Spring 2011 Newsletter
Opportunity is Knocking for Making Large Lifetime Gifts in 2011 & 2012
By the Attorneys at Vaughan, Fincher & Sotelo, PC
Patrick J. Vaughan, Donna E. Fincher, Martha L. Sotelo, C. Daniel Vaughan, Diane M. Yawn and Kathi L. Ayers
Just when we thought our legislators would provide clarity to the federal wealth transfer rules, Congress opted instead to simply kick the can down the road for two years. On December 17, 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “2010 Act”) was enacted, changing the federal wealth transfer tax rules, but only through 2012. The lifetime gift, estate and generation-skipping transfer (GST) tax exemptions are each increased to $5,000,000 per individual, and the maximum tax rate for all three regimes is reduced from 55% to 35%. It cannot be stressed enough, however, that these rules and rates are only temporary and are set to expire on December 31, 2012. At that time, if Congress does not pass new legislation, the $5,000,000 estate and gift tax exemptions will default to $1,000,000 each (and the GST exemption will default to $1,000,000, indexed for inflation), and the maximum tax rate will increase from 35% to 55%.1
While enthusiasm for historically high exemptions, combined with anxiety regarding potential reversion to significantly lower numbers, may cause motion sickness to practitioners and their clients, this two-year window provides significant opportunity for the wealthy. Focusing mainly on the increase in the lifetime gift and GST exemptions from $1,000,000 to $5,000,000, this article will identify several of these opportunities and explain how they can be implemented to achieve significant tax savings for clients and their families.
II. Lifetime Gift Strategies
A. Dynasty Trust.
1. Discussion: A dynasty trust is a trust designed for maximum duration for the benefit of multiple younger generations (i.e., children, grandchildren, great-grandchildren, etc.). Its primary goal is to preserve the grantor’s assets from erosion due to gift, estate and GST taxes. A secondary goal may be to reduce income tax liability by permitting the trustee to make discretionary distributions to any one or more members of a pool of beneficiaries, thereby shifting income to lower bracket family members. The 2011-2012 increased lifetime gift and GST tax exemptions enable donors to shift significant wealth to one or more dynasty trusts to take advantage of these planning objectives.
2. Example: Bill Client (83) and Carol Client (83) have a $15,000,000 estate, $12,000,000 of which consists of income-producing marketable securities and cash equivalents. Bill and Carol are in a high income tax bracket. Their sons, Tim (60) and Mike (58) are teachers who will soon retire. Each son is happily married with two children. Bill and Carol establish a dynasty trust for each son. The Tim Client Family Trust will benefit Tim and his descendants, and the Mike Client Family Trust will benefit Mike and his descendants. Bill and Carol name their sons as trustees of their respective trusts and name a succession of alternate trustees. The trusts authorize the trustees to make discretionary distributions of income and principal to or for the benefit of any one or more of the beneficiaries (including the authority to make distributions to individual beneficiaries to the exclusion of others) for their reasonable support, maintenance, education and medical care. Each trust provides that pursuant to §55-13.3.C. of the 1950 Code of Virginia, the rule against perpetuities does not apply to the trust. Bill and Carol make a gift of $2,500,000 to each trust. They file gift tax returns and allocate GST exemptions for the full amount of the gifts.
Bill and Carol have placed one-third of their estate (including its future growth) outside the federal wealth transfer tax system. In addition, by permitting the trustees to make distributions exclusively to lower bracket beneficiaries (if appropriate), they have empowered the trustee to reduce the income tax profile of the transferred assets.
B. Family Limited Liability Company (FLLC).
1. Discussion: Clients frequently want to give assets with one hand and control them with the other. The FLLC is ideally suited for this purpose. Senior family members form a FLLC and transfer assets to it. They will name themselves as managers with authority to make all decisions for the FLLC. Periodically, senior family members make gifts of FLLC interests to younger family members. There are usually restrictions on the transferability of FLLC interests (e.g., no transfers to non-family members). As a result of the lack of control and lack of transferability, the gift tax valuation of transferred FLLC interests may include significant valuation discounts. Of course, qualified appraisals should be obtained to support any discounts taken on a gift tax return.
