Morrison & Foerster LLP: Gift Tax Planning Opportunities: The Window Is Closing

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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