TRUSTS AND ESTATES
CLIENT E-ALERT
November 2010
Unique Planning Opportunities to End Soon
I. Lifetime Giving
The death of George Steinbrenner earlier this year garnered a lot of publicity — not only because he was the architect of the "Yankee Empire" but also because his estate was valued at $1.1 billion dollars and his heirs will pay no estate tax. Had Mr. Steinbrenner died any other year, the government might have collected about half the value of his estate. Although the one-year repeal of the estate tax did not create death-related planning opportunities, there is a significant wealth transfer opportunity that is expiring at the end of 2010. This year the transfer tax rate on lifetime gifts is 35% — the lowest since 1934. Unfortunately, it is not possible to predict with any certainty what the rate will be next year and beyond. If Congress takes no action, the tax rate on lifetime and death-time transfers will go up to 55% in 2011 (a 57% increase). If Congress reestablishes the tax structure that was in effect in 2009, the rate will be 45%. For lifetime gifts, that rate applies to all transfers over $1,000,000.
Earlier in the year, advisors were reluctant to recommend that clients take advantage of this historically low gift-tax rate because there was much uncertainty as to whether Congress would reinstate the 2009 structure retroactively to January 1, 2010. At this point, though, the likelihood of Congress enacting transfer tax legislation that is retroactive seems remote. Thus, clients who intend to eventually transfer significant wealth to younger family members have a strong incentive to do so this year — even though it will require the payment of a gift tax next April.
Another reason to consider making sizeable gifts this year is that the value of many assets may still be depressed. Your gift of assets at their depressed value will allow any appreciation in value to pass to your heirs tax free.
Not to be overlooked is the fact that Massachusetts does not tax gifts at all. Thus, this year you are able to (i) reduce your taxable estate by the amount of the gift, (ii) reduce your taxable estate by the amount of the gift tax you pay (assuming you live at least three years from the transfer), and (iii) avoid taxation of future appreciation in the value of the gift — all with no Massachusetts tax consequences.
An additional significant opportunity exists because of the current one-year repeal of the Federal Generation Skipping Transfer Tax (GST tax). The GST tax is an additional level of transfer taxation that is imposed on transfers to grandchildren or great-grandchildren. Such transfers, over the applicable exempt amount, are normally taxed at the highest marginal estate tax rate. In 2009, for example, a large gift to a grandchild would be subject to a 45% transfer tax on the gift plus an additional 45% GST tax. In other words, a $1 million gift would cost the donor an additional $900,000 in combined taxes. Next year, if Congress does not finalize a change to the transfer tax system, the same gift would cost the donor $1.1 million in combined taxes.
Of course, there are still risks that accompany this type of planning — but there are also some hedges against those risks. For example, Congress could make the estate tax repeal permanent — thus, you could be paying gift tax on transfers that will not ultimately be taxed at death. An example of a less financial and more 'family dynamic' risk is that, in order to take full advantage of the GST tax planning, gifts to grandchildren must be outright rather than in trust. In many families, transferring large sums to grandchildren with no restrictions is not consistent with the family's values. Careful planning can go a long way to lessen the associated risks but, unfortunately, they cannot be completely eliminated.
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A Refinement and an Illustration
One way of making a significant lifetime gift is to give a net gift — a gift in which the recipient agrees that he or she will pay the gift tax. The amount of the reportable gift is the amount transferred less the amount of the gift tax to be paid by the recipient. This, of course, reduces the amount going to Uncle Sam as well as to the recipient. For example, Granddad decides to make a $5,000,000 net gift to his granddaughter, Lucky. Assuming Granddad has already given away $1,000,000 in prior gifts, the gift tax to be paid next April will be about $1,300,000 (rather than $1,750,000 on a straight gift) leaving a net to Lucky of $3,700,000. If Granddad wants Lucky to have the use of the whole $5,000,000, he can loan her the money to pay the gift tax at a required minimum interest rate that is also at historic lows — the required interest that must be charged on a nine-year note in November 2010 is 1.6%. This is a form of estate tax freeze — the money loaned to Lucky will be appreciating at a maximum of 1.6% in Granddad's estate, while Lucky will have the whole $5,000,000 gift to invest at a hopefully higher return. In addition, GST tax savings of $1,125,000 (using 2009 tax rate numbers) will be realized by making the gift this year.
