Under current law, the unified credit for gift and estate taxes allows $5.12 million to be sheltered from tax. However, with the so-called "fiscal cliff" the exemption is scheduled to drop down to $1 million beginning in 2013 as the Economic Growth and Tax Relief Reconciliation Act (the "Bush Tax Cuts") finally lapse; in addition, the top estate tax rate is scheduled to rise from the current 35% up to 55%. Although it remains possible that the current estate tax rate and/or exemption will be extended further - in 2010, the Tax Relief Act prevented a lapse back to higher rates and lower exemptions just weeks before the end of the year - the potential for such a significant decline in the exemption and rise in rates makes it tempting to try to take advantage of the current rules before the scheduled change occurs.
Taking Advantage Of The Current Gift Exemption
The basic principle of taking advantage of the current gift exemption is to make a gift while the exemption is current $5.12 million, before it drops down to only $1 million. For example:
Harold has a net worth of $8,000,000. If Harold were to pass away this year - in 2012 - with a $5.12 million exemption and a top tax rate of 35%, he will owe estate taxes on $2.88 million of net worth, for a liability of just over $1,000,000. By contrast, next year - in 2013 - when the exemption has dropped down to $1,000,000, he will owe estate taxes on the remaining $7,000,000 at a top tax rate as high as 55%, resulting in a total estate tax liability of more than $3 milloin.
To avoid this result, Harold can gift away up to $5.12 million of his wealth to his children now, in 2012, while such a gift would still be protected by the current gift tax exemption. As a result, his remaining net worth is only $2.88 million - which at a 2013 top estate tax rate of 55% and a $1,000,000 exemption would be subject to an estate tax liability of just over $1.5 million.
In essence, Harold chooses to voluntarily use up all of his exemption - while it is still $5.12 million - by making a gift to his children (or other beneficiaries), rather than waiting and becoming subject to a potentially lower exemption in the future. The net result is that by gifting away assets before the current gift and estate tax levels lapse - and taking advantage of the $5.12 million exemption before it drops down to only $1 million - Harold saves almost $1.5 million of future estate taxes for his family!
Notably, in the case of a married couple, each spouse has an exemption of $5.12 million, allowing the couple to gift more than $10 million combined to take advantage of current gift tax exemptions!
Optimal Strategies To Utilize The Exemption
While it may be appealing to gift money to take advantage of the current $5.12 million exemption, the reality is that gifting money directly - i.e., cash - is actually a relatively "inefficient" way to transfer assets to the next generation.
For instance, if Harold's wealth included a family business held as a partnership, Harold might choose to gift shares of the family limited partnership (FLP) to the next generation. Because a minority share of a family business with limited liquidity would be relatively unappealing for someone to buy, the shares are eligible for a valuation discount, which can range anywhere from 10% to 35% (or occasionally more) depending upon the nature of the business. Thus, Harold might actually be able to gift $6.8 million of shares in a family limited partnership, which with a 25% discount would still be entirely sheltered by a $5.12 million exemption. To say the least, transferring $5 million worth of (discounted) business shares (ultimately worth $6.8 million) is better than "just" transferring about $5 million of cash that's only worth... $5 million!
Another popular strategy, effective with even larger estates and especially businesses, is to establish a so-called IDGT (which stands for Intentionally Defective Grantor Trust), which is treated as being outside Harold's estate for estate tax purposes. Harold might gift $5 million to the trust, which is then used as seed money to buy a large business out of Harold's estate; for instance, Harold might sell a $40 million business to the IDGT, in exchange for payments that continue for the shorter of either 20 years or until Harold dies (also known as a Self-Cancelling Installment Note, or SCIN), and use the $5 million cash to fund the initial payments (by the time the $5 million of cash has been depleted, the business should have generated enough cash flow to fund future payments). The end result is that the business is now in the IDGT, which may distribute the business to Harold's children in the future, or hold it in trust for their benefit safe from future creditors, or might even be held for multiple generations as a dynasty trust. The benefit of this arrangement is that all future appreciation of the business now occurs inside the IDGT, and not inside Harold's estate subject to future estate tax, effectively "freezing" the current value, while Harold simply receives fixed installment note payments that slowly increase his personal estate again. As an added benefit, Harold can cover the income tax liabilities of the IDGT from his personal assets, allowing the business outside his estate to continue to grow estate (and income) tax free, while his personal assets that are subject to estate taxes are whittled down further! Unfortunately, though, it's not entirely clear how long this tactic will last, as recent proposals from President Obama have taken aim at the IDGT strategy as it is currently commonly done.
