What Does the Future Hold for the Federal Estate, Gift and GST Taxes in 2011?

2010 will be remembered for many things among them being an underdog win at the Super Bowl, news of the last American troops leaving Baghdad, and the world coming together to cheer 33 miners who returned from being buried alive. 2010 will also be remembered as the year of uncertainty, rumor and speculation regarding the federal transfer tax system and changes coming in 2011. One possibility that has been introduced as potential legislation is a return to the 2009 structure of a $3.5 million applicable exclusion amount for each taxpayer, plus the reinstatementof a step-up in the basis of assets held at death. Some have even proposed that this return should be retroactive to January 1, 2010. The very latest has President Obama and House and Senate Republicans agreeing to a $5 million exemption and a 35% rate for two years. With only a few weeks to go before 2010 concludes it is still impossible to predict what the federal transfer tax system will look like next year.

If Congress takes no action before the end of the year, the federal estate and GST taxes are scheduled to return in 2011, with a diminished $1 million applicable exclusion amount for each taxpayer ($1 million, in the case of GST exemption, indexed for inflation.) The gift tax will stay unchanged, at a $1 million lifetime applicable exclusion amount. Top rates for the estate, gift and GST tax will increase to 55% and the step-up in basis will be restored.

We will send you a separate Wealth Planning and Preservation Update as soon as Congress acts.

Year-End Planning Opportunities to Immediately Consider

Make Outright Gifts to Take Advantage of Reduced Gift Tax Rate

The current federal gift tax rate of 35% is scheduled to increase to 55% as of January 1, 2011. Consequently, making gifts before the end of 2010 may provide significant transfer tax savings. In addition to the 20% you save by meeting that deadline, making lifetime gifts is always more cost-effective than arranging for gifts at death. This is due to the fact that monies used to pay gift tax are themselves not taxed but monies used to pay estate taxes are taxed. If you want to give $1 million to your child, you have two options. The first option is to give $1 million to your child now and, assuming a 50% gift tax rate, pay $500,000 million in gift taxes. The total cost to you is $1.5 million. Your second option is to leave your child $2 million in your Will, $1 million of which will go to pay estate tax (assuming a 50% estate tax rate). In this scenario, a lifetime gift to your child will cost $500,000 million less in transfer tax than a gift made under your Will. The benefit is compounded further by the lower gift tax in 2010.

Make Gifts to Take Advantage of the Absence of GST Tax

The next few weeks are an especially opportune time to make outright gifts to grandchildren. The GST tax was repealed for 2010 making an outright gift to a grandchild this year exempt from GST tax. Therefore, these types of gifts are only subject to the federal gift tax, which will be at the reduced rate of 35% until the end of the year.

Before proceeding, however, examine the structure of this type of gift, especially if being made to minor grandchildren, as gifts to trusts and uniform transfers to minors' accounts may be subject to the GST tax in subsequent years. Please feel free to contact us to discuss the mechanics of any such gifting.

Grantor Retained Annuity Trusts (GRATs)

Notwithstanding the many bills introduced this year containing provisions which would have limited the current beneficial use of GRATs, none successfully passed into law. So for the time being, GRATs remain extremely valuable planning tools. Their usefulness is increased in light of the historically low interest rates. Thus, it is advisable to create GRATs as soon as possible, before their advantages are curtailed by new legislation or a rise in interest rates in the not-to-distant future.

A GRAT is an irrevocable trust into which you transfer assets and retain the right to receive annual payments of a fixed dollar amount (the "annuity") for a specified term of years (as short as two years). At the end of the trust term, the remaining trust assets pass to family members.

The IRS assumes that a GRAT will grow at a rate equal to the 7520 rate at the time the trust is established (1.8% for December). Growth which exceeds the assumed rate passes to trust beneficiaries free of gift and estate tax. The lower the hurdle or interest rate, the larger the potential gift.

