From a tax planning perspective, should a client hold property until death or transfer it during his or her lifetime?  The answer depends on several factors, including the transfer tax rate and the taxpayer’s long-term capital gain rate.  Both of these variables were affected by the American Taxpayer Relief Act of 2012, which made two significant rate changes:

• The Act raised the top rate for capital gains to 20 percent for taxpayers with income in excess of the high-earner threshold ($400,000 for single filers, $450,000 for joint filers, and $425,000 for heads of households); and
• The Act raised the maximum federal estate and gift tax rate to 40 percent (up from 35 percent under prior law).

Each of these new rates must be taken into account to decide between a lifetime gift and a transfer at death. Before making a lifetime gift, the taxpayer must weigh the tax exclusive nature of the federal gift tax against the income tax consequences resulting from the loss of basis step-up.

Transfer Tax Considerations: Tax Exclusive vs. Tax Inclusive Taxation

The federal transfer tax system taxes the transfer of wealth during one’s lifetime (the gift tax) and the transfer of property at death (the estate tax).  A third transfer tax—the federal generation-skipping transfer (GST) tax—applies to transfers to recipients that are removed by more than one generation from the transferor.

The estate tax is tax inclusive, meaning that the funds used to pay the estate tax are themselves subject to the tax. In other words, the estate tax is imposed on the entire value of the estate, including assets that will ultimately pass to the federal government in the form of estate taxes.[1]

In contrast, the gift tax and is calculated based on the value received by the recipient of the transferred property.  This means that the amount paid by the transferor in connection with the transfer is not subject to the tax.[2]  Because of this, the gift tax is said to be tax exclusive.

This distinction has important consequences. Because taxes on lifetime gifts are tax exclusive, they are less expensive from a transfer tax standpoint than transfers that take place at death.

To illustrate, assume that Biden wants to transfer $1 million in cash to his daughter when the estate tax rate is 45 percent.  Let’s also assume for simplicity that Biden has no unified credit/exclusion amount available.

If Biden transfers the cash during his lifetime, his gift tax will be based on the amount actually received by his daughter.  This creates a circular computation since the amount of the gift isn’t known until the amount of the tax is determined. However, this computation can be expressed in algebraic terms: The taxable transfer will equal the amount of the transfer ($1,000,000) divided by 1 + the tax rate (1.45). In this case, the taxable transfer would be $689,655. Applying the 45 percent tax rate to this amount will result in a gift tax of $310,345.

On the other hand, if Biden holds the cash until his death (assuming no changes in value), the estate tax will apply to the entire amount included in his estate ($1,000,000).  As a result, he will owe $450,000 in estate taxes – $139,655 more than Biden would have paid if he had given the cash away during his lifetime. In other words, all else being equal, a transfer at death will result $139,655 more transfer taxes than a lifetime transfer.

Income Tax Considerations: Loss of Basis Step-Up vs. Transfer Tax Savings

Of course, transfer taxes are only part of the equation. If the transfer includes appreciated property, the income tax rules must also be taken into account.  Specifically, the taxpayer should discount the transfer tax savings by any appreciation that would be preserved in the property due to the loss of stepped-up basis.

Under the income tax basis rules (IRC § 1014(b)(9)), property that is held until death qualifies for a basis step-up, effectively erasing any appreciation. This basis step-up is forfeited if the property is transferred during lifetime, in which case the recipient will take the transferor’s basis in the property. As a result, all appreciation in the property will be preserved and eventually taxed when the recipient disposes of the property.

Whether the transfer tax savings will outweigh the loss of the basis step-up depends on the tax rates involved. In the current environment, a built-in 15 percent or 20 percent capital gains tax could erase any transfer tax savings that may result from a lifetime gift.

In the example above, assume that, instead of cash, Biden wants to transfer $1 million in property to his daughter.  Assume that the property has a $200,000 cost basis and that Biden’s daughter is subject to a 20 percent capital gains rate. In that situation, the income tax cost of the lifetime transfer would be $160,000 due to the $800,000 of deferred capital gain built into the transfer. The additional income tax cost of a lifetime gift exceeds the $139,655 transfer tax savings.

