By Genevieve M. Moore & Richard S. Kinyon, Morrison & Foerster LLP
As reported in
this space over the last several months, there has been unprecedented upheaval
in the federal transfer tax world in the last few years. One element of this was the unexpected
increase in the federal gift and estate tax "applicable exclusion amount"1 in 2011 to $5,000,000 per person and the reduction in the tax rate-to 35%-for
gifts or bequests in excess of that exclusion amount. This was a temporary two-year feature put in
place by the Tax Relief, Unemployment Insurance Reauthorization, and Job
Creation Authorization Act of 2010. As
such, these features are scheduled to "sunset" at the end of 2012, at which
point the estate and gift tax exemptions and rates will revert to levels from
more than a decade ago, namely: a
$1,000,000 per person exemption, and a top tax rate of 55% for gifts and
bequests.
Since the two-year
$5,000,000 applicable exclusion amount was indexed for inflation, it rose to $5,120,000
in 2012. This means that for the rest of
this year (barring changes by Congress), a person who has not yet used any of this
exclusion amount can give away up to $5,120,000 and pay no gift tax, and a
married couple can give away up to $10,240,000 free of gift tax. Moreover, gifts in excess of these amounts
are subject to a relatively low gift tax rate of 35%, before the maximum rate rises
to 55% next January. For wealthy
individuals, making significant gifts this year is an attractive way to reduce
transfer taxes that would otherwise almost certainly be payable in estate taxes
in future years.2 A lifetime gift is also more attractive than
a testamentary gift because any tax used to pay the gift tax is not itself
subject to tax (unless the donor dies within three years after making the gift),
which is not the case with the estate tax.
While these generous exemptions and gift tax rates are currently
scheduled to last through 2012, it is possible that Congress could change the
rules prior to year end. Also, some of
the gifting structures that maximize these transfer tax savings can be complicated
to put in place, or may utilize interest rates that could rise throughout this
year. Therefore anyone considering
taking advantage of these gifting opportunities should consult an estate
planning attorney right away to explore the options.
Outright Gifts.
The simplest gift, of course, is an outright gift of cash
to a donee. This can be accomplished
with a check or wire transfer, and would be reported on a gift tax return filed
by April 15, 2013. (All gifts discussed
in this article will require a gift tax return to be filed by next April.) Alternatively, gifts of other assets (e.g., stocks, artwork, real property) can
be gifted with appropriate title transfers.
Gifts of anything but cash or marketable securities will require some
type of valuation appraisal as of the date of the gift, and the appraisal will
be filed with the gift tax return in support of the reported valuation. We always recommend that our clients obtain
appraisals from reputable appraisers who have experience valuing the type of
asset at issue, and who have experience preparing appraisals that support the
values reported on gift and estate tax returns.
The upfront cost of engaging an experienced appraiser often makes the
difference in whether the return is subject to audit and, if audited, whether
the taxpayer's valuation position is successful.
Other Gifts: GRATs, QPRTs, CLATs and More.
Other gifting structures exist. These are not new structures, but they have
added appeal this year because of the generous gift tax exemption, the low gift
tax rate, depressed property values, and historic low interest rates. For example, it is possible to create a
grantor retained annuity trust (GRAT). A
GRAT is an irrevocable trust to which the grantor transfers assets while
retaining the right to receive an annuity in fixed or increasing dollar amounts
for a period of years.3 The property remaining in the trust at the
end of the period passes to other beneficiaries, for example the grantor's
children. The actuarial value of the
annuity, because it is retained by the grantor, reduces the amount of the
taxable gift. The only taxable gift is
the gift of the remainder interest, which is calculated using applicable rates
and discount factors published by the IRS every month. Because that calculation quantifies the
present value of a future interest, there is an automatic discount in the value
of the gift because it will not be realized by the remainder beneficiaries
until a future date. The current low applicable
interest rates used in the calculation depress the value of the remainder further
for gift tax purposes. For illustration,
a gift of $5,000,000 worth of property to a GRAT in April 2012 that pays $250,000
(5%) to the grantor every year for 20 years will result in a taxable gift of
only $665,225 (the actuarial value of the remainder interest using April's 1.4%
applicable federal rate, assuming the grantor has not used any of his or her
exemption prior to this gift). The
grantor thus pays a gift tax of $232,829 ($665,225 x .35) to transfer
$5,000,000 to his or her beneficiaries, while retaining a valuable
annuity. If the grantor did not create
this GRAT and passed away next year still owning the $5,000,000 in assets, the
grantor's estate would pay approximately $2,000,000 in estate tax on
these assets alone, assuming no change in the estate tax laws between now and
then. This is one of the key benefits of
a GRAT.
