This year, a window of opportunity exists for you to make a large gift to your heirs and shelter the gift from the gift tax, future estate tax, and potential generation-skipping transfer ("GST") tax. This opportunity is available due to the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act ("Act"), which President Obama signed into law on December 17, 2010. The Act increased the lifetime gift tax exemption ("gift tax exemption") from $1,000,000 to $5,120,000 in 2012. Consequently, in 2012, you have the ability to make gifts up to $5,120,000 without incurring a gift tax, and, if you are married, you can join with your spouse to make tax-free gifts up to $10,240,000.
This year and last year are the only two years in which the gift tax exemption has been so high. The gift tax exemption was $675,000 in 2001; it increased to $1,000,000 in 2002 and increased again to $5,000,000 in 2011. Prior to 2011, the gift tax rate had been as high as 55%, but the Act reduced the gift tax rate to 35% for 2011 and 2012. Under current law, the gift tax exemption will revert to $1,000,000 in 2013 with a 55% top gift tax rate.
In addition to increasing the gift tax exemption, the Act also increased the estate tax exemption to $5,120,000 in 2012; however, under current law, the estate tax exemption will revert to $1,000,000 in 2013 with a 55% top rate. The gift tax exemption and the estate tax exemption are unified, which means that if you make a gift of $1,000,000 this year then at death your estate tax exemption will be reduced by $1,000,000.
Another tax impacted by the Act is the GST tax. Generally, the GST tax applies when property passes to someone who is two or more generations below you. The GST exemption is currently $5,120,000, but under current law will revert to $1,390,000 in 2013 with a 55% rate.
If your estate is large enough that it will be subject to the estate tax at your death, and if you are in a position to transfer property without infringing on your ability to maintain your lifestyle and level of comfort, making a large gift this year is prudent. Some advantages of a large gift now include: (1) more property will be removed from your estate, free of gift and estate taxes, than would be removed in future years due to the expected decline in the gift tax and estate tax exemption amounts; (2) appreciation on the gifted property is removed from your estate and this appreciation will bypass the estate tax at your death; and (3) when coupled with the GST tax exemption and a gift to an irrevocable dynasty trust, the property should be exempt from the transfer tax.
One way to leverage a large gift is to give an asset that can be discounted. Some assets that may be discounted are stock in a closely held corporation, fractional interests in real estate, membership interests in a limited liability company, and limited partner interests in a limited partnership. The lack of control and lack of marketability associated with these assets may result in a discount between 25–45 percent. Applying a discount to the gift allows you to transfer more property at a lower value. For example, if a limited partnership has a gross value of $7,000,000, and you give a 75 percent limited partner interest, the gift may be valued at $3,412,500 if a 35 percent discount applies instead of the $5,250,000 undiscounted value.
What if you do not own an asset that can be discounted but instead you own marketable securities and real estate? In this case, you may be able to establish a limited partnership to which you contribute your marketable securities and real estate in return for a limited partner interest. However, it is very important that the limited partnership have a valid business purpose in order for the discounts to be respected by the Internal Revenue Service. Much analysis must be undertaken before a limited partnership is established, and the formation and operation of a limited partnership are beyond the scope of this article.
Another way to leverage a large gift is to make a gift of a discounted asset to an irrevocable trust.
Some advantages of an irrevocable trust include protecting the property from (1) claims of creditors; (2) divorce; and (3) a beneficiary who may not be able to manage large amounts of property. Also, if the trust lasts for the beneficiary's lifetime and the lifetimes of future beneficiaries, which is commonly referred to as a "dynasty trust," and the transfer to the trust is exempt from the GST tax, the property in the trust should escape the estate tax and GST tax when the beneficiaries die. If you live in a state that does not allow dynasty trusts, you may be able to establish the trust in a state such as Delaware that permits dynasty trusts.
An added benefit of the irrevocable trust is that it can be structured in a manner so that you are responsible for paying the income tax on the income of the trust during your life. This type of trust is commonly referred to as a "grantor trust." Your payment of the income tax is viewed as a tax-free gift from you to the trust, and the trust grows tax-free since its assets are not depleted to pay the income tax.
It should be noted that President Obama has proposed in his fiscal year 2013 revenue proposals to eliminate the benefits of grantor trusts, the use of discounts on certain assets, and the duration of dynasty trusts. If these restricting provisions are enacted, there is the possibility that gifts of discounted assets to dynasty trusts entered into before the date of enactment may be grandfathered. Consequently, there is even more incentive for you to make large gifts of discounted assets to an irrevocable dynasty trust this year.
So this all sounds great, but what do the numbers look like? One study reported that a gift of a $1,000,000 asset to a dynasty trust that is exempt from the gift tax and GST tax would have values as follows (assuming no distributions and a five percent rate of return after taxes and fees): end of year 20—$2,650,000; end of year 40—$7,040,000; end of year 70—$30,425,000; and end of year 100—$131,500,000. These numbers would be much greater if you are responsible for the income taxes on the trust during your lifetime. If the $1,000,000 gift is outright instead of to a dynasty trust that is exempt from the gift tax and GST tax, the same study reported that the value would be only $32,875,000 at the end of year 100 assuming a 50 percent transfer tax rate.
If your estate will be subject to the estate tax upon your death, you should seriously consider making a large gift this year to an irrevocable dynasty trust to maximize the tax savings before this window of opportunity shuts.
Article originally published in Furman University's The Advisor newsletter, 2012 Issue and is posted with the permission of Furman University. Visit www.furman.edu.