In other words, number crunching is required to determine the tax consequences of holding property until death. Making the transfer at death will make sense if the capital gain built into the property exceeds the transfer tax saving attributable to the tax exclusive nature of the gift tax.  This requires a relatively low transfer tax rate and a relatively high built-in capital gain. If, on the other hand, the transfer tax savings inherent in a lifetime gift exceed the built-in capital gain, the taxpayer should consider a lifetime gift.

The American Taxpayer Relief Act of 2012 (ATRA) was passed only a few months ago.  Because it doesn’t automatically sunset like the prior two acts, estate planners finally felt like they were in a stable planning environment.

But since the Treasury recently released President Obama’s 2014 budget proposals, there’s been a lot of grumbling about the President’s proposed estate, gift, and generation-skipping transfer tax provisions. If enacted, these proposals would change the estate tax laws yet again.

So is the Current Estate Tax Law Really Permanent?

President Obama’s proposals have caused a stir in the estate planning community.  As one attorney complained, “estate planning should not be a process where the rules change every year and the government keeps moving the goal posts.”

So is ATRA permanent? In a word, yes. It is as permanent as it can be. But in this context, “permanent” must be understood relative to prior law. It simply means “does not automatically sunset.” It does not mean that it is an inviolable law that can never be changed.

I take President Obama’s budget proposals as position statements. His prior proposals regarding the transfer taxes had a zero effect when it came down to actually passing legislation. Both the budget and the Republican response are nothing more than political posturing.

I don’t think this is an uncertain tax environment. I hope that planners won’t latch onto this and encourage overly-complex planning “just in case” the President’s budget becomes law. While I think there’s still good reasons for credit shelter trusts and valuation techniques for taxpayers that are on the cusp of the current exemption, the vast majority of taxpayers don’t need full blown estate tax planning.

With that said, let’s take a look at the estate, gift, and generation-skipping transfer tax provisions of President Obama’s 2014 budget.

Reset Federal Estate, Gift, and Generation-Skipping Transfer Tax to 2009 Levels

ATRA set the exemption from estate, gift, and generation-skipping transfer (GST) taxes at $5 million, indexed for inflation after 2011 (currently $5.25 million). Surviving spouses may be eligible to double that amount using portability or credit shelter planning.  The tax rate on gifts in excess of that amount is 40 percent.

According to the President:

ATRA retained a substantial portion of the tax cut provided to the most affluent taxpayers under [Tax Relief Act of 2010] that we cannot afford to continue. We need an estate tax law that is fair and raises an appropriate amount of revenue.

The President would reset the estate, gift, and GST tax to 2009 levels. As a result, the exemption amount would be reduced to $3.5 million for estate and GST taxes and $1 million for gift taxes, without indexing for inflation.  The top tax rate would rise from 40 to 45 percent. Taxpayers would not owe taxes on prior gifts made while the exclusion was set at the current amount, and portability would still apply.

Require Consistency in Basis and Fair Market Value Reporting

Under current law, a taxpayer’s basis in property inherited from a decedent is stepped up to the fair market value of the property at the date of death. This is an income tax concept. Property included in a decedent’s gross estate is also valued at fair market value on the date of death. This is a transfer tax concept. Even though both the income tax laws and the transfer tax laws require the property to be valued at fair market value, current law does not require that the value for income tax purposes be the same as the value for transfer tax purposes.

The President believes that taxpayers should be required to take consistent positions when reporting basis and fair market value to the IRS.  This would require both a consistency and a reporting requirement. The value used to step up basis for income tax purposes would be required to match value used for estate tax purposes. The executor of the decedent’s estate would be required to report the basis and valuation information to the recipient and the IRS. Similar rules would apply to lifetime gifts.

