Fiduciary Trust International

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Many individuals put tax planning on hold last year given the unclear future of U.S. tax law. When the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 was signed into law, it offered much anticipated (although temporary) clarity. The Act is effective through 2012, offering a two-year window to implement wealth transfer plans that take advantage of today’s law.  

The Act reunified the gift and estate tax exclusions, enabling individuals to transfer up to $5 million tax-free, which can be applied either to lifetime gifts or to amounts passing at death through an estate. The law extends the exclusion even further by allowing for “portability” between spouses, so any unused exclusion amount may be transferred to a surviving spouse.1 In addition, the Act increased the Generation Skipping Transfer (GST) tax exemption to $5 million. The current top tax rate for gift, estate and GST tax is 35% for transfers made above the $5 million exclusion amount.

In 2013, if Congress does not act to alter the law, the gift and estate tax exclusion will be reduced to $1 million, and any transfers above $1 million will be taxed at a top rate of 55%. In addition, the top GST tax rate is also scheduled to increase to 55% after 2012, with a reduced exemption of $1 million. While no one can predict what actions Congress will take to change the law, if tax rates increase as planned, the next two years present a unique opportunity to transfer more wealth tax-free, and make any additional transfers at a much lower rate.

STRATEGIES TO TAX-EFFECTIVELY TRANSFER WEALTH UNDER TODAY'S LAW   Keeping a current wealth management plan is critical to protecting wealth through changing tax environments. The following solutions offer particular advantages under the current law for individuals who are looking to tax-effectively transfer their wealth.

1. The election must be made on the decedent’s estate tax return, even if no estate tax is due. We caution against relying on of a deceased spouse’s exemption because the amount is not indexed to inflation, there is no assurance that portability will apply after 2012, and a deceased spouse’s unused exemption amount is lost if a spouse remarries.

1. MAKE LIFETIME GIFTS
The Act significantly increased from prior law the amount that individuals may gift without incurring a gift tax. Therefore, more assets, and any future appreciation of those assets, can be removed from the estate. There are a number of ways to take advantage of the law:

• Utilize the annual gift tax exclusion
  The annual gift tax exclusion is a simple way to maximize lifetime transfers without reducing an individual’s $5 million lifetime transfer tax exclusion. The annual exclusion permits individuals to give up to $13,000 per year2 (or $26,000 by a married couple3) to as many recipients as they wish.
  
• Pay for others’ medical and educational expenses
  Another way to transfer wealth free of gift tax is to pay for another person’s current medical or educational expenses. As long as payments are made directly to the provider, such gifts do not reduce an individual’s $13,000 annual exclusion or the $5 million lifetime transfer tax exclusion.
  
• Make tax-free gifts under the lifetime exclusion
  Making significant gifts up to the $5 million lifetime transfer tax exclusion can be another effective planning strategy. Many individuals may wish to consider making gifts to take advantage of this higher exclusion before the end of 2012, as the exclusion is scheduled to decrease to $1 million in 2013.

A risk in making lifetime gifts up to the higher exclusion amount is that there may be a tax “clawback” at the estate tax level if the grantor dies after 2012. If grantors gift the full $5 million exclusion amount, but a lower exclusion is in place at the time of death after 2012, estate tax could be owed on the difference. While there is speculation about how this issue will be addressed, as it stands, estate taxes would apply to any tax-free gifts made in the past above the exclusion amount in effect at the time of the grantor’s death. Nevertheless, making large gifts makes sense because the appreciation on the gifted assets is not “clawed back”; however, estate plans should take into account how the “clawback” tax would be paid.

Factors to Consider When Making Lifetime Gifts

It is important to keep in mind that gifts are irrevocable. While lifetime gifting can provide significant tax advantages, grantors should take other considerations into account before making gifting decisions: Are the beneficiaries ready to manage the gifted assets responsibly? Will there be other beneficiaries to consider in the future? Are the grantors comfortable living with their remaining assets? Because future tax law changes are always unpredictable, making gifting decisions solely for tax reasons without considering family issues can result in an undesired outcome, especially if future tax law is more favorable than expected.

Advantages of Lifetime Gifts

• A larger tax-free gifting opportunity. Today’s favorable $5 million transfer tax exclusion is scheduled to be reduced to $1 million in 2013.
• Protection from estate tax. Gifted assets are not subject to federal estate tax since they are removed from the grantor’s estate. There is the possibility of tax “clawback.” This means estate tax may be triggered on assets that were gifted tax-free under a higher exclusion amount during the grantor’s lifetime if the exclusion amount is lower at the time of death.
• Tax-free future growth. Appreciation of gifted assets is not subject to estate tax because the growth occurs outside of the grantor's estate.
  

