Judicious Use of Your Estate and Gift Tax Exemption Requires Action Soon

The year 2012 presents U.S. taxpayers with a gift planning dilemma. As the law stands today, and at least until December 31, 2012, every person may transfer up to $5,120,000 ("Estate Tax Exemption") of assets to any one or more persons (excluding spouses) without incurring estate or gift tax obligations. For a married couple, that amount doubles, up to $10,240,000. This is in addition to the $13,000 that each person can gift annually to as many individuals as he or she desires ($26,000 for a married couple). The Estate Tax Exemption is reduced dollar for dollar for any annual gifts in excess of $13,000 ($26,000 for a married couple).

In addition, transfers to grandchildren and younger generations in trust are subject to a second layer of tax at the grandchild's death, known as the generation-skipping tax. The generation-skipping tax system also exempts up to $5,120,000 of assets per transferor (also reduced for prior gifts exceeding $13,000 per year, per person to those who are in the grandchildren's generation or younger).

President Obama's proposed budget would reduce these amounts to $3.5 million ($7 million per couple). In addition, his budget would make dramatic changes to the use of unique planning opportunities offered by grantor trusts and grantor retained annuity trusts. It is highly likely that nothing will change before the November elections. After that, anything may happen - including nothing - which would take us back to the law as it was in 2001. This would reduce the $5,120,000 exemption to $1 million (with indexing, this is about $1,130,000). We have also been advised that even if these exemptions are reduced in 2013, taxpayers who take advantage of the higher exemption amount now will retain the full benefit of the current exemption, notwithstanding the fact that there may be a lower exemption at the time of their deaths.

For this reason, there is already a flurry of activity in the estate planning area for clients with significant wealth. Many are making outright gifts of significant amounts to children and grandchildren. Some are doing so using irrevocable trusts, in order to regulate distribution and protect trust assets from dissipation caused by divorce and creditor claims. People are living longer and the prospect of second marriages raises concerns for the senior generation. Trusts provide the grantor with the ability to preserve family wealth for the grantor's bloodline.

Still others are employing leveraging transactions such as grantor trusts or grantor retained annuity trusts, which are specially crafted trusts that effectively increase lifetime gifting. Family limited liability companies continue to serve as valuable planning vehicles for both wealth transfer and asset protection. There are any number of powerful estate planning techniques that can be used to take advantage of the increased exemption in the most tax-efficient manner.

What if you cannot afford, though, to give up control of the wealth you transfer, but wish to lock in the $5,120,000 exemption? If you are married, one possibility is for each spouse to set up different trusts so that the other spouse has use of the gift during his or her lifetime and that, upon death, the property goes to the lineal descendants. If both spouses live to their "life expectancy" ages, the income and principal of the trust, within limits, will be fully available to the spouses making the transfer, for most of the rest of their lives. At the same time, the full exemption is used and the transfer could be exempt from estate taxation forever. Here is an example:

Rick and Leslie are married. Rick's net worth is $20 million, consisting almost entirely of the value of the family business owned by Rick. Leslie's net worth is $10 million, which includes the principal residence, a second home in California, about $4 million of investable assets and about $4 million of stock in the family business. Rick and Leslie expect their estates to pay an estate tax, at the death of the survivor, of at least $10 million. They want to take advantage of the current $5,120,000 per person exemption in 2012 and also remove appreciation in assets from their estates.

In February 2012, Rick established an irrevocable grantor trust. It provides that Leslie gets all of the income and principal, as needed, to support her lifestyle. Rick transferred his non-voting shares of the family business to the trust with a value of $5,120,000. A bank was selected as trustee.

In May 2012, Leslie decided to do something similar to Rick, except that her trust may, at the discretion of the trustee, accumulate income. In addition, the principal may be distributed to Rick, again at the discretion of the trustee, and his will contains a power of appointment which enables him to affect the relative ownership of shares of the trust by the next generation. One of Leslie's trusted friends is the trustee.

Until the death of either Rick or Leslie, they will have the full benefit of the income and, potentially, the principal as needed from both trusts. When one dies, the survivor must be able to live without the income from 1/2 of the property, although life insurance can be purchased to protect against a premature death. In the alternative, certain limited powers of appointment may be used to prevent the loss of income on the first death.

There are also many other leveraged ways to take advantage of the current law. Do not be lulled into a false sense of security based upon the current $5,120,000 exemption. As noted above, we do not know what Congress will do, and there is a possibility that the exemption may revert to $1,130,000. Although no one can tell what will happen in the future, there are ways to lock in today's law without giving up full control over the property you gift. For more information, please contact any of our Tax and Wealth Management Attorneys:

James Mackey - 216-928-2921
Lacie O'Daire - 216-928-2901
Robert Horbaly - 216-928-2934