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2012: An Unsurpassed Opportunity to Avoid Federal Wealth Transfer Taxes for Generations to Come ?

For wealthy people, time is of the essence to consider and to implement  a substantial gift arrangement in 2012. An unsurpassed opportunity to transfer wealth for federal estate, gift and  GST tax purposes (collectively, I will refer to such taxes as “wealth transfer taxes” in this article) exists for planning done in 2012. After 2012 this opportunity will be lost or greatly reduced. Why? In 2012, a donor may make a gift of up to $5,120,000, outright or in trust, without incurring any wealth transfer taxes. After 2012, unless Congress enacts favorable legislation, a donor will only be allowed to gift up to $1,000,000, free of wealth transfer taxes. For a married couple, these figures (exemption equivalents, which I will call “exemptions” for ease of reference) are doubled to $10,240,000 for 2012, but are only $2,000,000 thereafter. Moreover in 2012, any gift above these exemptions results in a maximum wealth transfer tax of 35% of the value of the wealth transfer. After 2012, the maximum wealth transfer tax equals 55% of the value of the wealth transfer!

Unless a “clawback” tax applies1, a married couple’s family stands to lose a tax asset of $4,532,000 if the couple fails to fully utilize their combined exemptions of $10,240,000. This tax asset is the result of multiplying the 2013 maximum wealth transfer estate rate of 55% by $8,240,000 (the difference between the couple’s 2012 exemptions and their 2013 exemptions).

In other words, even with proper planning to defer the wealth transfer tax until the surviving spouse’s death, if these higher exemptions are not used by the married couple in 2012, their family will incur additional wealth transfer taxes of more than $4.5 million when the surviving spouse dies after 2012. Hence, less than six months are left in 2012 to avoid or minimize this liability through the use of the current exemption amounts.

In addition, the higher 2012 exemptions can be leveraged or magnified with various strategies. When using these exemptions with such strategies, substantially more underlying value may be sheltered from wealth transfer taxes, not just at the time of the married couple’s death, but for multiple generations to come. 2

Other lawyers of our Tax Practice Group have written about some of the available strategies to avoid or minimize wealth transfer taxes.  Refer to Tax Planning Newsletter dated February 2011: Lifetime Gifts – Time To Take Another Look: Increase In The Lifetime Gift Tax Exemption to $5 Million For 2011 And 2012 Transfers May Provide Estate Planning Opportunities; and Tax Planning Newsletter Alert dated December 2010: 2010 Tax Relief Act:  Key Estate, Gift and Generation Skipping Transfer Tax Changes. Hence, this article does not readdress those strategies but is a call to action so that you do not lose this planning opportunity, which will likely be lost forever after 2012.3

Economic and other circumstances also make major planning actions attractive in 2012. For example, America is in the midst of historically low commercial interest rates. Minimum interest rates required by the Internal Revenue Service (IRS) for related party sales and loans are referred to as “applicable federal rates” or “AFRs” and are likewise at historically low levels. These low interest rates enable the making of leveraged sales and gifts that have tremendously higher potential for shifting wealth to or for the benefit of children and other descendants than has been seen in several decades. The AFRs are based on the average market yield on outstanding market obligations of the United States. Therefore, as long as the economy remains weak, AFRs are likely to remain low. AFRs change monthly. Hence, donors/sellers cannot consider very low AFRs to be a permanent opportunity. Certain wealth transfer tools, such as a grantor retained annuity trust (“GRAT”), depend on low AFRs and after 2012 will also depend on the failure of the next Administration to pass the tax legislation President Obama has proposed in his 2013 budget proposal.

In addition, many wealthy individuals’ assets are currently at artificially depressed values. Many closely-held businesses have lost value, not because the businesses are less attractive, but largely as a result of the flagging economy. Because the values of closely-held businesses are substantially lower than what were available as recently as five years ago, these artificially low values also represent an opportunity to pass greater wealth from the current generation to the next and future generations without incurring substantial wealth transfer taxes. What better time than now for wealthy individuals to give or sell these assets, at amazingly low values, to or in trust for their children, grandchildren and more remote descendants?

Although the IRS has had some litigation success involving taxpayers claiming valuation discounts with respect to gifted or sold interests in closely-held corporations, family limited partnerships (FLPs) and family limited liability companies (LLCs), it remains clear that a properly documented, formed and administered LLC or FLP created with the appropriate, provable motivation, can still generate significant wealth transfer tax discounts that will withstand IRS challenge. For a donor to succeed, it is critically important that he or she painstakingly follow all formalities associated with the LLC’s or FLP’s establishment and operation. Equally important is for the individual to have a legitimate and significant non-tax reason for setting up the entity.

However, President Obama’s budget proposal includes a “reform” that would severely limit the use of valuation discounts in wealth transfer tax planning regardless of a donor’s reasons for engaging in such planning and how carefully the individual implemented such planning. The possibility for legislation enacting such “reform” is much greater after 2012 when the acrimony of the current Presidential election is lessened.

