Gifting And The Rest of 2012

I met with a client last week who has a child with special needs. His daughter has a syndrome I cannot remember, except that it is quite rare and was named after a physician who practiced at Children’s Hospital here in Cincinnati. He is concerned about her welfare, especially after he passes away. We wound up talking about gifting and expected changes in gift tax law.

Let’s talk about the gift tax today.

There is an opportunity to gift up to $5,120,000 without paying gift tax, but this expires at the end of 2012. If you are married, then double that amount (10,240,000). If you exceed that amount, then gift tax is 35%. The $5,120,000 is set to drop to (approximately) $1,360,000 in 2013, and the 35% rate is slated to increase to 55%. If you are in or above this asset range, 2012 is a good time to think about gifting.

Here are some gifting ideas to consider:

(1)   Use up your $13,000 annual exemption per donee. This is off-the-top, before you even start counting. If you are married, you can have your spouse join in the gift, even if you made the gift from your separate funds. That makes the exempt gift $26,000 per donee.

(2)   Let’s say that gifting appeals to you, but you do not want to part with $5,120,000. Perhaps you could not continue your standard of living. I know I couldn’t. One option is to have one spouse gift up to $5,120,000 without gift splitting. This preserves the (approximately) $1,360,000 exemption for future use by the other spouse.

(3)   By the way, gifting between spouses does not count as a taxable gift. Should one spouse own the overwhelming majority of assets, then consider inter-spouse gifting to better equalize the estates. This is more of an estate planning concept, but it may regain interest if the estate tax exemption decreases next year.

(4)   Consider intrafamily loans. The IRS forces you to use an IRS-published interest rate, but those interest rates are at historic lows. For example, you can make a 9-year loan to a family member and charge only 0.92% interest. Granted, the monies have to be repaid (or gifted), but the interest is negligible.

(5)   Consider a family limited partnership. We have spoken of FLPs (pronounced “flips”) before. A key tax benefit is being able to discount the taxable value of the gift for the lack of control and marketability associated with a minority interest in the FLP.

(6)   Consider income-shifting trusts to move income and asset appreciation to younger family members. A common use is with family businesses. Say that you own an S corporation, for example. Perhaps the S issues nonvoting stock and you transfer the nonvoting stock to your children using Qualified Subchapter S trusts.

(7)   Consider a grantor retained annuity trust (GRAT). With this trust, you receive an annuity for a period of years. The shortest period I have seen is 2 years, but more commonly the period is 5 or more years. The amount you take back reduces the amount of the gift, of course, but not dollar-for-dollar. I am a huge fan of GRATs.

(8)   Consider a qualified personal residence trust (QPRT, pronounced “Q-pert”). This is a specialized trust into which you put your house. You continue to live in the house for a period of years, which occupancy reduces the value of the gift. If you outlive that period then you can continue to live in the house, but you must begin paying fair market rent to the trust.  I have seen these trusts infrequently and usually with second homes, although I also can see a use with a principal residence in Medicare/Medicaid planning.

(9)   Consider a life insurance trust (ILIT, pronounced “eye-let”). This trust buys a life insurance policy on you, and its purpose is to keep life insurance out of your estate. You might pay the policy premiums on behalf of the trust, using your annual gift tax exclusion. This setup is an excellent way to fund a “skip” trust, which means the trust has beneficiaries two or more generations below you. The “skip” refers to the generation-skipping tax (GST), which is yet another tax, separate and apart from the gift tax or the estate tax.

(10)  Consider a dynasty trust if you are planning two or more generations out. This technique is geared for the very wealthy and involves an especially long-lived trust. It is one of the ways that certain families (the Kennedy’s come to mind) that family wealth can be controlled for many years. A key point to this trust is minimizing or avoiding the generation-skipping tax (GST) upon transfer to the grandchildren or great grandchildren. The GST is an abstruse area of tax law, even for many tax pros.

OBSERVATION: You could incur both a gift tax and a GST tax. That would be terribly expensive and I doubt too many people would do so intentionally.

Although not frequently mentioned, remember to consider any state tax consequence to the gift. For example, does the state impose its own gift tax? If you live in California, would the transfer of real estate reset the assessable value for property taxes?

