Photo by Evgeni Dinev
THE PERFECT STORM FOR WEALTH TRANSFER:
Understanding the Tax Relief Act of 2010.
by Barry Levin
As January 1, 2010 approached, professional advisors involved in wealth transfer planning and wealth management, among others, were convinced that Congress would act to change a rare situation where it was suddenly possible to avoid Federal estate and generation skipping taxes ("GST") in their entirety.
But January 1, 2010 came, and went, without Congressional action, and month by month, 2010 progressed and Congress was focused on other issues. Then came the Congressional elections, with the Republicans taking the majority in the House of Representatives and, for those focused on taxes, the specter of the "Bush era tax cuts" expiring, with the potential resultant
increases in many taxes, including taxes on capital gains, dividends and estates and gifts. Finally, Congress was motivated to act as many began to wring their hands and beat their chests under the threat of these tax "increases."
On December 17, 2010, the President signed the Tax Relief, Unemployment Insurance Authorization, and Job Creation Act of 2010 ("Tax Relief Act").
By way of background, without action by Congress, in 2011 Federal estate, gift and generation skipping taxes would have changed substantially when compared to 2009 (setting aside the aberrant 2010 regime where it was possible for the estates of 2010 decedents to avoid Federal estate and generation skipping taxes in their entirety), so that, in 2011, the estate and generation
skipping tax exemption would have been reduced to $1,000,000 per taxpayer from the $3,500,000 exemptions that existed in 2009. And the Federal gift tax exemption would have remained at $1,000,000. In addition, the maximum tax rates for these taxes would have increased to 45% from 35%.
These would indeed have been a "game changer" for many wealth management plans and planners. As the end of 2010 approached, the din of uncertainty was increasing, though Congress seemed to be ignoring it until mid-December.
While there are many provisions of interest in the Tax Relief Act, our focus here is primarily on the Federal estate, gift and generation skipping tax provisions of this Act and the opportunities that they offer. Special note should be made of the fact that many of these opportunities are scheduled to expire after December 31, 2012.
Estate, Gift and GST Exemptions:
For the first time since 2003, for 2011 and 2012 the estate, gift and GST tax regimes are truly unified again. The exemptions for all three Federal estate, gift and GST taxes are $5,000,000. The GST exemption is indexed for inflation beginning in 2010. And the maximum marginal tax rate of any of these taxes is 35%.
In addition, the carryover basis regime that was in effect for 2010 has been repealed, so that step-up in basis again applies, meaning that assets that are in the estate of a decedent who dies in 2011 or 2012 will obtain a step-up in basis to date of death (or alternate valuation date) values.
For the first time ever, the unused exemption of a deceased spouse can be used by the surviving spouse for either estate or gift tax purposes, but is not available for GST purposes. This means that if a spouse dies without having used his/her available exemption, it is possible, subject to certain requirements and limitations, for the surviving spouse to use the unused exemption
of the predeceased spouse.
Some Planning Opportunities for High Net Worth Taxpayers:
While the total potential $10,000,000 of estate, gift and GST tax exemptions for 2011-2012 will remove estate and gift tax concerns for most families, for the high net worth family, these increased exemptions offer significant planning opportunities.
A husband and wife can give as much as a combined $10,000,000 in assets to or in trust for children or grandchildren. Even if the donors have already used a combined $2,000,000 of gift tax exemption in prior years, an additional $8,000,000 of exemption is now available. How and what to give is up to the donor, but prudent wealth planning would suggest that, while one knows that
these exemptions are available and given the wherewithal to take advantage of these exemptions, one make gifts of up to $10,000,000 to GST exempt trusts for the benefit of children and/or descendants.
When the gift tax exemption was $1,000,000 per donor ($2,000,000 for a couple), wealth transfer planners advised using these exemptions to remove assets and their growth from the donors' estate. Planners embraced not just gifts of assets valued at the amount of exemption available but also leveraged gifting. Such leveraging took the forms of Grantor Retained Annuity Trust ("GRAT's"),
sales to trusts, sales to defective grantor trusts, charitable lead trusts and other techniques.
Each of these techniques has its advantages and disadvantages, and each may be more suited to one kind of asset than another. Now that the gift tax exemptions have been substantially increased, the opportunities for leveraging gifts have likewise been substantially expanded; and doing so in 2011 and 2012 is well-advised.
For example, in the context of the family-owned business, senior generation owners are often interested in transferring ownership interests to their children, either because they want to continue family ownership or because they are preparing for a sale in the future. In this situation, where the business can "fund" distributions to owners, planners often advised having
the stock (or membership interests) valued and then selling stock to a trust for the benefit of children and descendants.
Prudent advisors would, based on IRS assumed criteria, suggest that any such sale include a 10% down payment. Prior to 2011, such a down payment requirement would limit the total amount of business interests that could be sold to a maximum to $20,000,000. Now, however, provided that the seller is willing to "prime the pump" with a $10,000,000 gift, one could conceivably
sell as much as $100,000,000 of stock in the family business.
If the valuation provided a reasonable 35% discount from full value for the stock, these new exemptions would allow for a sale of >$150,000,000 of stock, plus remove its future growth from the estate of the seller. Given that the Applicable Federal Rates (which are the least that should be charged in such a transaction) have been so low lately (1.95% for mid-term, 3
to 9 years, rates for January, 2011) the confluence of increased exemptions and low interest rates may create a "perfect storm" for transfers of business interests.
This storm may be even more perfect if one were to use a Defective Grantor Trust as the purchase vehicle, since such a trust provides that the grantor pays the income taxes on the stock owned by the trust, thus allowing any distributions from the company (both tax distributions and additional dividends) to be used to pay off the note given by the Trust for the purchase
of the stock.
One can only speculate what will happen for 2013 and beyond. Recent experience shows us that it is difficult to predict what Congress will do and when, so it is prudent for families to consider now what their wealth transfer and wealth management objectives are and how to fulfill those objectives given the current state of the law.
If you would like to discuss the new tax law, your business developments or wealth management needs, please feel free to contact The Beringer Group.