Require a Minimum Term for Grantor Retained Annuity Trusts

Grantor-retained annuity trusts (GRATs) have been a perennial concern of the President’s budget proposals. According to the President:

GRATs have proven to be a popular and efficient technique for transferring wealth while minimizing the gift tax cost of transfers, providing that the grantor survives the GRAT term and the trust assets do not appreciate in value. The greater the appreciation, the greater the transfer tax benefit achieved. Taxpayers have become adept at maximizing the benefit of this technique, often by minimizing the term of the GRAT (thus reducing the risk of the grantor’s death during the term), in many cases to two years, and by retaining annuity interests significant enough to reduce the gift tax value of the remainder interest to zero or to a number small enough to generate only a minimal gift tax liability.

In other words, the President is targeting short-term, zeroed out GRATs.  Under current law, zeroed-out GRATs are a low-risk, high yield estate planning technique that exploit the Internal Revenue Code’s fixed valuation assumptions. If the assets in the GRAT decrease in value, the grantor is in no worse position than if the GRAT had not been established. But to the extent that the GRAT assets outperform the Internal Revenue Code’s valuation assumptions, the benefit is passed to the remainder beneficiaries tax-free.

The President’s proposal would make GRATs more risky by imposing a minimum and maximum term for the GRAT. The minimum would be 10 years; the maximum would be the grantor’s life expectancy plus 10 years. The GRAT would also be required to have a remainder interest with a value that is greater than zero at the time the interest is created and prohibit a decrease in the annuity during the term of the GRAT. These rules would apply prospectively to trusts established after the date of enactment. If enacted, these proposals would curb, if not eliminate, the use of GRATs as an estate tax planning technique.

Limitation of Duration of GST Exemption

Under current law, the allocation of GST exclusion to a trust excludes all future appreciation and income of the trust from GST tax for as long as the trust is in existence. At the time that the GST was enacted, the law of almost all states had some version of the rule against perpetuities, which limited the term of the trust.

Many states have now repealed or extended their rule against perpetuities statutes. By choosing a favorable jurisdiction, taxpayers can create GST exempt trusts that will grow in perpetuity, without the assets ever being subject to future transfer taxes.

The President would put a 90-year expiration date on the GST exclusion. On the 90^th anniversary of the creation of a GST-exempt trust, the GST exclusion would terminate and the trust would become subject to GST tax.

Eliminate Intentionally Defective Grantor Trusts

Under current law, grantors can make gifts to trusts that are considered complete for federal tax purposes but incomplete for federal income tax purposes. These “intentionally defective grantor trusts” allow the grantor to decrease the value of his taxable estate by the amount of the gift and continue to pay income tax on the gift as though he had not made the transfer. The payment of income taxes on the completed gift further decreases the grantor’s taxable estate.

The President would eliminate this planning technique by coordinating the transfer tax and income tax rules. Gifts to trusts that are treated as grantor trusts for income tax purposes would be treated as incomplete gifts for federal transfer tax purposes.

As stated above, I take these proposals with a grain of salt. We can expect more of the same as Congress grapples with the budget deficit and discuss tax reform. But that doesn’t mean that change is imminent or that it’s time to plan for a speculative worst case scenario.  We have a law that doesn’t automatically sunset.  And, all things considered, a $5 million exemption indexed for inflation and built-in portability is a good deal.

President Obama signed the American Taxpayer Relief Act of 2012 (ATRA) on January 2, 2013. Whether ATRA is a “relief” to taxpayers depends on how you look at it. Things aren’t as good as they were under prior law, but they aren’t as bad as they could have been if Congress had not acted.

On the plus side, ATRA set the exemption for federal estate, gift, and generation-skipping transfer taxes at $5 million, indexed for inflation since 2011. It also made portability a permanent feature of the tax law.  For 2013, that means that taxpayers can pass $5.25 million ($10.5 for a married couple using credit shelter trusts or portability) to the next generation free of all transfer taxes.

But not all changes were positive. ATRA raised the maximum transfer tax rate from 35 percent to 40 percent.  ATRA also added a 39.6 percent high income tax bracket and raised the capital gains rate to 20 percent for taxpayers with income in excess of the high-earner threshold ($400,000 for single filers, $450,000 for joint filers, and $425,000 for heads of households). These higher tax rates are in addition to the 3.8 percent tax on net investment income required under the Patient Protection and Affordable Care Act.

