Denha & Associates, PLLC Blog

Some Planning Approaches To Utilizing The Increased $5 Million Gift Exemption

By: Randall A. Denha, Esq.

On December 17, 2010 Congress passed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“The Act”).  This legislation dramatically changed the laws that would have come into effect on January 1, 2011; however, they only extend the existing legislation for two more years.  So although we have some certainty, it is only temporary.

Estate, Gift and Generation Skipping taxes (collectively referred to as “transfer taxes”) are imposed to tax the transfer of wealth from one generation to the next.  Politics aside, many people wish to avoid this type of transfer tax.  As of December 2010, these transfer taxes increased from previous years, however, they became tied together so that every individual may transfer the exempt amount (now $5M) during his or her life or at death.  Transfers exceeding $5M will be taxed at a flat rate of 35%.  The new law also provides for “portability.”  Portability allows a surviving spouse to preserve a deceased spouse’s unused estate tax exemption by filing a federal estate tax return.  This preservation ensures that the couple may ultimately transfer a combined $10M before paying any transfer tax.

Aside from having your existing estate planning documents reviewed in light of recent legislation, you may wonder what else can be done to reduce the dreaded transfer tax.   Here are ten planning approaches to utilizing part or all of the current gift tax exemption with a brief description of each technique:

1.  Lifetime Credit Shelter Trust for Donor’s Spouse

The donor may wish to make gifts in a way that still allows the donor (or the donor’s spouse) to retain the use of these assets in case ever needed as a “rainy day” fund.  A very popular way of using the increased gift exemption may be for a donor to make gifts to a “lifetime credit shelter trust” for the spouse’s benefit.  The trust would be for the benefit of the donor’s spouse, containing very similar terms as is found in a standard credit shelter trust. In some ways, this is the ideal kind of trust for the spouse because the spouse is a discretionary beneficiary, can be the trustee, can have a limited power of appointment (exercisable at death or in life), and the trust may be protected against claims of both the donor’s and spouse’s creditors. This is a wonderful technique to consider for those looking to not only utilize the gift tax exemption but also achieve creditor protection. 

2.  Discretionary Trusts in Self-Settled States

Currently, twelve states have adopted varying approaches regarding the “self-settled spendthrift trust”: Alaska, Delaware, Hawaii, Missouri, Nevada, New Hampshire, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, and Wyoming. This kind of trust allows the grantor to appoint an independent trustee to act as a watchdog over the moneys transferred and still have a “discretionary interest’ in the trust if the money is ever needed again by the grantor.  Think of this as a “Rainy Day Trust.” While there are no guarantees that a creditor might still be successful in accessing the moneys in the event of a lawsuit, many clients remain undeterred and continue to establish these trusts in the jurisdictions noted. The typical feeling by most individuals that establish this sort of trust is “you are no worse off than trying” so why not set up something that might actually work?

3.  Maximizing the $5 Million Generation Skipping Tax (“GST”) Exemption

There are no assurances that the GST exemption will remain at $5 million.  Making a $5 million gift and allocating the $5 million of GST exemption that is currently available is one way of assuring that the full $5 million GST exemption can be used.  The safest way of utilizing the $5 million GST exemption would be to make direct skip gifts, to as low a generation as is practicable.  Any other transfers of the GST exemption such as to dynasty trusts run the risk that the full $5 Million of exemption once used would be considered for certain generation-skipping transfers.

4.  Forgiveness of Outstanding Loans to Children

Consider forgiving existing loans to children as an easy way of utilizing the $5 million gift exemption.  Be careful if you have been repeatedly forgiving loan payments. If the IRS can establish intent from the outset that the entire loan would be forgiven eventually, the IRS may treat the gift as occurring all in the year of the initial advance. Typically, the forgiveness will not result in discharge of indebtedness income. The IRS has previously ruled that “debt discharge that is only a medium for some other form of payment, such as a gift or salary, is treated as that form of payment, rather than under the debt discharge rules.”

