In the last issue of The Wealth Counselor, we took a closer look at the new tax law in effect for 2011 and 2012, examining some of the opportunities and challenges that face estate planning professionals as we incorporate these changes and uncertainties into our client's estate plans.
In this issue, we will look more closely at the powerful planning
opportunities that exist for the next two years with the $5 million gift
tax exemption. Let's begin with a quick review of the new law.
Gift, Estate and GST Exemptions and Tax Rates
In 2011 and 2012, the gift, estate and generation-skipping transfer tax
exemptions are all $5 million and the tax rate is 35%. If Congress does
not act again, in 2013 the exemption will be $1 million and the top tax
rate will be 55%. This is the current law and must be considered in all
planning. The portability of the gift and estate tax exemption between
spouses was also introduced, but only for spouses who both die between January 1, 2011, and December 31, 2012.
Note that, unlike a surviving spouse's ability to use a predeceased
spouse's unused unified credit, the new law does not allow a surviving
spouse to use the unused GST tax exemption of a predeceased spouse. This
is just one weakness of the new portability provision.
Be cautious when deciding how to plan for insurance needs, disclaimers
and how to fund the bypass trust, considering whether to plan for a $5
million exemption or some lower (e.g., $1 million) exemption. Also, the
portability of exemption between spouses may not be around after 2012.
Be sure your clients understand the exemption is scheduled to revert to
$1 million in 2013, that these uncertainties exist, and that their
planning will need to be updated as the laws change.
We also have lower income tax rates for the next two years, but
President Obama has made it clear he wants higher tax rates in 2013.
Unless there are changes in the next two years, in 2013 the long-term
capital gains rate will increase to 20%, the maximum tax on qualified
dividends will go back to 39.6%, and the additional 3.8% surtax will be
Take advantage of the lower income tax rates that we have for the next
two years, and look for opportunities to accelerate income into 2012.
Choose an 11/30 year-end for any estates currently being administered to
maximize the lower income tax rates for as long as possible.
2010 Planning Revised
The estate tax was reinstated for 2010, with a $5 million exemption and
35% tax rate. Estates may elect out and pay no estate tax, but the
modified carryover basis rules would apply. The gift tax exemption in
2010 remains at $1 million with a 35% gift tax rate.
Because of the "sunset," there may be only a two-year window of
opportunity to make substantial gifts using the $5 million gift
Tax Planning Opportunities in 2011 and 2012
With the gift tax exemption at $5 million per person, we can expect a
huge transfer of wealth over the next two years. Those who have already
used their $1 million exemption now have an additional $4 million to use
for gifts. And while we cannot be absolutely certain that the $5
million gift tax exemption will be honored if it returns to $1 million
in 2013, it would certainly make sense for Congress to do so. Let's look
at some of the planning opportunities that will immediately maximize
Start meeting with your wealthier clients now to discover which
properties they could give away now that will be relatively painless for
Spousal Access Trusts
The general concept of a Spousal Access Trust is that one spouse can
transfer up to $5 million in trust for the benefit of his/her spouse,
children and future generations. Benefits include asset protection,
estate tax protection, direct descendent protection (property stays
within the bloodline) and income shifting. Risks are the reciprocal
trust doctrine and grantor trust rules.
In U.S. Estate of Grace, 395 US 316 (1969), the Supreme Court
developed a two-part test to determine whether trusts will be ignored
because they are "reciprocal": a) the trusts must be inter-related and
b) the trust creation and funding must leave the grantors of the trusts
in essentially the same economic position as they would have been in if
they had created the trusts naming themselves as life beneficiaries. If
both parts are met, the IRS and/or the courts will uncross the trusts
and include the value in each of the grantor's gross estate, nullifying
their careful planning.
Planning Tip: To avoid the reciprocal trust doctrine, the lawyer on the planning team must take care to draft outside of the Grace
doctrine and not make the trusts identical. Be sure to file the gift
tax return and allocate the GST exemption if desired rather than rely on
the automatic allocation rules.
Gifts to an Irrevocable Life Insurance Trust
Life insurance can be used to provide income for a family, pay estate
taxes, and as an income tax shelter. If structured properly so that the
trust maker does not have any incidents of ownership, none of the assets
(policy proceeds) of an irrevocable life insurance trust (ILIT) will be
included in the trust maker's taxable estate, making them free of both
income and estate taxes. ILITs will become more popular as income tax
rates increase, in 2013, from the current 35% rate to39.6% or even to
43.4% for clients subject to the 3.8% surcharge.
The general concept is that the ILIT is the owner and beneficiary of the
policy on the trust maker's life. The trust maker makes gifts to the
trust to cover the insurance premiums, and the trustee makes the premium
payments. At the trust maker's death, the proceeds are paid to the
trustee who can use the funds to purchase assets from the estate and
provide liquidity for estate taxes and other expenses. The trustee can
make discretionary distributions of income and principal during the
lifetime of the trust's beneficiaries, which can include the trust
maker's spouse, children and future generations. Assets that remain in
the trust are not included in the beneficiaries' estates and are
protected from creditors.
Using the $5 million gift and GST exemption amounts can provide
substantial amounts of life insurance (think single or 2-pay premium)
and benefit the grantor's children without future estate, gift and/or
Be very cautious about canceling existing insurance policies now. If
possible, wait until 2013 nears, when we will know what the exemption
will be at that time.
