As noted in the July McGrath North newsletter, there is a limited window of opportunity for individuals to utilize the currently available $5,120,000 lifetime gift tax exemption amount. The “exemption” amount is the amount an individual may give away without incurring gift tax. Under current law, beginning in 2013, the lifetime federal gift and estate tax exemptions are scheduled to decrease to $1,000,000 with a top tax rate of 55%. As recently as last month, certain House Democrats proposed to establish the estate and gift tax exemptions at $3,500,000 with a top tax rate of 45% beginning next year. Although some Republican proposals have included maintaining the current exemption amounts and even repealing the estate and gift tax altogether, the future is very uncertain. Therefore, utilization of the lifetime exemption this year is an opportunity to effectively “cash in” on savings of potentially millions of dollars of estate and gift tax.
In order to accomplish a gift in 2012, the assets to be gifted (if real estate, closely held business interests or other assets that do not have a readily apparent fair market value) must be appraised and the gift transaction must be completed before year end. Often, those assets that require appraisals are the best assets to utilize in a gifting strategy because discounts may be applied to the asset value if the asset is a minority interest in a business, a non-marketable interest in a closely held business and/or a fractional interest in real estate. The applicable discount allows leveraging of the gift tax exemption by allowing for greater overall value to be gifted at a lower value for gift tax purposes. As an example, if a 99% non-voting interest in a limited liability company that has $5,000,000 of assets is discounted by 33%, while $4,950,000 of value has been gifted ($5,000,000 * 99%) only $3,267,000 of the gift tax exemption should be utilized ($4,950,000 * 66%). In addition, if the underlying assets in this example are likely to appreciate over time, not only will the current value of the assets be removed from the donor’s taxable estate, but so will all of the future appreciation of the gifted assets.
One of the risks associated with making a gift of hard to value assets (such as interests in closely held businesses) is that the Internal Revenue Service may subsequently challenge the appraised value of the gift which may result in a bill from the government for gift tax. If the IRS decides to challenge the appraised value, the IRS will likely argue that a third party purchaser under similar circumstances would not have discounted the applicable assets at all, or at least would have applied a much lower discount in determining a fair purchase price. In order to guard against a potential IRS challenge, the use of a “defined value” gift should be considered.
A defined value clause may be useful for gifts of assets that are hard to value and/or where a steep discount is taken for lack of marketability and/or lack of control (or, with real estate, perhaps due to the existence of a fractional interest). Defined value clauses have been accepted and recognized in recent tax cases. One method of utilizing a defined value clause is that the donor (the person making the gift) limits the gift to a fixed percentage or number of shares or units in the assets being gifted. For example, “I hereby gift that number of shares of stock in X Company to my trust having a value of $5,000,000 with the balance of such shares to charity.” In other words, the donor fixes the number of units or shares being transferred to an intended value with any excess passing in a manner that is tax free – to a charity, donor advised fund or even a spouse. If the IRS subsequently challenges the appraised value of the gifted assets, no gift tax should be due since any excess value passes in a manner that is free of gift tax (charity or spouse). In other words, the IRS’s challenge would merely increase a tax deduction, not the tax liability.
Another approach (which may carry with it more risk) is for the donor to simply fix the dollar amount of the assets being transferred, without addressing the excess value. For example, “I hereby gift that number of shares of stock in X Company that equals $5,000,000 divided by the total number of shares of stock of X Company I own as finally determined for federal gift tax purposes.” In this case, the donor has simply fixed the gift to a certain dollar amount, no more and no less. If the IRS challenges the value of the gift, the number of units or shares of the closely held business gifted is simply adjusted and more units are retained by the donor.
Several court cases have upheld both versions of the defined value clause discussed above. For example, one court upheld the validity of a gift of a specific dollar amount of units of a limited liability company and held that despite the formula employed by the donor, the only intended gift was the stated dollar amount, and that gift was valid. In 2009, an appellate court in Nebraska’s circuit approved the use of a formula gift that resulted in any value over the appraised amount (as determined by the IRS) being paid to charity (and thus, the IRS attempt to increase the value of the assets at issue, by challenging the discounts applied to the asset, simply resulted in an increase in a charitable deduction – leaving the IRS without any increase in tax owed). Ultimately, formula clauses are a great tool in accomplishing gifts in 2012 under the right set of facts.
In addition to valuation risks for gifts to be made in 2012, some prospective donors may postpone the appraisal process and may reach a point during the year in which the assets to be gifted will not be able to be appraised (thus postponing a final valuation determination until 2013). For those prospective donors who would like to make use of the high exemption amounts this year through gifting closely held business assets or fractional interests in real estate but who are not able to accomplish valuations this year, consideration should be given to the “fund and switch” approach. Under this approach, a gift of cash or marketable securities could be made during 2012 to a trust that contains a “power of substitution” – i.e., a power that allows the donor to reacquire the gifted assets by substituting assets with the equivalent fair market value. The IRS has consistently ruled that the assets transferred to a trust in which the donor retains the power to substitute property of equivalent value does not, by itself, cause an inclusion of trust assets in the taxable estate of the donor, even if the power is exercisable without the imposition of any fiduciary duties. However, the trustee must have a fiduciary obligation to confirm that the substituted assets are of equivalent value to the initially gifted assets; and the substitution power cannot be exercised in a way that shifts benefits among beneficiaries. In addition to allowing for flexibility for substituting trust assets, the power of substitution should also provide income tax benefits by causing the trust property to continue to be treated as owned by the donor for income tax purposes, thus allowing the donor to continue to pay income tax with respect to the gifted assets (and allowing the gifted assets to grow on an income tax free basis for the benefit of the beneficiaries).
Assuming that the donor has sufficient cash or marketable securit
ies to make the gift in 2012, the initial gift of those assets would be reported to the IRS based on the fair market value of the cash or marketable securities transferred to the trust. Following year end, the other assets the donor could not have appraised in 2012 would be appraised in 2013. After the appraisal is completed, the donor may substitute the cash and/or marketable securities for the newly appraised closely held business assets or real estate interest. The power of substitution is also useful many years following a gift in allowing the donor to exchange high basis assets that were not gifted for low basis assets that were gifted in order to take advantage of the step-up in basis at death.
Not only does the power of substitution strategy allow the gift to be accomplished in 2012, but it should preserve the ability of the donor to make use of the defined value gift when making the substitution. Though not formally approved by the IRS or a court, a defined value substitution should be treated the same as a defined value initial gift, allowing for discounts to be taken on the substitution and providing a level of protection for a later IRS audit. Therefore, the two strategies may be combined to assist donors in accomplishing gift.