This year has been full of surprises in the estate planning world. One surprise few would have predicted is that there would be no federal estate tax this year. Congress has started and stopped several times in attempts to enact legislation that would address the situation, and bring much needed certainty to the estate planning community and our clients. In 2009, the $3.5 million exemption permitted a husband and wife with proper estate planning to plan to pass up to $7 million to their family members and others completely free of estate tax. This year, of course, there is no federal estate tax and no generation-skipping transfer (GST) tax (on transfers to or benefiting individuals two or more generations younger than the transferor). The federal gift tax remains in effect and is imposed on taxable gifts made after one has used up his or her $1 million cumulative lifetime exemption from the gift tax. However, the gift tax rate for 2010 is only 35% compared to a top rate of 55% in 2009.
But unless Congress acts, the law that has been in effect since 2001 sunsets on December 31 and on January 1, 2011 (a) the top federal gift tax rate will increase to 55%, (b) there will again be an estate tax with rates of up to 60% and only a $1 million exemption, and (c) a 55% GST tax will return with a $1 million exemption indexed for inflation. As a result, next year a husband and wife with a combined estate in excess of only $2 million—compared to $7 million in 2009—face the prospect of significant federal estate tax exposure. So, unless Congress acts quickly, millions of people who have not had to worry about the federal estate tax for the past several years (the exemption has been over $1 million since 2004) will soon face, and must quickly plan for, a potentially huge tax hit to their estates.
In anticipation of these impending changes, there are several, quite possibly once-in-a-lifetime, planning opportunities that could be implemented before the end of 2010. While these ideas may not be appropriate for all, we believe that it is imperative that all of our clients review their estate plans, either now or early in 2011 at the latest.
We have discussed in previous Alerts that today's current economic environment, while gloomy in many respects, is very auspicious for effective estate planning. The confluence of various factors, in particular, very low interest rates, low asset values and recent taxpayer successes in sustaining substantial valuation discounts over Internal Revenue Service challenges, make this a particularly good time to implement various gifting techniques. See our prior Private Client Alerts regarding Grantor Retained Annuity Trust (GRATs), Charitable Lead Trusts, and sales to so-called Intentionally Defective Grantor Trusts.
In addition, with less than three months left in the year, time is running out on the ability to make annual exclusion gifts of up to $13,000 per donee ($26,000 per donor couple to each donee), and to effect certain other transactions before the gift tax rate increases above its current 35% and the GST tax comes back into effect. Estate planning through lifetime gifts will reduce your estate which in 2011 will likely be subject to the federal estate tax.
While we expect Congress will eventually provide more certainty to the estate planning landscape, it has proven futile to predict the specifics of any new legislation. Recent history has shown Congressional unwillingness to come to a consensus on what gift, estate and GST tax rates should be and what the estate and GST exemptions should be. To be sure, this topic has been somewhat of a political football, with Republicans and Democrats pointing fingers and disclaiming responsibility for inaction. There has been talk of making certain changes retroactive, and much discussion of whether that would be vulnerable to a constitutional attack. About the only thing that seems reasonably likely (but by no means certain) is that the gift tax exemption, which has been frozen at a lifetime exemption of $1 million per individual donor, will not be significantly increased. Even in a gift and estate tax neutral world, Congress would not be eager to permit the highest income tax bracket donors to shift too much income-producing property to donees in lower income tax brackets, particularly when the spread between the top and lowest brackets could increase.
We are recommending to our clients who have been planning to make a gift, or have been considering doing so, to take action this year, while interest rates are at or near historical lows and before tax rates increase, and before Congress limits the use of certain estate planning vehicles and techniques, such as GRATs and certain valuation discounts. Although an outright gift may be advisable in some circumstances, we strongly recommend gifts using trusts which provide asset protection to your beneficiaries.
A GRAT is a particularly effective technique which results in a negligible gift and takes advantage of the IRS's low "hurdle" rate on the assets transferred. The Internal Revenue Code § 7520 rate is 2% for GRATs created and funded in October, so a transfer to a GRAT this month of an asset you expect to outperform the 7520 rate would be advisable. The GRAT remainder should be payable to an irrevocable trust. The transfer will move the asset's appreciation over 2% out of your taxable estate as long as you outlive the term of the trust. If you overestimated the asset's appreciation potential, or if death occurs before the GRAT ends, there is no tax disadvantage to you or your estate. As noted in a prior Alert on this topic, there has been significant Congressional interest in limiting GRATs and requiring that these last a minimum of 10 years, thus making it more difficult to outlive the GRAT and make it successful. Consequently, even if interest rates and asset values remain low for some time, acting now is preferable to waiting and missing the opportunity to use a short term GRAT.
Another extremely effective estate tax savings technique is a sale to an intentionally defective grantor trust which is financed in large part by a note payable by the trust to the seller/grantor of the trust. This sale is not an income taxable event, but the note must carry a specified interest rate depending on its term. For a sale taking place in October, this is only 0.41% if the note is payable in 3 years or less, and only 1.73% for one due in more than 3 but less than 9 years, which is the typical range for the financing period. Notes due in more than 9 years carry a higher, but still reasonable, 3.32% interest rate. This means that the cash flow necessary for debt service will likely be more manageable now than at any time in recent memory. These low interest rates also apply to any loan made to family members (i.e. not in connection with a purchase). So, even if no other gift transfer or sale idea seems appealing, it is certainly advisable to make loans to children and other family members now: the family member invests the loan proceeds and the appreciation above the interest rate payable on the loan is shifted out the lender's estate.
Since there is no GST tax in 2010, it is possible to make an outright gift of any amount to a grandchild without using up any of your GST exemption (which was $3.5 million in 2009) or incurring any GST tax. Of course gifts in excess of your remaining lifetime gift tax exemption —$1 million if you have never made a taxable gift—would trigger a current gift tax but only at a 35% rate.
In order to avoid the gift tax and take advantage of the lack of a GST tax in 2010, we are also recommending that clients who have an interest in making gifts to grandchildren (or more remote descendants) do so this year with gifts of cash, marketable securities or interests in closely held businesses with a value of less than your remaining $1 million lifetime gift tax exemption. For some, gifts exceeding the $1 million lifetime gift tax exemption may be appealing, as such gifts will be taxed at only 35%. Since Congress may act late in the year and attempt to reinstate the tax retroactively, those who are most risk averse may prefer to make arrangements to complete such a transfer as late in December as possible, or to build in a formula or disclaimer mechanism so that the gift can be limited or unwound depending on how the law changes. We normally recommend trusts as vehicles for gifts to grandchildren, particularly when they are minors, but there is substantial uncertainty about whether a gift in trust, while exempt from GST tax upon its funding this year, would be vulnerable to a reinstated GST tax in a later year when a distribution is made from the trust or when it terminates. We believe an outright gift minimizes this risk and may be the best opportunity for overall transfer tax minimization in this context.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
