By: Randall A. Denha, J.D., LL.M.
At this time last year, I wrote about a technique called the “Disclaimer Trust” which permits a donor to make a “wait and see” gift to a loved one. That is, if the tax laws are favorable for a gift to be made then the gift can be completed and if they are not so favorable then the gift can be withdrawn or disclaimed. Either way, the control was in the hands of the donor. In this same fashion, the strategy presented in this article involves a potential planning technique that permits taxpayers to utilize up to their current $5.25 million exemption (scheduled to increase to $5.34 million in 2014 per spouse) without actually parting with the assets at one time.
Many taxpayers engage estate planning counsel this time of year and find themselves in a rush to complete gifts prior to year-end, whether it be to utilize the $5.25 million exemption in place today or to make taxable gifts before the rates go up at some point in the future. However, some people are not in the position to utilize all or some part of their exemption amount prior to January 1, 2014. The reasons for not to wanting to make a large gift now can vary. For example, some may not have significant assets currently but could be expecting to earn or inherit large sums of wealth in the future, while others may either have liquidity concerns or simply do not want to part with their assets. As can be expected and unfortunately, many experts predict that gift tax rates will go up in the future. It’s not a matter of “if” but “when.” We are facing deficits, congressional deadlock and a mounting national debt so it’s likely that increases in the tax rate lie ahead.
One way a taxpayer can utilize the larger exemption amount today (or use the lower rates still in effect in the case of taxable gifts) is through the use of making a gift of a promissory note. To the extent a person issues a promissory note, i.e., makes a promise to pay a transferee an amount of money or other property in the future, and does not receive adequate and full consideration in exchange then that person has made a taxable gift. Note that in this example, the transferor has not actually departed with any funds to make the gift. This is the benefit of making a gift of a promissory note. It’s in essence a promise to make the transfer.
By way of background, let’s quickly go over what the federal transfer tax system provides for this technique to work. In order for a gift to be respected for this purpose it: (a) cannot be an arm’s length and bona fide business transaction made at arm’s length; (b) it has to be a real or bona fide gift; and (c) enforceable under local state law. In fact, according to longstanding case law, the “intent” of the transferor is irrelevant. Instead of looking to intent, the tax laws look only to what the transferor gave up and what was received in return. In the event that a transferor gave away more than he got back, there is a gift.
In the case of a gift of a promissory note, the transfer will be respected as a completed gift for tax purposes as long as the gift is one which is enforceable under local law. This may require the gift either to be structured as an enforceable agreement (including offer, acceptance and consideration).
Making a gift before the end of the year in the form of a promissory note in the amount of the exemption amount permits a taxpayer to benefit from the entire $5.25 million exemption amount without losing control of assets. This is a great year end planning tool, but taxpayers need to make sure to seek qualified counsel since there are many pitfalls that need to be avoided.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.