II. Roth IRA/Charitable Planning
In 2010, in contrast to past years, there are no income limits applicable to taxpayers wishing to convert a traditional IRA to a Roth IRA. Briefly, the advantages of the Roth IRA are that there are no required minimum distributions when you reach retirement age, and the withdrawals from the Roth IRA are not subject to income tax. Traditional IRAs are funded with pre-tax dollars, but those dollars plus all the subsequent earnings are taxed as withdrawals when made. And withdrawals must be made, starting in the year that you turn 70½. Many people are reluctant to make the Roth conversion because they would have to take the converted amount into income and pay the income tax. One planning opportunity available in 2010 only is that, rather than reporting 100% of the income in 2010, the taxpayer can report half the income in 2011 and half in 2012.
One way to reduce the impact of that income tax bite is to match a Roth conversion with one of a number of planned giving techniques - this can minimize or manage the income tax hit, satisfy your philanthropic goals, and possibly pass wealth down to descendants on a discounted basis.
One method of accomplishing this goal is to set up a Charitable Lead Annuity Trust (CLAT). You create a CLAT by transferring cash or other assets to an irrevocable trust. Your chosen charity receives fixed annuity payments from the trust for the number of years you specify. At the end of that term, assets in the trust are transferred to the non-charitable remainder beneficiaries that you specify when you set up the trust — typically a child or grandchild.
You can set up a CLAT so that you will receive an immediate and sizeable income tax deduction. This deduction can offset the income realized from the Roth conversion. Note that, in the second and following years, you must report the income earned by the trust even though it is actually paid to the charity in the form of an annuity. However, it is still beneficial because you are spreading out the income tax liability over many years rather than one or two. If you expect your income to drop in future years because of a planned retirement, for example, you will be paying for that Roth conversion at a lower tax rate, while taking advantage of the time value of the unpaid taxes. Another advantage of the CLAT is that it allows a "discounted" gift to family members. The value of a gift is determined at the time the gift is made. Because the ultimate beneficiary of the CLAT must wait for the charity's term to expire, the value of that remainder beneficiary's interest is discounted for the "time cost" of waiting. The cost of making a gift is lowered because the value of the gift is decreased by the value of the annuity interest donated to charity. And remember, the gift tax rate applicable this year is the lowest in 75 years, and any appreciation on the value of the assets is free of either gift or estate taxation in your estate.
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To Illustrate
If you fund a 10-year CLAT in November with $1,000,000 and a 5% per year payout to the charity, the income tax deduction will be $455,000. The charity will receive $50,000 per year and, if the trust earns 3% per year, the remainder beneficiary will receive $760,000 after 10 years. You will have made a taxable gift of $545,000 which, if no other significant gifts have been made, will not generate a current transfer tax but will reduce what you can give away tax-free at death. If you have already used your $1,000,000 exemption from gift tax, the gift tax owed would be $190,000.
There are other planned giving opportunities available and other methods of generating deductions to offset the effects of a Roth conversion. This is a great time to explore those options.
We invite you to contact our office to set up an appointment to reexamine your estate plan, and ensure its efficiency in this changing environment.
CONTACT
If you have any questions about this alert, please contact the author, Marjorie Suisman.
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This article is provided as a courtesy and may not be relied upon as legal advice, or to avoid taxes and penalties. Distribution to promote, market, or recommend any arrangement or investment to avoid or evade taxes, including penalties, is expressly forbidden. Any communication with the author as to its contents, does not, of itself, create a lawyer-client relationship. Under the ethical rules applicable to lawyers in some jurisdictions, this may be considered advertising.
IRS Circular 230 Notice: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding U.S. tax penalties.