How ATRA Affects Estate Planning in 2013 and Beyond

ATRA didn’t make any revolutionary changes to the way estate tax planning is done. Many of the same techniques that worked in 2012 still work under ATRA. But ATRA did affect the estate planning environment in several ways:

• Unlike its predecessors, ATRA is permanent. There is no automatic sunset provision that will cause ATRA to expire automatically if not extended. ATRA gives a much-needed reprieve from the uncertainty that has plagued estate and gift tax planning for the past decade.
• Very wealthy taxpayers who haven’t already used their exemption still have an opportunity to do so through lifetime gifting. Even though ATRA doesn’t automatically sunset, Congress may still lower the exemption or raise the tax rates. The only way to lock in the current favorable exemption is to fund the exemption amount now. Making the transfer now will also move all future appreciation out of the taxpayer’s estate.
• Very wealthy taxpayers might also consider making taxable gifts in excess of their exemption amount. Due to the tax inclusive nature of the estate tax, lifetime transfers are more tax-efficient than transfers that take place at death.
• Given the higher capital gains rates, the use of intentionally-defective grantor trusts (which allow the grantor to continue to pay the tax on completed gifts) may no longer be the right choice. If the transferee is in a lower tax bracket, the better choice may be to terminate the grantor trust status.  This would allow the beneficiaries to pay tax on the trust income at lower rates (assuming that the grantor’s spouse is not a co-beneficiary of the trust). The trust could make distributions to the beneficiaries to cover the additional tax liability.

Perhaps the biggest takeaway is that the vast majority of Americans need not be concerned with federal transfer tax issues. Only individuals with gross estates (defined very broadly) worth more than $5.25 million are potentially subject to estate tax. This means that most people can forget about estate tax planning and focus on what truly motivates them, including:

• Ensuring that their assets are distributed to the people that they want to have them and at the time that they want them to have them;
• Protecting estate assets from actual or potential creditors of family members and loved ones (or from their own bad decisions);
• Planning for the possibility of their own incapacity; and
• Protecting assets from frivolous lawsuits.

These non-tax goals are at the heart of most estate planning decisions for everyday clients. Advisors can now focus on accomplishing these goals without the unnecessary complication of estate tax planning.

What ATRA Didn’t Do

ATRA is also significant for what it doesn’t include. President Obama’s budget proposals (including the recently-released budget proposal for 2014) continue to include provisions that would curtail the use of taxpayer-friendly planning techniques.  Specifically, the President would:

• Require a minimum term for grantor-retained annuity trusts (GRATs);
• Limit the duration of the generation-skipping transfer (GST) tax exemption;
• Include the assets of an intentionally-defective grantor trust in the grantor’s estate; and
• Impose additional consistency and reporting requirements relating to basis in property inherited from a decedent.

Whether any of these proposals will become law is a matter of speculation. It seems clear that the Obama administration will continue to propose these changes, especially in a time when the issue of tax reform pervades most political discussions. But for now, there are still opportunities for estate tax planning for taxpayers with estates that exceed the $5.25 million (2013) threshold.

I wrote recently about pot trusts and how they can be used to provide for a more equitable distribution for minor children. As I mentioned, pot trusts allow all trust assets to be held in a common “pot” for the benefit of children until a certain triggering event occurs (attaining a certain age, graduating from college, etc.) for all of the children. Pot trusts are used as an alternative to the more-common method of dividing the trust into separate shares at the death of the trust creator.

