Estate planning: the clock is ticking--use it or lose it before 2013.

• Author: Pratt, David
• Position: Tax Law

On December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Pub. L. No. 111-312, 124 Stat. 3296 (2010) (2010 act). The 2010 act ushered in some significant changes to the estate, gift, and generation-skipping transfer (GST) tax regimes, namely reducing the estate, gift, and GST tax rates to 35 percent, increasing the estate, gift, and GST tax exemptions to $5 million, (1) and reunifying the estate and gift tax exemptions. (2) However, these provisions of the 2010 act will remain in effect only through December 31, 2012, when the act is scheduled to sunset. (3) Unless Congress enacts new legislation prior to then, on January 1, 2013, the law will revert to the laws in effect in 2001, with top estate, gift, and GST tax rates of 55 percent, estate and gift tax exemptions of only $1 million, and a GST tax exemption of only $1 million (indexed for inflation). (4) Thus, in order for clients to avail themselves of the maximum benefits under the 2010 act, clients should consider engaging in one or more of the planning techniques discussed in this article as soon as possible. Each of these techniques can significantly reduce one's taxable estate at death by taking advantage of the provisions of the 2010 act before they expire.

Clients Should Use Exemption to Make Nontaxable Gifts

With the increase in the gift tax exemption from $1 million to $5 million per person, clients may significantly reduce their estates simply by mak ing direct gifts to their descendants or any other individual (or to trusts for their descendants or anyone else, as discussed below). In fact, a married couple can gift $10 million to their descendants or any other individual without paying gift tax. (5) Additionally, clients should consider using their increased gift tax exemptions to forgive loans that were previously made to their descendants or others, particularly when such "loans" may be at risk of being recharacterized as gifts because they may not necessarily have been respected as a loan. (6)

By making gifts during life, clients can remove from their estates all of the future appreciation and income on the gifted property. This may be particularly appealing for clients who do not need or plan to spend such income. For example, if a client makes a $5 million gift this year and dies 25 years from now, the value of that gift, including appreciation, could range from over $13 million, assuming modest four percent growth, to over $54 million, assuming 10 percent growth. (7) Additionally, if the gifted property produces income of $200,000 (four percent, for example) per year, then, over the 25-year period, $5,000,000 of income will be removed from the client's estate (assuming the client would not have otherwise spent or gifted such income prior to the client's death).

Gifts in Trust

Although it may be simpler to make direct gifts of property to individuals, there are many advantages of using a client's gift tax exemption to make gifts of property in trust. The most significant advantage is the ability to allocate GST tax exemption to gifts to trusts for the benefit of a client's descendants. Allocating GST tax exemption to such trusts enables the funds in the trust, plus all future income and appreciation, to pass to children, grandchildren, and more remote descendants without the imposition of any estate, gift, or GST tax at any generational level, subject to the rule against perpetuities. Moreover, if the trust is structured as a "grantor trust," the trust's income is taxed to the client instead of to the trust or the trust's beneficiaries. This, in essence, allows clients to make additional tax-free gifts to the trust equal to the amount of the income tax that the trust or the beneficiaries would otherwise have to pay. (8)

Furthermore, gifts in trust are protected from claims by the beneficiaries' creditors, including spouses (in the event of divorce), and can ensure that the assets do not pass outside of the family bloodline. This protection applies to every generation for the longest period allowed under law (i.e., a maximum of 360 years under Florida law). (9)

Leveraging Gifts

Rather than making gifts of cash or marketable securities, clients should consider gifting interests in a closely held corporation, partnership, or limited liability company (LLC) to descendants or others (or to a trust for the benefit of descendants or others). By doing so, clients can leverage their gift tax exemptions (and GST tax exemptions for gifts made to "skip persons," such as grandchildren, or in trust) by applying minority interest and lack of marketability discounts to the gifted interest, thereby maximizing the use of the exemptions.

For example, assume a married client is willing to gift interests in a limited partnership to a trust for their descendants and that a valuation report by a qualified appraiser indicates that a 30 percent valuation discount may be applied to the interests that will be gifted. In this case, the client could gift interests in the limited partnership with an underlying value of $14 million and still be under the $10 million combined gift tax exemption for a married couple. (10)

Tax Rates for Taxable Gifts (Gifts Above the $5 Million Exemption)

Although the gift tax rate for 2012 is 35 percent, in 2013, the rate is scheduled to revert to 2001 rates (ranging from 41 percent to 55 percent for gifts over $3 million). Accordingly, to the extent that clients wish to make taxable gifts (i.e., gifts in excess of the clients' available gift tax exemptions), they should consider making such gifts prior to 2013. In addition to paying the gift tax at a lower rate, all of the...