GRATs are also "grantor trusts" which means that the grantor (creator of the trust) is taxed on all of the income. Payment of these income taxes is effectively a tax-free gift to the trust beneficiaries since the trust assets can grow without reduction for income tax payments. Further, after the expiration of the GRAT, the remainder stays in a grantor trust for which the grantor continues to pay the income taxes even though the assets are outside their estate. This provides an opportunity for additional tax-free gifts.

In short, by using a GRAT, a client can transfer assets to a trust on a gift-tax-free basis, receive the assets back over a period of years with a rate of return and any excess growth is outside the client's estate.

Family Limited Partnerships

Family Limited Partnerships (FLPs) are well established estate planning tools utilized by many of our clients. (Family limited liability companies, which are substantially similar, are also referred to here as FLPs.) The advantages of an FLP are many. Family wealth can be transferred into an FLP by the original partners. Annual exempt gifts of partnership interests can be made at a discount to beneficiaries. Creditor protection is afforded as in other limited partnerships. Other advantages include the consolidation of family held entities with centralized management and a potential greater return on investment due to the investment of a larger pool of assets. The entity could be controlled by the general partner who can be funded with as little as 1% of the total assets.

The value of assets held in an FLP may be substantially reduced by using lack of control and/or lack of marketability discounts. This reduction in value provides lower estate and gift tax liability. As it did with GRATs, the Obama administration has expressed the desire to eliminate or minimize valuation discounts with respect to non-operating assets. While that has not been accomplished as of yet, knowing that valuation discounts are on the Administration's hit list suggests that FLP planning should be pursued sooner rather than later.

As in past years, the IRS attacked the use of FLPs in various contexts and with mixed success throughout 2010. Nonetheless, careful planning continues to make FLPs an integral part of a properly planned estate plan.

Sales to "Defective" Grantor Trusts

Selling assets in installments to a "defective" grantor trust is another method of avoiding transfer tax while transferring assets. A "defective" grantor trust is a trust whereby the property is treated as owned by the grantor for income tax purposes, but not owned by the grantor for federal gift and estate tax purposes. This distinction can allow the grantor to pay the income tax on trust income enjoyed by the trust beneficiaries and, under current federal income and gift tax laws, avoid having the payment of that income tax being treated as a gift by the grantor.

To make an installment sale to a "defective" grantor trust you would sell assets likely to appreciate in value to the trust in exchange for a fair market down-payment and a promissory note for the balance. From an income tax point of view, there would be no taxable gain on the sale of the property to the trust because of the trust's status as a grantor trust. Essentially, this is a sale to yourself. For the same reason, the interest payments on the note would not be deductible by the trust or a tax liability to you. This technique can be made more effective by using FLP interests. This would result in the sale of a discounted asset and the leverage of the estate tax benefit.

If the value of the assets outpaces the prevailing Applicable Federal Rate (which for sales in December 2010 is as low as .32%), as with a GRAT, the appreciation will pass free of gift and estate tax. The current record low interest rates make sales to defective grantor trusts most opportune to proceed with now.

Planning Ideas for 2011 Regardless of Outcome of Estate and Gift Tax Regime

Gift Residence or Vacation Home Using Qualified Personal Residence Trusts

A discounted and leveraged gift of a residence is possible using a qualified personal residence trust (QPRT). After the gift to the QPRT you can continue to live in the residence until the QPRT ends, and even thereafter, if the property is leased back at fair market value from the new owners.

This planning technique is most effective when the value of the residence to be given is low and the IRS assumed rate of return is high. However, even though the IRS assumed rate of return is currently low, housing prices continue to drop nationwide, making the use of a QPRT beneficial. Also, unlike with GRATs, the value of the gift may be further reduced for gift tax purposes by retaining a contingent reversionary interest in the event you die during the term of the QPRT (the value increases with your age). As a result, QPRT gifting is an important alternative to consider in 2011.

If you would like to discuss implementing any of the planning techniques described here, please contact us at info@law-morris.com to make an appointment. And don't delay... we will be ringing in 2011 before you know it!