By Michael D. Koppel, CPA
Gray, Gray & Gray, LLP
April 2012
As a tax accountant my job is to make sure my clients meet their legal obligations to the Internal Revenue Service, while helping them to retain as much of their assets as possible. It is a delicate balance that may soon be tipped further in favor of the tax collector. This is especially true for successful business owners who have managed to accumulate significant savings.
President Obama’s 2013 federal budget proposal includes a provision that would roll back estate tax rates and exemptions to 2009 levels. That’s not good news, as the gift and estate tax exemptions have been very favorable for the past few years. The potential reversion makes it imperative for you to consider preserving your assets by giving them away. This year may be the last year for a long time that “gifting” will be a highly effective way to protect your money from the taxman.
Gifting has long been an essential wealth management and estate-planning tool. By making a gift of your assets while you are still alive, you can decide where your money will go and avoid steep estate taxes. But the amount you are allowed to gift tax-free may be about to change dramatically, making 2012 a year when you may want to accelerate your gifting.
The Most Favorable Time is Now
The estate and gift tax lifetime exclusion, which is the amount that a person can gift to another in excess of the annual exclusion without paying taxes, is $5,120,000 – the most it has ever been. (Keep in mind that gifts between spouses are tax-free and a spouse can join in a gift to double the exemption.) But the current exemptions expire at the end of 2012. While nobody can be certain what will happen next year, the President has proposed significant changes in gift and estate taxes in his proposed 2013 budget that would roll back the exemptions to a much lower level. This would expose more of your assets to estate taxes.
The budget proposal reduces the estate tax exclusion to $3,500,000 with a maximum top rate of 45%. That’s not the worst news. The proposal would “unlink” the gift and estate exclusion. The new gifting exclusion would be reduced to $1,000,000. This reduction would significantly reduce the ability make to significant gifts, especially for parents who own a business and intend to provide the next generation ownership opportunities.
Business succession may be further complicated by restrictions on discounts. Valuation discounts are an important part of gift and estate planning. Discounts are often taken for lack of marketability and lack of control. These discounts can substantially leverage the amounts of gifts. Combined discounts of 40% are not unusual. This means that a gift with a value of $5,000,000 would only use $3,000,000 of gift tax exclusion. The proposed budget indicates it would limit discounting but does not indicate how.
Changes to Trusts
The proposed federal budget also affects trusts, including Grantor Retained Annuity Trusts (GRATs). Put simply, a GRAT is an annuity whereby the donor receives an annual payment from the annuity for a fixed period of time. At the end of the term, any remaining value in the trust is passed on to a beneficiary of the trust as a gift. the beneficiary must be a family member of the donor. If the donor dies before the end of the term, then the value is included in the deceased estate.
Because of the current low interest rates GRATs have become a popular gift tax planning tool. Because the power of the GRAT is lost if the donor dies, a shorter term for a GRAT is most effective. For example two year GRATs have become popular. The White House budget proposal would require GRATs to have a life of at least 10 years potentially making them less effective.
An Intentionally Defective Grantor Trust (IDGT) sound a little odd, but represents a very powerful estate planning tool. An IDGT allows for the income of the trust to be taxed for one party (the donor) while another party enjoys the distributions tax-free. The advantage is obvious. The donor continues to pay the taxes on the income of the IDGT, thus reducing their estate, while the beneficiaries get the benefits from the income tax-free. But the 2013 budget proposal requires that the distributions to the beneficiaries be treated as a gift from the donor, possibly subject to being taxed.
Portability is relatively new estate tax concept. It was introduced as part of the Tax Relief Unemployment Insurance Reauthorization and Job Creation Act of 2010. Portability allows a spouse to use the unused portion of a deceased spouse’s estate tax exclusion as their own. For example, if a husband died this year and only used $3,000,000 of the $5,120,000 of his gift tax exemption, the remaining $2,120,000 would be added to the remaining spouse’s exemption. The President’s proposed budget would maintain the concept of “portability.”
As we indicated, nobody can be sure what is going to happen in the gift and estate tax area. We do know that the current estate and gift lifetime exemption will expire at the end of this year and if nothing is done both will return to $1,000,000 with no estate tax portability. Gift and estate tax planning is always complex and is even more so given the future uncertainty. However, it is safe to say that 2012 will likely present the last time we will see such an advantageous situation.
Michael Koppel is a Tax Partner at Gray, Gray & Gray Certified Public Accountants, Westwood, MA (www.gggcpas.com).