It is frustrating to plan with so much uncertainty about tax law. We do know that – for the balance of this year – you can gift over $5 million without incurring a gift tax liability. That much is a certainty. If this is you, please think about this window in combination with your overall estate plan. This opportunity may come again – or it may not.

The Use Of A Dynasty Trust

President Obama’s 2012 budget included a provision to limit dynasty trusts to approximately 90 years.

What is a dynasty trust? This creature exists because of estate taxes and generation-skipping taxes. Say that you and your spouse are worth $25 million. You have a daughter, and you come to me because you want to plan your estate. You think you can live on $10 million. To make this easy, say that all your wealth is in publicly-traded stocks. We call the broker and transfer $15 million in stocks to her. At the end of the year you will have a gift tax return. The gift tax exemption this year is $5 million per person, which means that you and your spouse combine for a total exemption of $10 million. You will have a gift tax, as the net gift subject to gift tax is $5,000,000 ($15,000,000 - $10,000,000).

When your daughter passes away, that $15 million will be included in her estate again and she will pay estate tax.

Ah, you say. You now understand what the estate tax is doing. What if you gift to your grandson, that way the $15 million will escape estate tax at your daughter’s death. You “skipped” a generation. Enter the generation-skipping tax, whose purpose is – you guessed it – to tax that transfer to your grandson. No skipping allowed.

Let’s tweak this a bit. Say that you gift $10 million to your daughter and $5 million to your grandson. Now you have an interesting case study. You see, the generation-skipping tax has an exemption. That exemption amount is currently $5 million per person, or $10 million for you and your spouse. You can transfer up to $10 million to your grandson, have it escape the estate tax (at the daughter’s death) and also escape the generation-skipping tax.

Let’s tweak this again. Say that your grandson receives the gift amount (at some point in the future – it doesn’t matter when). When he passes away, the $5 million is in his estate and there will be estate tax. Is there some way to skip his estate tax?

Enter the dynasty trust. You put the $5 million in a dynasty trust. Your grandson is a beneficiary and receives distributions. He does not have enough retained power to dragnet the trust into his estate upon death. The trust escapes his estate and passes on to the next tier of beneficiaries, which are presumably your great-grandchildren.

This trust is designed to never be snared by the estate or generation-skipping tax ever again. Wow!

Enter the rule against perpetuities. There is a common law principle that allows a trust to carry-on for only so long without vesting, which is about 90 years. I studied trust law at the University of Missouri Law School and, frankly, its application in practice confused me both then and now. However, there are 23 states (including Kentucky and Ohio) that have “waived” the rule against perpetuities and allow dynasty trusts. So we can employ a dynasty in Ohio, for example, and sidestep the rule against perpetuities.

Enter Obama’s proposal to limit these trusts to 90 years or so. It would do so, not by limiting the trust, but by limiting the generation-skipping exclusion. As the trust is a creature of tax policy, the effect would be the same. Do not overly worry about this happening soon, however, as Obama’s budget was voted down without dissent in the Senate. However, the proposal does provide insight into future sources of revenue that Congress may revisit.

Because of the long-lived nature of these trusts, you are (almost by default) looking at a corporate trustee. If you haven’t reviewed trustee rates recently, you may be surprised at how expensive this can be. This in turn means that you want a certain minimum amount of money to seed the trust in order to justify the fees. This tax planning is not for the middle class. You also have to be careful in how much power is reserved to the beneficiaries, as too much may result in the trust being included in a beneficiary’s estate. You have to reserve a certain minimum, of course, such as the ability to dismiss and replace a trustee that has become unproductive or overly expensive.

I see these trusts primarily as a means of asset protection against creditor claims and divorces. It may also be a means to keep family businesses under family control, such as by placing the business(es) in a family limited partnership and then placing the partnership units into the dynasty. This would also allow one to utilize gift tax discounts, further magnifying the leverage of the dynasty trust. However, I can also see that society has an interest in not bankrolling a class of nonproductive trust-fund-uberwealthies. Perhaps the President has it right on this one: maybe 90 years is enough time for this tax vehicle.