2. Example: Dave Client (75) and Ann Client (75) have a $12,000,000 estate, $9,000,000 of which consists of equity in rental real estate properties. Dave and Ann want to share future income and asset growth with their children, Doug (45) and Cindy (42), but want to retain decision-making control over those assets. They establish Client Family LLC, the initial members of which are Dave (50%) and Ann (50%). In the LLC operating agreement, Dave and Ann are designated as managers, and retain all decision-making authority on behalf of the company. In addition, the operating agreement applies significant restrictions regarding the transferability of member interests. They deed all of their rental real estate properties into the LLC. A year later, Dave and Ann make gifts of LLC member interests to their children. After these gifts are made, the ownership of LLC member interests is: Dave (10%), Ann (10%), Doug (40%) and Cindy (40%). A qualified appraiser discounts the gifts by 30% for lack of control and lack of marketability. Dave and Ann file gift tax returns reporting gifts totaling $2,520,000 to each child ($9,000,000 x 40% x 70%).
By pairing the utilization of increased lifetime gift exemptions with this leveraged gifting strategy, Dave and Ann are able to transfer significant wealth to their children. In addition to watching the transferred interest grow outside of their taxable estates for estate tax purposes, Dave and Ann enjoy that the income attributable to the transferred interests is reportable on Doug’s and Cindy’s income tax returns (presumably at rates lower than that of Dave and Ann).
C. Grantor Retained Annuity Trust (GRAT).
1. Discussion: A GRAT is a trust into which the grantor transfers assets and takes back a fixed annuity payment, made at least annually, for a specified term. The grantor is treated as making a gift equal to the value of the assets transferred to the GRAT less the present value of his or her retained annuity payments. Upon the expiration of the annuity payment term, the remaining trust assets are distributed to younger family members, typically either outright or subject to trusts for their benefit. If the grantor survives the annuity payment term, the remaining trust assets will pass to the trust beneficiaries free of federal estate and gift tax. The grantor achieves a transfer tax-free shift of wealth to the trust beneficiaries to the extent the trust’s combined rate of income and growth exceeds the applicable Section 7520 rate (this technique works best when the 7520 rate is low). If the grantor dies before the end of the annuity payment term, a portion or all of the remaining trust assets will be includible in the grantor’s estate and be subject to estate tax.
2. Example: Susan Client (65), divorced and not remarried, is in good health and has a $10,000,000 estate, $5,000,000 of which consists of bank stock she recently inherited from her mother. Susan expects the local bank to be acquired by a national bank at a premium within the next ten years. Susan wants to replicate the bank dividends she currently receives by retaining an annuity of $250,000 per year payable quarterly for ten years (the “annuity payment term”). Upon the expiration of the annuity payment term, the stock will be distributed to her children. In April of 2011, Susan creates a ten year GRAT with a 5% annual annuity payment (paid quarterly) and funds it with $5,000,000 of bank stock. Susan will receive a quarterly annuity payment of $62,500 ($5,000,000 x 5% ÷ 4) for ten years.
If Susan survives the annuity payment term, the remaining assets in the GRAT will be distributed to her children free of additional wealth transfer taxes. If Susan dies before the end of the annuity payment term, the remaining assets in the GRAT will be includible in Susan’s estate and be subject to estate tax. Susan files a gift tax return reporting a gift of $3,039,713 ($5,000,000 less the present value of Susan’s retained interest of $1,960,287). If Susan survives the annuity payment term, she will have taken advantage of utilizing a large portion of the $5,000,000 lifetime gift exemption available to her in 2011-2012 and will have placed the trust’s assets, plus future growth on those assets (including the potential explosion of value associated with the possible future acquisition of the bank), outside of her estate for estate tax purposes.