Generally, a dynasty trust is one that benefits multiple generations,
and none of the trust assets are included in the trust maker's or any of
the beneficiaries' taxable estates. Not being taxed at each generation
(historically at 45-55%) allows the assets to grow tremendously over the
However, there is a generation-skipping transfer tax that applies when a
transfer is made by the grantor to a "skip person" (grandchild,
great-grandchild, or other person more than 37.5 years younger than the
grantor). Currently, each grantor is allowed a lifetime GST exemption on
the first $5 million of taxable transfers directly to a skip person or
to a trust that could benefit a skip person. A husband and wife can
combine their GST exemptions. This perhaps temporary GST exemption
increase will make dynasty trusts even more popular over the next two
The dynasty trust established in the right jurisdiction can
theoretically go on forever, with the trustee making discretionary
distributions for the lifetime of each beneficiary in each generation.
Advantages include creditor protection, divorce protection, estate tax
protection, direct descendent protection, spendthrift protection and
consolidation of capital, which typically results in higher returns and
better management options.
The choice of situs is critical. Choose a state with no income tax,
good creditor and divorce protection, and no Rule against Perpetuities.
Make sure you file a gift tax return. If the trust maker allocates
enough GST exemption to cover the entire gift, neither the gift nor any
distribution from the trust will ever be subject to the GST tax.
Be aware of the President's budget proposal to limit GSTT-exempt trusts
to 90 years, regardless of the applicable rule against perpetuities.
While this was introduced in 2011 and will not likely gain support in
the current Congress, this may gain support in the future.
The concept here is to shift income to younger family members to reduce
income taxes. Parents can move up to $10 million ($5 million each) in
income-producing assets gift tax-free to their children who can then use
the income to invest or purchase insurance.
Example: A husband and wife gift $10 million of non-voting
S-Corporation stock to their four children (15% each) via using
Qualified Sub-Chapter S Trusts. There is no gift tax because the parents
use both of their $5 million gift tax exemptions. After the gift, 15%
of the income generated by the S-Corporation will pass through to each
Benefits include creditor protection on the assets; estate tax savings
because the assets are being transferred to the children and out of the
parents' estates; and income tax savings because the children will pay
income taxes at a lower rate than their parents. Over time, this can
save a tremendous amount in income taxes.
Long-Term Tax Planning Opportunities
After the $5 million exemption has been used, it may be advantageous to
give away more and pay the gift tax at the current 35% gift tax rate.
Also, the gift tax is "tax-exclusive" while the estate tax is
"tax-inclusive." A taxable gift of $1.00 makes the donor liable for a
$0.35 gift tax, for a total of $1.35. On the other hand, $1.35 in a
decedent's estate taxed at 35% nets only $0.88 to the heirs.
As was the case in 2010, gifting can be a wait and see scenario. As we
get closer to 2013, we hope to know what the 2013 gift tax rate will be.
If the rate is moving to 55%, it would be advantageous to make
additional gifts and pay the 35% gift tax in 2012 rather than wait and
pay a 55% gift or estate tax in 2013.
Grantor Retained Annuity Trusts (GRATs)
The creator of a GRAT retains an annuity payout for a fixed term. At
the end of the annuity term, any residual assets remaining in the trust
pass to the remainder beneficiaries, such as the trust creator's
children, free of any gift and estate tax (but not free of GST tax
The tax treatment of a GRAT is based on the assumption that the GRAT
assets will grow at exactly the Section 7520 rate in effect at the time
the GRAT was established (2.4% in January, 2011). If the GRAT assets
outperform the 7520 rate, there will be a larger than anticipated (for
tax purposes) balance to transfer to the trust's remainder beneficiaries
at the end of the annuity term. In addition, all income earned by the
GRAT during its term is taxed to the trust's creator because the trust
is "defective" for income tax purposes, allowing for an enhanced
probability of having a tax-free gift to the remainder beneficiaries.
GRATs are currently most effective for property that is extremely
volatile or is difficult to value, or for large estates that have
already used their $5 million exemption. Unlike a dynasty trust, a GRAT
can only create a one-generation transfer unless GST exemption is
allocated to it based on the actual value of the trust assets at the end
of the annuity term.
Intentionally Defective Grantor Trusts (IDGT)
An IDGT is a trust that is a grantor trust for income tax purposes, but
not for gift, estate, and GST tax purposes. IDGTs are especially
powerful right now for wealthy clients because of the $5 million gift
and GST tax exemptions and historically low interest rates.
Using an IDGT, a married couple can currently gift up to $10 million in
undivided interests in highly appreciating assets, then sell additional
interests in the same assets to the IDGT. The value of both the donated
and the sold assets can be discounted due to minority interest. If the
assets are wrapped in an LLC or limited partnership, their value may
also be adjusted for lack of marketability and lack of control. The
trust then pays an installment note back to the trust maker. Assuming
the growth rate on the assets sold to the IDGT is higher than the
interest rate on the installment note, the difference is passed on to
the trust beneficiaries free of any gift, estate and/or GST tax.
Also, because the IDGT is a grantor trust (i.e., "defective" trust for
income tax purposes), no capital gains tax is due on the installment
sale, the interest income on the installment note is not taxable to the
grantor, and all income earned by the trust is taxed to the grantor,
effectively allowing for a tax-free gift to the trust's beneficiaries
equal to the tax burden borne by the grantor. Discretionary
distributions of income and principal are made to the trust
beneficiaries during their lifetimes, and all assets in the IDGT remain
outside of their taxable estates.
The grantor should make an initial gift of at least 10% of the total
transfer value to the IDGT or have other security for the financed sale
so that the IDGT has sufficient capital to make its purchase of assets
from the grantor commercially reasonable.
Estate planning professionals have an exceptional window for transfer
opportunities in 2011 and 2012 with the $5 million estate, gift, and GST
tax exemptions; lower income and estate tax rates; and still-depressed
property values. And, as is often the case, these opportunities provide
excellent opportunities to work with a team of advisors to provide the
best possible results for mutual clients.