Many states, including Nebraska and South Dakota, allow a donor to establish trusts that are designed to exist longer than permitted under the so-called “Rule Against Perpetuities.” In other words, many states, including Nebraska and South Dakota, allow a trust to last into perpetuity. This presents the opportunity to establish a trust that will benefit the donor’s spouse and/or lineal descendants forever. In such case, the only limiting factor would be whether the trust would run out of funds. Hence, perpetual trusts are an incredibly powerful tool to save wealth transfer taxes for multiple generations. For example, if a wealthy individual merely made an outright gift to his children, then the gifted property (other than what is consumed by the children) will be included in the children’s respective taxable estates. By contrast, that donor could instead make a large gift to an irrevocable perpetual trust in a wealth transfer tax advantageous manner and allocate his or her GST exemption to the gift. Moreover, such perpetual trust could include the donor’s spouse as one of the beneficiaries of the trust in case the donor was worried that the gift could be too large. Except to the extent of prudent distributions out of the perpetual trust, the value of the trust’s property will never be included in anyone’s taxable estate. In other words, instead of having a wealth transfer tax potentially assessed at every generation level, a perpetual trust enables the donor to avoid paying wealth transfer taxes at the generational levels of all current and future trust beneficiaries.

Again, however, this estate planning benefit may not be available indefinitely. President Obama’s 2013 budget proposal includes a provision that would limit the effective duration of an allocated GST exemption to 90 years. At its 2010 annual meeting, the American Law Institute adopted a proposed rule that would limit the duration of trusts to the lives of beneficiaries no more than two generations removed from the donor. Regardless of your view of the advisability of a perpetual trust from a macro or societal standpoint, time is of the essence to take advantage of a perpetual trust if your family could face wealth transfer taxes for several generations. At only a $1,000,000 wealth transfer tax exemption after 2012, this risk of future wealth transfer taxation seems likely for many families.

Moreover, whether a recipient trust is perpetual or not, it is also possible for the donor to establish and fund such a trust so that it is treated by the IRS as if the donor remains the owner of the trust’s assets for income tax purposes, but not for wealth transfer tax purposes. The result of creating such a trust (commonly referred to as a “grantor trust”) is that, while the value of the trust property, regardless of how large it may grow, will not be subject to estate tax at the grantor’s death, all items of income, gain, loss, deduction and credit will, for income tax purposes only, belong to the grantor. Thus, to the extent the trust produces taxable income, the donor will be legally obligated to pay, out of his or her own funds, the federal income tax on the trust’s taxable income. The trust property, to the extent not distributed to beneficiaries, may therefore grow unreduced by federal income taxes during the donor’s lifetime, and the donor’s eventual taxable estate will be reduced by the income taxes he or she pays on the income generated by the trust. To put it another way, a grantor trust allows the gifted property to grow on a pre-tax basis without incurring wealth transfer taxes with respect to the income accumulating during the donor’s lifetime. Once the donor dies (or effectively turns off the grantor trust treatment, which is currently allowed under applicable income tax law), the trust would incur the income taxes resulting from accumulated trust income.

In summary, combining all or even some of the elements of what is now possible under various planning strategies has the potential to produce truly amazing and unprecedented wealth transfer tax benefits. As mentioned above, a donor and/or his/her spouse could make a combined gift of up to $10.24 million to an irrevocable perpetual trust that is a grantor trust for income tax purposes. The trust could have its taxable situs located in a state that imposes no fiduciary income tax, although special planning may be required for a Nebraska resident. The property used to fund the perpetual trust could be property that, in the current economic environment, is artificially depressed in value, and that property, before it is transferred to the perpetual trust, might be transferred to a family LLC with respect to which significant valuation discounts could be available. Alternatively, the perpetual trust might be funded with closely-held business interests, such as S corporation stock. In addition, the perpetual trust could be funded by a part gift, part sale. The sale could be made in exchange for an extremely low interest promissory note with interest only payable during the term of the note.

This planning opportunity may, however, be lost or greatly diminished after 2012. The current exemptions and current rates are certain. The future is very uncertain. In light of our huge federal debt, unless you believe that the wealth transfer tax laws will be changed to reduce such taxes, time is of the essence while the current, certain benefits are available. Therefore, the readers of this article are urged to readdress their estate plans and to explore the currently available, unprecedented opportunities as soon as possible.4  Members of our Tax Practice Group are available to help you take advantage of the opportunities while they exist.


1 Beware of the possibility of a “clawback” tax which refers to the possible recapture of the $4.5 million in wealth transfer tax savings at death. Even if the clawback tax applies, making the maximum possible lifetime gift should still be a benefit because all the post-transfer appreciation would be removed from the donor’s taxable estate calculation. In addition, most commentators believe Congress did not intend for a clawback tax and, therefore, expect Congress to pass corrective legislation to prevent a clawback tax. However, such legislation is not certain.

2 President Obama’s 2013 budget proposal, however, if enacted, would outlaw or diminish the benefit of some of these strategies, substantially reducing the tax shelter offered by their use. Given our country’s $16 trillion debt, there is a good chance that these “reforms,” coupled with the reduction in the exemptions and the increase in the wealth transfer tax rates, will result in a wealth transfer tax increase of substantially more than the $4.5 million summarized in this article.

3 Some people believe the next Congress will re-instate the current exemptions and tax rates. President Obama has said in previously published statements that he would settle for a $3.5 million exemption ($7.0 million for a married couple) and a wealth transfer tax rate of 45%. It is submitted that none of these possible outcomes are certain. The only certainty is that the exemption for a single person and the wealth transfer tax rate are $5.12 million and 35%, respectively, during 2012.

4 Although lifetime gifts of appreciated property mean that the gifted property will not enjoy a step-up in basis at the time of the donor’s death, the federal capital gains tax rate, which could be as high as 23.8% next year, pales in comparison to the federal wealth transfer tax rate of 55%. Moreover, while some people believe that a reversion to the $1,000,000 exemption and the 55% marginal wealth transfer tax rate will not be allowed to happen, those same people may have been equally certain that the one-year repeal of the federal estate tax in 2010 would never happen, but it did. In these uncertain times, readers are urged to explore these opportunities now.