the fractional, undivided interest evaluation methodology. Lastly, as discussed above, if the trust is created as a grantor trust, the payment of the rent will not be taxable to the trust, creating additional tax-free gifts.
The second technique would be the use of a Qualified Personal Residence Trust (QPRT) which allows you to gift at a reduced value. A QPRT contains certain provisions required by the Internal Revenue Code which allows you as the grantor to retain the right to live in the residence for a specified number of years. You must outlive the specified term in order to avoid the estate tax. During the time you reside in the residence you are still responsible for all of the expenses, including taxes, maintenance, etc. Once the term of the trust expires, then the value of the home including all of the appreciation will pass via the terms of the QPRT. Most likely, either to your children or trusts for their benefit without any further exposure to gift or estate tax.
The Use of an Intentionally Defective Grantor Trust
Another method would be to sell assets to an Intentionally Defective Grantor Trust (IDGT) in order to freeze the estate tax. The sale to the trust is in exchange for a promissory note. All of the appreciation accruing after the sale will not be included in the estate. It is possible, depending on the asset sold, to garner additional valuation discounts.
Leveraging Life Insurance
Since all assets owned by you are taxed at the time of your death, any life insurance owned will also be taxed. Thus by creating an Irrevocable Life Insurance Trust (ILIT) you can avoid any taxation on your death benefits paid from your life insurance policy.
You have several options with regard to life insurance:
1) Gift existing life insurance policies to an ILIT. There are certain rules and restrictions which must be followed in order to avoid estate taxation;
2) Gift your exemption to an already existing or to-be-created life insurance trust. This will allow the use of the exempted amount to pay all future premiums on current policies without having the worry of complying with the Crummey Withdrawal rules which create a present value gift, especially when using large life insurance policies wherein the $13,000 annual exclusion gift may not be enough. Ceding the trust with the exemption amount of $5,000,000 will solve this dilemma.
3) The third option of leveraging up is to cede the ILIT with the $5,000,000 exemption and then have the trust purchase a life insurance policy equal to three to ten times the amount of the exemption. This automatic appreciation can be passed down to the heirs’ estate, gift, and GST tax free. It is possible to structure the trust to allow you the ability to use some of the values within the trust as well.
We are currently in an environment of extremely low interest rates and depressed asset values. To not take advantage of these would be wasting thousands upon thousands of dollars. There are several strategies that allow for excess interest over the investment returns which are set by the IRS to be left in the trust for the benefit of the beneficiaries. These would include IDGTs, Grantor Retained Annuity Trusts (GRAT), Charitable Lead Annuity Trusts (CLAT), and Intra-Family Loans. Some of these techniques are under review by the Joint Committee for their consideration to changing tax laws. Thus, it is important to act now if any of these make sense to your planning. Currently the Joint Committee is looking to reduce the valuation discount breaks we currently have.
Grantor Retained Annuity Trust
A Grantor Retained Annuity Trust (GRAT) is a method to transfer property at virtually no gift tax cost. Not only do you benefit from no gift taxes, but you also benefit in today’s low interest rate environment and down markets. With that combination the benefits of creating GRATs are multiplied exponentially. You are able to pass to your children all future appreciation while reducing the value of your gift to virtually zero.
Probably one of the simplest techniques of utilizing the low interest rate environment is to make an intra-family loan either directly to your children or in trust. The Internal Revenue Code has set forth rules that make it possible to loan family members at rates lower than charged by commercial lenders without deeming the loan to be a gift. As an example, if an intra-family loan were made today for $10,000,000 and the loan had a term of three to nine years, the September 2011 rate would be 1.63%. Any amount of appreciation on the invested dollars from the loan above 1.63% would accrue and inure for the benefit of the borrower. As you can see, these types of loans will provide an opportunity of shifting wealth from one member of the family to another. In addition to transferring wealth, these loans may also serve a better purpose than third party loans since all of the interest expense is paid to the beneficiaries or the trust.
If your goal and intention is to pass as much wealth to your family and future generations while minimizing estate, gift, and GST taxes, then it behooves you to act now as many of these strategies may not be of available in the near future. That near future may be as short as the end of 2012.