No doubt you have heard about the “fiscal cliff” or “sunset” looming up at year end. Although most of the commentary in the popular media is focused on possible income tax increases, of even greater importance to many of our clients are the possible increases in the transfer taxes: Unless Congress acts quickly, the estate, gift and generation-skipping transfer (“GST”) tax laws currently in effect will expire on Dec. 31.
Until then, you may make lifetime gifts of up to $5,120,000 (or $10,240,000 if you are married) free of gift tax. (If you have previously made large gifts, the amount you can give away this year may be lower.) Beginning on Jan. 1, 2013, if no new law is passed, the amount you can give away free of estate, gift and GST tax will return to $1 million (with the GST exemption adjusted for inflation). In addition, the highest gift, estate and GST tax rates will increase from 35 percent to 55 percent.
Since we cannot predict what Congress or the president will do, we are encouraging clients who are able and willing to make substantial gifts to do so before the end of the year. This could be a once-in-a-lifetime opportunity to take advantage of high exemption amounts!
N.B.: The techniques described in this Alert cannot be implemented overnight. Appraisals may be required; careful planning will certainly be required. Holidays and vacations can easily derail plans in late November and December. Clients who wait until then to get started may find that they cannot complete the process by year-end.
Q: I would like to take advantage of the large exemption, but if I make a large gift, I’m not sure I will have enough assets to support my lifestyle in retirement. What can I do?
A: Consider making a gift to an irrevocable trust for the benefit of your spouse and other family members such as children and grandchildren. The tax on the gift can be sheltered by your exemption, and if it turns out that you are running low on assets, the trustee of the trust could make distributions to your spouse, assuming your spouse is still living. The design of this trust will be important to ensure it is not taxed in your spouse’s estate. Also, only your $5,120,000 gift tax exemption, not your spouse’s, could be used for a gift to a trust of which she is a beneficiary — gift-splitting would not be available for this gift.
Q: Wait a minute — why doesn’t my spouse set up a similar trust for the benefit of me and the family? That way my spouse’s exemption could be used, too. Pretty good planning, right?
A: Sorry, the IRS and the courts are ahead of you on this — they have developed a “reciprocal trust doctrine” designed to cut down on this type of double-dipping. Still, we may be able to design trusts that will satisfy your financial and tax objectives and avoid being considered “reciprocal.” This type of planning could also be accomplished using the laws of other states such as Delaware or New Hampshire. If you are interested, we would need to have a more specific discussion.
Q: I think I understand the tax advantages of making gifts, but won’t large gifts reduce my children’s drive and ambition?
A: Many of our clients share your concerns, but we have found that we can generally satisfy these concerns by using irrevocable trusts customized to address each family’s situation.
Q: Interest rates are low now. How does that affect our gift planning?
A: Interest rates are historically low — the lowest interest rates in history apply to gift planning involving GRATs (Grantor Retained Annuity Trusts) and installment sales to “defective” grantor trusts. Low interest rates are extremely beneficial to this type of planning. These techniques can permit large amounts of wealth to pass tax-free to children or to trusts for the benefit of children and other family members. GRATs are especially good devices for volatile assets — assets that may experience substantial increases or decreases in value. Installment sales are ideal for assets with strong cash flow. On the other hand, low interest rates are not helpful in planning with QPRTs — Qualified Personal Residence Trusts. Low interest rates mean that the valuation discounts produced by QPRT gifts will also be low. For some clients, though, especially elderly clients or those who believe the values of their residences are only temporarily depressed and are likely to recover dramatically, QPRTS may still make sense.
Q: We live in Massachusetts — how do Massachusetts taxes come into play?
A: Gift planning is especially valuable for Massachusetts residents because Massachusetts does not have a gift tax. However, Massachusetts does have an estate tax with a top rate of 16 percent. Gift planning can save substantial amounts of Massachusetts estate tax.
Q: We own investment real estate. Could we make gifts of it?
A: Yes — although it would probably be beneficial to contribute the real estate to a LLC and then make gifts of LLC interests. Doing so could allow you to retain control over management of the real estate; it could provide additional liability protection, and it could lead to substantial valuation discounts.
Q: So I should go ahead and make gifts now?
A: Hold on. While we want you to act expeditiously, each situation is different, and we want to make sure that we have time to work through all important aspects of your gift plan with you. We want to identify the best assets to give away and the most efficient way to give them. We want to design a trust that works for your family and to consider its impact on your overall estate plan. There may be important income tax considerations, particularly if the gifted assets have a low tax basis, and other technical tax issues need to be considered. You may also want to work through the impact of gifts on your cash flow.
Q: That does sound complicated. Should I just wait until December and see whether Congress and the president solve this problem for me?
A: Careful planning is required when implementing irrevocable trusts and making large gifts. If you have an interest in making gifts before the end of 2012, it is important to start the process now to make sure the gifts can be completed in time. Please schedule a meeting with your estate planning lawyer as soon as possible. Many of our clients have already moved to take advantage of the types of techniques described in this Alert; we anticipate that many others will want to do so before 2013. Please be sure to allow enough time!
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:Peckham-Thomas
This article was originally published by Bingham McCutchen LLP.