D. Qualified Personal Residence Trust (QPRT).
1. Discussion: The QPRT is a trust into which the grantor transfers his or her primary or secondary home but retains the exclusive use of the property for a specified term of years (referred to as the “QPRT term.”). The grantor is treated as making a gift equal to the value of the home less the present value of his or her retained use of it, computed by using the applicable Section 7520 rate. At the end of the QPRT term, the home will pass to the beneficiaries specified in the trust document (usually younger family members). If the grantor survives the QPRT term, the home (including any appreciation) will pass at that time to the trust beneficiaries free of any additional transfer taxes. The grantor can be allowed to remain in the home after the QPRT term if he or she pays fair market rent to the trust beneficiaries. Rental payments will reduce the grantor’s estate and not be treated as gifts. If the grantor dies before the end of the QPRT term, the home will be includible in his or her estate and be subject to federal estate tax.
2. Example: Andy Client (65) is a widower who is in good health. Andy has an $8,000,000 estate, $3,000,000 of which is the appraised value of an oceanfront beach home Andy inherited from his parents. He expects the property to appreciate substantially in the future. The beach house is Andy’s secondary residence. Andy wants to retain exclusive use of the proerty for ten years and then shift ownership to his children. In April of 2011, Andy establishes and funds a ten year QPRT (the “QPRT term”) with his beach house. If Andy survives the QPRT term, ownership of the beach house will shift to his children, free of any additional transfer taxes. If Andy dies before the end of the QPRT term, the beach house will be includible in his estate and be subject to estate tax. Andy files a gift tax return reporting a gift of $1,752,750 ($3,000,000 less the present value of Andy’s retained interest of $1,247,250).
III. A Word of Caution
In the past, many wealthy clients were either reluctant to utilize an appreciable portion of their lifetime gift exemptions (in order to preserve the precious resource for future opportunities) or were restrained in their gifting programs by the $1,000,000 limit. Now that the 2010 Act has quintupled the lifetime gift exemption from $1,000,000 to $5,000,000, focus has been placed on potential utilization of the additional $4,000,000 exemption in 2011 and 2012. Before the champagne is uncorked, poured and served however, several cautionary observations should be considered:
1. At the time of this writing, it is unclear what effect, if any, the scheduled expiration of the additional $4,000,000 lifetime gift exemption will have on the estate of a decedent who uses the additional exemption in 2011-2012 and then dies after its expiration. The additional exemption might be “clawed back” (i.e., recaptured) in the decedent’s estate, causing estate tax liability on an imputed asset equal to the excess exemption used for lifetime gifts. A cost-benefit analysis may very-well favor making the lifetime gifts even in light of possible recapture. However, a thorough analysis, taking into consideration predicted post-transfer growth of gifted assets and reduced post-transfer income tax burden for the family group, must be performed prior to the completion of the gift.
2. As with any lifetime gifts, carry-over basis will apply to any transferred assets and the donee will not receive a step-up in basis on those assets upon the donor’s death.
3. Finally, to state the obvious, gifts are irrevocable and may not be undone once completed. The tax tail should never be allowed to wag the dog, and clients should only engage in gifting strategies if their economic realities support the proposed transactions.
The increased lifetime gift and GST exemptions afford wealthy family members considerable latitude in transferring assets to less wealthy family members. Maximizing the use of the increased exemptions can enable clients to remove significant assets from exposure to transfer taxes (not only upon their deaths, but for generations to come) and can provide opportunities to reduce the income tax burden placed on assets for the entire family group. At least for 2011 and 2012, opportunity is knocking for making large lifetime gifts.
Vaughan, Fincher & Sotelo, PC, with offices in Vienna and Leesburg, is dedicated to providing estate planning and estate administration services to families in the Washington metropolitan area. Firm attorneys are experienced in developing and delivering comprehensive estate plans tailored to client individual needs and circumstances.
1 Under the 2010 Act, the sunset of the EGTRRA estate and GST tax provisions—which had been scheduled to apply to estates of decedents dying, and generation-skipping transfers made, after Dec. 31, 2010—is extended to apply to estates of decedents dying, and generation-skipping transfers made, after Dec. 31, 2012. (2010 Act §101(a)(1)).