2. UTILIZE GRANTOR RETAINED ANNUITY TRUSTS
A Grantor Retained Annuity Trust (GRAT) is an irrevocable trust that can allow individuals to transfer the appreciation of assets to heirs free of gift tax. GRATs are particularly attractive for individuals who have assets they believe will significantly appreciate and who would like to remove this appreciation from their estate.

The grantor transfers assets to the GRAT and, in turn, receives an annuity paid from the trust over a specified term. Generally GRATs are set up so that the annuity payments to the donor equal the amount of assets originally transferred into the GRAT, plus an assumed rate of return that is established by the IRS, known as the “hurdle rate” (this technique is called “zeroing out”). At the end of the GRAT’s term, any appreciation of trust assets that exceeds the IRS hurdle rate passes free of gift tax to the beneficiaries.

This example is for illustration and discussion purposes only. Example assumes a two-year GRAT with 8% annual appreciation and a 2.8% IRS 7520 hurdle rate.

GRATs are generally structured for short periods of time, and donors often use successive GRATs. This approach lowers the risk of a grantor passing away during the GRAT’s term, which would nullify the estate tax benefit since the assets in the GRAT would then revert back to the estate.

The environment for GRATs is especially advantageous because the IRS hurdle rate is just 2.8%.4 Since any appreciation above the hurdle rate amount transfers tax-free to beneficiaries, the lower the hurdle rate, the higher the potential amount transferred to beneficiaries.

The tax advantages of GRATs have been challenged by recent budget proposals that would require longer GRAT terms, which would make it more difficult for grantors to outlive the trust and successfully transfer the assets. The proposals have also sought to prohibit the practice of zeroing out a GRAT, which would limit the amount that can be transferred free of gift tax. While these proposals have not yet been adopted, they may increase the urgency in employing a GRAT strategy.

Advantages of Grantor Retained Annuity Trusts

• No gift tax paid by the donor. Assets transferred to the trust are free of gift tax (assumes the GRAT is zeroed out).
• Annual income stream. The grantor receives annuity payments each year.
• Beneficiaries are not subject to tax. The assets received by the beneficiaries at the end of the trust term are not subject to gift or estate tax.

3. ESTABLISH A DYNASTY TRUST
Current tax laws in some states allow individuals to create trusts that exist in perpetuity, called Dynasty Trusts. Assets placed in Dynasty Trusts pass from one generation to the next free of estate tax. None of the assets held by the trust are included in either the grantor’s taxable estate or any of the beneficiaries’ taxable estates.

The new $5 million transfer tax exclusion provides a greater opportunity to avoid gift tax and Generation Skipping Transfer (GST) taxes. If individuals elect to apply their gift and GST tax exclusion, they will not be subject to gift tax when funding the Dynasty Trust. And, when assets are removed from the trust, future generations will not be subject to GST tax when they remove the assets. 
 
A Dynasty Trust is most effective if grantors have not already depleted their GST tax exemption. By allocating the GST exemption to the trust, the grantor can avoid the imposition of significant GST taxes on distributions to beneficiaries.

Advantages of Dynasty Trusts

• Benefits future generations. Assets can remain in the trust to benefit distant generations.
• Long-term tax benefits. The principal amount plus any appreciation is passed onto successive generations free of estate tax and Generation Skipping Transfer tax.
• Creditor protection. The terms of the trust may offer creditor protection for the trust beneficiaries.
• Estate tax protection. Assets gifted to the trust are removed from the grantor’s estate and thus are not subject to federal estate tax.

IMPORTANT REMINDER
Importantly, individuals who made gifts directly to grandchildren in 2010 to take advantage of the 0% GST tax rate must opt out of the automatic allocation of the GST tax exemption on their gift tax return.

SPEAK WITH YOUR FIDUCIARY TRUST CONTACT OR YOUR ADVISOR TODAY
With current tax laws set to expire on December 31, 2012, now is a good time to review your estate plan. We encourage you to contact us or your advisors to discuss the best approach for your individual situation.

2. The annual exclusion is scheduled to be indexed to inflation.
3. Married couples must file a gift tax return, Form 709, in order to elect to split gifts if just one of the spouses is funding the gift.
4. IRC 7520 rate as of February 2011.

This communication is intended to provide general information. The information and opinions stated are as of February 15, 2011, unless otherwise indicated, and do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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