A GRAT works best with income-producing assets that are
expected to outperform the applicable federal rate over the term of the trust,
and can be useful if the grantor wishes to make a significant gift but retain
income from the property. If the grantor
does not survive the trust term, all or a substantial portion of the value of
the trust assets will be included in the grantor's gross estate for estate tax
purposes, which eradicates all or much of the tax savings feature of the
GRAT. This risk can be eliminated if the
grantor does not retain the right to the annuity, or minimized by setting a
GRAT term that the grantor is reasonably expected to survive. By not retaining the right to the annuity, or
by retaining the annuity but surviving the GRAT term, the value of the assets-including
any appreciation after the date of the gift-will not be subject to estate tax
in the grantor's estate if the grantor survives the transfer by three years.
Other irrevocable trusts use the same general approach but
with different assets or for different purposes. For example, a qualified personal residence
trust (QPRT) can accomplish a similar result if a grantor wishes to retain the
right to use a primary home or a vacation residence, but gift a remainder
interest in the property to children or others at the end of the trust term,
outright or in further trust. Today's weak
real estate values can provide further leverage for the gift of a residence, by
depressing the value of the gift and placing future appreciation in the hands
of the remainder beneficiaries, provided that the grantor survives the term of
the QPRT.
For a grantor with philanthropic desires and no need for
income from the gifted property, a charitable lead annuity trust (CLAT) can
provide a favorite tax-exempt charitable organization with the right to an
annuity for a period of years, with the remainder passing to the grantor's
children or others at the end of the trust term, outright or in further trust. Again, the taxable gift is the present value
of the remainder interest at the time of the gift using the applicable federal rate.4 In this case the grantor will be entitled to
a gift-tax charitable deduction for the present value of the annuity, and pay
gift tax (or use gift tax exemption) only of the discounted value of the
remainder interest.
The current low applicable federal rates also provide
opportunities to employ installment sales as a companion to gifting techniques,
to transfer further value to family members.
For example, a single donor may wish to sell an investment property to
his children. If the property is worth
more than the amount of his available 2012 gift tax exemption (ignoring for
this example discounts that may be available based on the nature of the
property or the entity in which it is held), the balance could be sold to the
children in equal shares in exchange for long-term notes payable to the grantor
using the applicable federal rate for the month of the gift (taking into
account discounts that would be available for the purchase of a non-controlling
minority or fractional interest). For
illustration, a 15-year note for $300,000 in April 2012 should use an
applicable federal rate of at least 2.72%, resulting in annual interest
payments of $8,160 owed by each child; notes with terms less than nine years
would have a significantly lower rate:
1.15% in April 2012.
Another type of trust with favorable tax benefits in
certain situations is an "intentionally defective grantor trust" ("IDGT"). This is an irrevocable trust which a grantor
would establish for the benefit of others, e.g.
children and grandchildren. Normally an
irrevocable trust in which the grantor retains no beneficial interest would be
its own taxpaying entity, and it or its beneficiaries would be subject to
federal and state tax on its income and gains.
In the IDGT, though, the grantor retains certain limited powers that
require the income and gains of the trust to be reported by the grantor. The grantor pays the taxes associated with
the trust for as long as he or she holds the powers, which allows the trust
assets to grow in value without reduction for income taxes.
Donors might also consider using this year's historic low applicable
federal interest rates and large exemptions to gift interests in closely-held
businesses or other assets to the next generation. These types of gifts are more complicated, often
utilizing various types of trusts and business entities to consolidate the
management of the closely-held business after the gifts are made. These structures can also include installment
sales to IDGTs that are disregarded for income tax purposes. With careful planning and ongoing respect for
the business structures that are employed, such gifts can represent very
significant long-range gift and estate tax savings. Many of our wealthier clients are utilizing a
variety of the planning mechanisms outlined in this article. Individuals who are considering these gifts
should act soon and work with an experienced estate planning attorney, because
these structures can take some months to put in place (depending on the assets
being transferred) and will require the assistance of a qualified and
experienced appraiser, who will need ample time to value the gifts at issue and
prepare a thorough valuation report.
GST Tax.
An estate planning attorney can also advise on other taxes
that should be considered as part of the planning process. One of these is the federal
generation-skipping transfer ("GST") tax, which (along with the estate and gift
tax) is the third of the three federal transfer taxes. Like the gift and estate tax, this year the
GST tax also enjoys a low marginal tax rate of 35% and a $5,120,000 per person
exemption, before reverting to a 55% rate and a $1,360,0005 exemption
next year. An estate planning attorney
can advise a donor with long-range gift planning goals about the most effective
way to utilize the GST exemption and provide for minimal transfer taxes over
successive generations, if that is desired.
