Pulling the Plug on Estate and GST Tax Savings
Now that the November 2010 elections are over and control of the House shifted from the Democrats to the Republicans, all eyes are on Congress to see how they address various estate, gift, and generation skipping transfer (GST) tax issues.
As discussed in previous newsletter articles and under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the federal estate and GST taxes were repealed for the 2010 tax year. The gift tax is still in place—but with a reduced top rate of 35% (the $1 million lifetime exemption amount is the same). Under the sunset provisions of EGTRRA, the gift, estate and GST tax provisions return to pre-2002 law on January 1, 2011. Thus, without Congressional action in 2011, the gift, estate and GST tax exemption would be $1 million with a top tax rate of 55% (plus a surcharge of 5% on transfers between $10 million and $17,184,000). A few days ago, the President and the Republicans reached the framework of an agreement that would, among other income tax considerations, reinstate the estate tax in 2011 with an exemption level of $5 million and a top rate of 35%. However, it should be noted that legislation based on this agreement has yet to be passed by Congress. Given these forthcoming changes, serious consideration should be given to a number of estate and gift planning ideas.
Consider making gifts prior to year-end. At this point in the year, there is a very low likelihood of a retroactive rate change being implemented, so one could take advantage of the 35% gift tax rate. Given the exclusive nature of the gift tax versus the inclusive nature of the estate tax, it is always cheaper to pay gift tax than estate tax (assuming that there is an estate tax) and the 35% rate makes it even cheaper. For example, assume you want to transfer $10 million to your child. If you transfer it via gift prior to year-end 2010, you could transfer approximately $7.4 million to your child and pay gift tax of approximately $2.6 million. However, if you wait until January 1, 2011, to make the gift, you could only transfer approximately $6.45 million to your child and pay approximately $3.55 million of gift tax. The result is even worse if the transfer is subject to estate tax in 2011. In that case you could transfer only $4.5 million to your child and pay $5.5 million of tax.
Serious consideration should also be given to making gifts to grandchildren prior to 2010 year-end, as unlimited gifts may currently be made without paying GST tax (although gift tax may still apply). Please note, however, that there is an important caveat to address if the gift is not made directly to the grandchild. Since there is no GST tax for 2010, there is no GST exemption amount to allocate to transfers in trust. Accordingly, it is uncertain whether gifts to such trusts in 2010 may be subject to GST tax when future distributions are made to skip generations. To minimize this risk, gifts to a "skip person" could be made outright. If there are concerns about doing so, then assets such as interests in LLCs, partnerships, etc. might be considered. These types of assets would provide less control and liquidity to the grandchildren. Please also note that there is recent case law concerning gifts of such interests and whether they will qualify as present interest gifts for purposes of the gift and GST tax laws. As such, a great deal of caution must be taken and a discussion with your tax advisors is recommended in this area.
Regardless of whether the tax rates rise after year-end, it remains an ideal time for planning as interest rates and asset valuations are historically low, volatility is up and valuation discounts currently remain in effect despite certain legislation proposals. There are a number of effective techniques that may be utilized under these conditions to maximize the effectiveness of transfers. The following are examples.
Consider inter-family loans. With interest rates still historically low, it may be a good time to make loans to children and grandchildren to purchase assets and let them capture any future appreciation outside of your estate.
Consider planning techniques such as an installment sale to an intentionally defective grantor trust (IDGT) or a grantor retained annuity trust (GRAT). Both of these techniques involve transferring assets to children or grandchildren via a trust and then receiving either note or annuity payments in return. For these techniques to be successful, the assets transferred to the trust should appreciate at a rate greater than the interest rates used to calculate the note or annuity payments. Since the interest rates are currently so low, the likelihood of success is greater. Please note there are legislative proposals regarding GRAT that, if enacted, could add significant challenges to the success of this technique. It may be important to consider creating GRATs in a timely manner.
If one has charitable inclinations, consider creating a charitable lead annuity trust (CLAT). A CLAT works much like a GRAT, but the annuity payments are made to a charity instead of the grantor. This technique is also often more beneficial for estate planning purposes in a low interest rate environment, such as now. Depending on the exact structure of the CLAT, additional benefits may be the annual charitable deductions created by the annuity payments.