The bottom line is that in situations where an individual does want to take advantage of the current $5.12 million estate tax exemption, engaging in strategies that allow some amount greater than $5.12 million to be frozen, sheltered, or otherwise transferred, is far more appealing than "just" transferring cash!
Caveats To Gifting Strategies
Of course, as with any strategy, there are often caveats before proceeding, and trying to utilize the current $5.12 million exemption is certainly no exception.
The first caveat to the strategy is actually a technical one. Strictly speaking, it's not entirely clear how the actual calculation of future estate taxes will work if the exemption declines. The complication is that, under the technical rules for calculating the estate tax, prior gifts made are supposed to be added to the current/remaining estate, in order to calculate the taxes due, and from which the unified gift and estate tax credit amount is netted. In a world where the estate tax exemption remained flat or increased, this was relatively straightforward, and simply ensured that people would be subject to the same estate tax rates - all else being equal - regardless of whether they gifted money while alive, or held it until death. In a world with a declining exemption, though, it's not clear whether or not this calculation might cause a "clawback" of the taxes avoided from gifting with a higher exemption to reappear when calculating estate taxes under a lower exemption. At this point, estate planning attorneys are still split on whether a clawback would apply or not. Congress has proposed legislation to definitively declare that a clawback will not occur (see, for instance, Section 201 of S. 3393, the Middle Class Tax Cut Act), but no such legislation has yet been enacted. Notably, though, if clawback were to occur, the worst case scenario would simply put the taxpayer in the same position as if the gift had never happened in the first place; in other words, making a gift that turns out to become subject to a clawback doesn't leave the individual in a worse position, it simply causes the gift to have not improved the situation.
The second important caveat to these gifting strategies is simply that $5,000,000 is a lot of money to give away! For someone in Harold's situation, with "just" $8,000,000 of total net worth, such a gift could strain Harold's overall financial security, depending on his age and anticipated remaining years of retirement (clearly, it would be far more of a problem if Harold were 65 and healthy than 88 and unhealthy). While a married couple can gift a whopping $10.24 million, taking even further advantage of the current gift tax exemptions, this in turn requires even more family net worth to remain financially viable after the gift. Consequently, this gifting strategy has been most popular with individuals who have at least $10 million in net worth, or couples who have at least $15 million, to ensure that adequate assets for lifestyle will remain. On the other hand, it's notable that the strategy still works with any estate that is greater than $1,000,000 (the exemption in 2013); $5.12 million simply represents the maximum gift that can be done to engage in the strategy, not the minimum!
The third important caveat is that these strategies that take advantage of the current Federal gift and estate tax exemption should still be coordinated with any state estate taxes that may apply. The good news is that, in general, gifting strategies for Federal estate taxes are generally effective and beneficial for state estate taxes as well; in fact, in many states gifting strategies are highly effective for anyone with assets in excess of the (typically $1 milllion) state estate tax exemption, even if there is no Federal estate tax exposure! However, there are a few states that have state gift taxes that may complicate the situation, and some states have inheritance taxes that may be impacted as well. Consequently, it's still important to coordinate Federal estate tax planning strategies with state laws.
Perhaps the greatest caveat to the strategy, though, is simply to note that notwithstanding a lot of close calls, Congress has never actually allowed the estate tax exemption to decline since the Great Depression (nor has the estate tax rate been allowed to increase since World War II). If the current exemption is extended, the net result of a gifting strategy may be to simply to transfer assets and lose control and access to them for no benefit at all (although notably, some gifting strategies can still be effective to shift future appreciation away from estate tax exposure, even if it yields no current benefit). Or alternatively, even if the estate tax exemption drops for a year or few, it may well be increased again thereafter. Consequently, many planners have ultimately leaned more towards estate planning strategies that simply allow for flexibility and a "wait-and-see" approach, rather than making dramatic and irrevocable gifts, unless clients are in very poor health and face an elevated risk of passing away in 2013.
Nonetheless, the pressure is on for those who do want to engage in gifting and take advantage of the current estate tax laws as they apply. With election uncertainty looming, that doesn't necessarily means gifts have to happen immediately, but if there's a desire to gift before the end of the year - after the election outcome is known, and once we see whether Congress engages in any lame duck legislation in December - preparation should begin now, especially if FLPs, IDGTs, or some of the other more complex estate planning strategies are desirable.
So what do you think? Are you engaging in (or preparing for) any end-of-year gifting strategies to take advantage of the current estate tax exemption? Do you anticipate the estate tax exemption will decline (and/or that the maximum estate tax rate will increase)? How are you handling these discussions with your clients?