Just as importantly, the attorney can advise the donor how to avoid
inadvertent GST taxation on gifts to family members or others whose receipt of
a gift will be deemed to "skip" a generation (e.g., 37 ½ years in the case of gifts to non-family members).
Income Taxes.
In planning a large gift, it is also important to analyze
the effect of applicable income taxes when deciding what assets to transfer,
since gifted assets have a carryover income tax basis, whereas assets
transferred at death enjoy a stepped-up (or stepped-down) basis. High-basis assets are generally considered better
candidates for gifting than low-basis assets, to (i) reduce the capital gains
tax paid by the gift recipient on any later sale of the asset, and (ii) to permit
the low-basis asset to receive a step-up in basis on the owner's death, to
minimize capital gains taxes on its subsequent sale. However, these are complex calculations that
take into account many variables, so the choice among available assets for
gifting should be carefully evaluated by the donor, with the assistance of his
or her estate planning attorney and possibly an accountant and financial
advisor.
State Taxes.
In terms of state taxes, an estate planning attorney can
also advise whether the donor's state of domicile imposes its own state gift tax, and the effect of that gift
tax-and any other relevant state taxes-on the proposed 2012 gifts. For example, a gift or sale of real property to family members in California
can result in reassessment for property tax purposes which might be avoidable
if the transaction is structured correctly, by use of various exemptions from
reassessment. A gifting plan that is
advantageous from a federal tax perspective may lose much of its appeal if it
comes with a hefty state tax price tag.
A similar analysis should be made if the donor is subject to any non-U.S.
gift tax laws.
Future
Legislation?
Legislative changes have been proposed that might impact
the ability to make some of the gifts described here, e.g., gifts to GRATs, gifts of minority interests in certain assets
to family members, and the use of IDGTs.
We do not know if or when these changes will occur, or in what form, but
the fact that Congress and the administration are paying special attention to
these particular planning tools suggests that an individual interested in using
them act sooner rather than later, before there are any changes in the
applicable law.
Also, there is a possibility that future federal
legislation will try to recapture (or "clawback") the benefits taxpayers obtained
in 2011 and 2012 by utilizing their increased gift tax exemptions. The most likely way this might occur is that
upon a taxpayer's death, the value of prior gifts is required to be reported on
the taxpayer's estate tax return, and the difference between this year's gift
tax exemption amount and the future estate tax exemption amount in effect at
the taxpayer's death would be subject to estate tax, either at the estate tax
rate in effect in the year of death, or possibly at the 35% rate in effect this
year. Most experts believe this scenario
is unlikely for basic reasons of fairness:
taxpayers should not be penalized at a later date for having relied upon
current law for their gift and estate planning.
However, since the ultimate answer will depend to a degree upon an
interpretation of the 2001 Tax Relief Act (upon which the current estate and
gift tax system is based), and upon future Congressional action, it is
impossible to predict the outcome with any certainty.
Final Thoughts.
One important caveat:
the financial condition of the donor is paramount. The ability to transfer significant wealth at
low (or no) transfer tax cost this year does not necessarily mean that it is
the right decision in every case. As
with any large gift, a donor should carefully consider his or her cash flow
needs well into the future. Minimizing
taxes can be beneficial, but not if it leaves the donor with financial worries
or a lack of financial security in future years.
Despite this caveat, for the right donors with sufficient
wealth and donative intent, it is worth considering making gifts this year
while the tax rates and exemptions are so favorable.
1 Sometimes referred to as one's gift or estate tax "exemption."
2 There is always the possibility that Congress could
reduce or eliminate the federal estate tax, but making gifts this year within
one's available exemption amount will not subject the donor to any tax that
might otherwise be avoided later on repeal of the estate tax.
3 There is a similar trust, a grantor retained unitrust
(GRUT) that provides annual payments based on a fixed percentage of the value
of the trust assets, determined annually.
4 For a CLAT, there is an added advantage of being able
to use the applicable federal rate in effect for the month of the gift or
either of the two preceding months, to minimize the taxable gift.
5 Subject to further inflation adjustment.
Morrison & Foerster's Trusts and Estates group provides sophisticated planning and administration services to a broad variety of clients. If you would like additional information or assistance, please contact Patrick McCabe at (415) 268-6926 or PMcCabe@mofo.com.
© Copyright 2012 Morrison & Foerster LLP. This article is published with permission of Morrison & Foerster LLP. Further duplication without the permission of Morrison & Foerster LLP is prohibited. All rights reserved. The views expressed in this article are those of the authors only, are intended to be general in nature, and are not attributable to Morrison & Foerster LLP or any of its clients. The information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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