5.  Gifts and/or Sales to Grantor Trusts.

Making transfers to grantor trusts, where the donor continues to pay income taxes on the trust income, has a huge impact on the amounts that can be transferred over time. Why?  By having the grantor pay the income taxes owed on trust income, the trust can continue to grow without any diminishment by the payment of income taxes. Therefore, the trust assets compound free of income tax, and the payment of income taxes by the grantor will further reduce his/her estate. Imagine gifting a large amount of money to this sort of trust and paying the income tax on the assets year after year?  The result is a considerable shift in assets to the next generation and away from Uncle Sam.

6.  Make A Gift To A Grantor Trust and Loan to the Same Trust

Think of this technique as being similar to #5 above but with a twist: instead of only gifting the assets, consider making a loan to the same trust.  Why?  By making an additional loan to this trust and retaining a promissory note with a predetermined rate of interest, the grantor can freeze the asset value and remove any post-gift appreciation from his/her estate and shift it to the trust. There are many variations to the option of dealing with grantor trusts that can be employed.  The foregoing is a simple explanation of one variation.

7.  Consider The Use of a GRAT

A GRAT, or grantor retained annuity trust, is an irrevocable trust designed to transfer the appreciation on assets contributed to it with minimal or no gift-tax consequences. It’s a popular strategy for transferring wealth in a low interest-rate environment. If the assets in the trust appreciate more than the annuity payments you are required to take out of it — and the odds of that are high with a low “hurdle” rate of 3.0% (April 2011) — the excess goes to your beneficiaries tax-free. (If it turns out the asset has appreciated less than the payments to you, the trust fails; the asset returns to you, and you can start another GRAT and try again.) In fact, for those grantors wanting to take advantage of current market volatility, consider a strategy of GRAT planning that involves setting up GRATs in rolling, two-year intervals. Why?  Research has shown that over the long term, a strategy of rolling two-year GRATs funded with publicly traded stocks is almost always preferable to a long-term GRAT because it captures the market volatility and because it keeps more of the funds committed to the strategy. Despite legislation that sought to curb the use of short term GRATs, the strategy is still here and should be considered.

8.  Life Insurance Transfers

With a larger gift tax exemption, grantors can gift funds to specially designed trusts to purchase life insurance and allow that trust to provide the needed funds to the family at the time they need it and for the purpose it was acquired. Under the law (both past and present) there is a limit on how much can be gifted to a life insurance trust.  Now that the amount that can be gifted is much greater, more can be gifted with less of a concern for the payment of gift tax.

9.  Qualified Personal Residence Trust

A Qualified Personal Residence Trust is a special trust used as an estate planning technique to leverage a gift of your principal residence or vacation home out of your estate at a significant discount from its current value. The technique, when successful (which requires your outliving the term of the trust) can save substantial estate taxes. This technique is similar to that of a GRAT (as described above.) You gift your house to a QPRT and reserve the right to live in the house for a specified number of years, typically 5-10 years. After that time period the heirs own the house. Often you reserve the right to continue to lease the house after that term at fair market value. How much rent to pay?  Pay as much as is commercially reasonable because it allows the grantor to shift more money away from Uncle Sam and leave more to the beneficiaries by the payment of rent.

10.  Annual Exclusion Gifts

Now that that gift tax exemption has increased to $5 million and the annual exclusion gift amount is still $13,000 for an individual gifting and $26,000 if the spouse consents to the gift, consider equalizing gifts to children and/or grandchildren.  The extra exemption amount of $4 million will permit grantors to now use some of these extra dollars to equalize those beneficiaries that may have received less in prior years because there wasn’t enough exemption to use. Of course to further leverage this transaction and many of the techniques described above, the grantor can seek a special appraisal of the asset gifted that will provide a valuation discount on such asset.  The discounts of lack of marketability and lack of control may result in a discount of 25% or more depending on the asset transferred.  So, a $1000 transfer of a business interest to the child will only be worth $750 for gift tax purposes. Now this is leverage! Finally, keep in mind that discounting can be achieved through various estate planning techniques.