The remaining months of 2012 provide an unprecedented opportunity for higher-net-worth individuals and families to transfer wealth to future generations without incurring federal gift tax. Under tax rules scheduled to expire at the end of this year, individuals can make tax-free gifts of up to $5,120,000 (married couples can gift twice that amount). Unless Congress acts, the exemption will drop to $1,000,000 in 2013. Taking advantage of this unique gifting opportunity before the end of the year could save a tremendous amount in future estate taxes.
Understanding Federal Gift and Estate Tax Rules
Gift and estate taxes are excise taxes imposed by the federal government on the transfer of assets during lifetime or at death. These taxes are only incurred if the value of the property transferred exceeds the applicable exclusion amount.
In the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “2010 Act”), the applicable exclusion amount was increased to $5,000,000 per person beginning in 2011. The inflation-adjusted exclusion amount increased further to $5,120,000 for 2012, creating the highest exclusion amount since the modern estate tax was enacted into law in 1916. The 2010 Act also lowered the tax rate on transfers above the exclusion amount to a flat 35%, creating the lowest gift and estate tax rate since the FDR administration (see Table 1). Finally, the 2010 Act “reunified” the exclusion amount for both gift and estate tax purposes, meaning the exclusion can be used to make lifetime gifts or transfers that take effect only at death. All of these changes to the federal gift and estate tax rules were welcomed as being very favorable to U.S. taxpayers.
Every situation should be evaluated on a case-by-case basis before deciding whether to make large gifts in 2012. Unfortunately, the favorable rule changes established by the 2010 Act are set to expire automatically at the end of 2012. Unless new legislation is enacted (which will require an agreement by both Houses of Congress, as well as the President), the exclusion amount reverts to $1,000,000 and the top tax rate rises to 55% for 2013 and beyond.
The fate of these and other Bush-era tax cuts will hinge to a large degree on the outcome of the November elections. While no one can predict with any certainty what will happen in the elections, one of these three scenarios will likely have an impact on future gift and estate tax rules.
• More gridlock. If Congress and the White House remain divided, with parts of the government controlled by the Republicans and parts of the government controlled by the Democrats, 2013 could begin with what some commentators are calling “Taxmageddon.” All Bush-era tax cuts will automatically expire after December 31, 2012, and many tax rules will revert to pre-2001 levels. The gift and estate exclusion amount will decrease to $1,000,000, the top tax rate will increase to 55% and the cost of transferring wealth will rise dramatically. (As a caveat, Congress may enact legislation any time during 2013 that could be made effective retroactively to the beginning of the calendar year.)
• The Democrats retain the White House and control the House and Senate. President Obama’s 2013 budget proposal recommended lowering the gift tax exemption to $1,000,000 but restoring the estate tax rules to their 2009 levels, with a $3,500,000 estate tax exclusion amount and a top tax rate of 45%.
• The Republicans gain control of the White House and the Senate and retain control of the House. Congress could extend the current gift and estate tax exclusion amount of $5,120,000 and the 35% tax rate, or the estate tax could be abolished altogether.
Who Should Take Advantage of This Unique Gifting Opportunity?
First, it is extremely important to point out that the vast majority of U.S. taxpayers will never owe federal estate taxes. For most individuals and married couples, the number-one planning objective should be securing a comfortable retirement. A lifetime gift is a permanent and irrevocable transfer of property, and you should never give away what you cannot afford to be without. Don’t let the “tax tail wag the dog.”
Second, there are no one-size-fits-all solutions in financial and estate planning. A single person in advanced age and declining health with a net worth of several million dollars might decide to make tax-free gifts to children or grandchildren in 2012 while the exclusion amount is high. On the other hand, a healthy married couple who has recently retired with a net worth of several million dollars might decide against making large gifts in 2012 because they do not want to risk running out of resources in their later years. Every situation should be evaluated on a case-by-case basis before deciding whether to make large gifts in 2012.
Basic Gifting Techniques
If, after careful evaluation, you decide to make a substantial gift in 2012, there are many ways to transfer wealth to children and more remote beneficiaries.
• Outright gifts. You can make an outright gift of cash, securities, real or personal property, art objects and collectibles, etc. The gift must be complete and unconditional. Transferring assets with higher potential for appreciation might result in even greater estate tax savings. Although no gift tax will be incurred unless the cumulative value of all your gifts exceeds the current $5,120,000 exclusion amount, all gifts exceeding the $13,000 annual gift exclusion amount must be reported on a U.S. Gift Tax Return.
• Gifting a business interest. There may be an extra advantage to making gifts of an interest in a closely held business. Typically, the gift tax value of an interest in a closely held business may be reduced by discounts for lack of control and lack of marketability. The combined discount can often be as much as 35–45%. You should consult with a qualified business valuation expert before reporting such gifts on a U.S. Gift Tax Return.
• Gifts in trust. If you are making gifts to younger beneficiaries, you might consider creating a gift trust for them. You can structure the trust to provide for the beneficiary’s health, education, maintenance and support. You may also allocate a portion of your Generation-Skipping Tax Exemption to gifts in trust that could exempt the trust assets from all future estate taxes.
• Insurance trusts. An effective way to leverage a transfer of wealth is to make a gift to an Irrevocable Life Insurance Trust. If the trustee purchases life insurance on an individual or a married couple, the insurance proceeds payable to the ILIT will be excluded from the insured’s estate for federal estate tax purposes. The trustee of the ILIT can purchase a single-premium, paid-up life insurance policy or invest the trust corpus and pay annual insurance premiums out of income derived from the investments. Existing life insurance policies can also be gifted to individuals or in trust.
• Loan forgiveness. If you have made a loan to a child or other beneficiary, the forgiveness of the loan amount can be treated as a gift.
• Charitable Remainder Trusts. A CRT can be structured to provide an income stream to a noncharitable beneficiary for a specified number of years, or for the life of the beneficiary, followed by a gift of the remaining trust assets to one or more qualified charitable organizations. The donor receives a current charitable income tax deduction equal to the actuarial value of the remainder gift made to charity.
• Other advanced gifting techniques. More advanced gifting strategies include: Grantor Retained Annuity Trusts, Qualified Personal Residence Trusts and Family Limited Partnerships.
If you are unsure whether this unique gifting opportunity is something you should take advantage of, or to learn more about these and other gifting strategies, contact your Baird Financial Advisor and tax and legal professionals for additional information.
ABOUT THE AUTHOR:
Richard A. Behrendt is director of estate planning for Baird’s Private Wealth Management group, based in Milwaukee. Prior to joining Baird in 2006, Rich spent 12 years as an Estate Tax Attorney with the IRS. Rich has contributed articles on estate planning subjects to numerous publications and is frequently invited to speak to lay and professional groups on various estate planning topics. He taught an adjunct course at the University of Wisconsin law school from 2007–2011.
This information is not provided as legal advice, but for information purposes only. You are strongly advised to seek advice from competent legal and tax counsel to determine the applicability of this information to your estate and financial planning decisions. You are also encouraged to seek qualified legal counsel to determine if any estate planning documents should be prepared that relate to this information and to have legal counsel prepare all estate planning documents you may need to carry out your estate plan.
Article provided by Robert W. Baird & Co. with the authorization of its author for Evan Guido, Vice President, Financial Advisor at the Sarasota office of Robert W. Baird & Co., member SIPC. The opinions expressed are subject to change, are not a complete analysis of every material fact and the information is not guaranteed to be accurate.
Evan R. Guido
Vice President of Private Wealth Management
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Sarasota, FL 34236-4702
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