I’ve been working on a pot trust for a client and thought I’d share the clause I’m drafting. This particular client wants the trust assets to be held in trust until all of his children have either graduated from college and had two years of graduate education or have reached age 26. One of the children has already been in drug rehabilitation, so the client wants to be sure that the pot trust isn’t drained to provide for that child’s drug problems. He wants to do this by capping the total amount of drug and alcohol related expenses to $20,000.00 for any one child. Here’s the clauses that I’m using:

4.01       Management of Trust for the Benefit of My Children.

Until all of my children have either completed all undergraduate education and at least two years of graduate education or attained the age of twenty-six (26) years, whichever occurs first, the Trustee shall from time to time pay to or use and apply for the benefit of any child of mine so much of the net income of this Trust and principal thereof, in such amounts and proportions, equal or unequal, as the Trustee may deem necessary for the health, support or maintenance of such child in accordance with his or her standard of living prior to my death, and for the education of such child at any available level and at any formal educational institution, whether or not accredited, including college and postgraduate schools; provided, however, that in no circumstances shall my Trustee make more than Twenty Thousand Dollars ($20,000.00) in aggregate distributions to pay for any single child’s care in alcohol or drug rehabilitation facilities or programs.  In each case, the Trustee shall take into consideration other income and assets of such child and trusts of which he or she is a beneficiary and which are known to the Trustee.  The Trustee (i) may pay all or part or none of the net income or principal of the Trust or both; (ii) may make unequal payments; (iii) may from time to time exclude one or more of such persons from payments hereunder; and (iv) may make payments to any such person who is living at the time of such payments even though such person is not living at the time of the creation of the Trust.  Any part of the net income of the Trust not so paid or used shall be accumulated, added to and made a part of the principal of such Trust.

4.02       Distribution of Trust.

As soon as practical after the date upon which all of my children have either completed all undergraduate education and at least two years of graduate education or attained the age of twenty-six (26), whichever occurs first, the Trustee shall divide the Trust into as many shares as there are children of mine then living, and one share for the then living descendants, collectively, of each deceased child of mine (a “Child’s Share”).  The Trustee shall distribute, outright and free of trust, one Child’s Share to each child of mine and one share to the living descendants, collectively, of each deceased child of mine, the lineal and adopted lineal descendants of any child who predeceases me to take the share such deceased child would have taken if living, per stirpes and not per capita, subject to the provisions of Section 4.03 hereof.

4.03       Trust for Descendant of a Deceased Child of Mine.

If any part or share of the Trust becomes distributable to a descendant of a deceased child of mine who is under the age of twenty-six (26) years, then though his or her share shall be vested in him or her, the Trustee may, but shall not be required to, continue to hold the same in trust with all of the powers and authority given to the Trustee with respect to other trust property held hereunder, until such descendant attains the age of twenty-six (26) years.

So what do you think? Is it helpful? Any room for improvement? Let me know in the comments below.

There seems to be a great deal of confusion about the annual exclusion from gift taxes.  Most of my clients with taxable estates have been told that they can give a certain amount (currently $13,000) per individual each year. Many view this as a hard rule.  They believe that any gift over the annual exclusion will have catastrophic tax consequences.

This isn’t always the case.  The vast majority of people need not be concerned with gifting more than $13,000 per year, especially under the current estate tax laws.  Let’s take a quick look at the estate and gift tax rules involving the annual exclusion to see why.

What is the Annual Exclusion? A Quick Primer

The annual exclusion is an amount that the Internal Revenue Code allows you to give away to as many people that you wish, each year, without the amount being subject to gift tax or requiring the filing of a gift tax return.  The annual exclusion is currently $13,000 but is indexed for inflation in $1,000 increments.

As a planning tool, the annual exclusion allows clients to reduce the value of their taxable estate.  Every $13,000 that is gifted under the annual exclusion is $13,000 less that will be subject to estate tax at the client’s death.

For example, assume that a husband and wife have three grown children and three grandchildren.  By giving the annual exclusion amount to each child and grandchild, husband and wife could make annual exclusion gifts of $78,000 per year ($13,000 X 6 beneficiaries).  The same husband and wife could also make annual exclusion gifts to the spouses of their children, allowing them to gift another $39,000 per year ($117,000 total).  That’s $117,000 more that the client can leave to the next generation free of gift and estate taxes.

The annual exclusion can also be leveraged to give away more than $13,000 of actual economic value to each recipient free of estate or gift taxes. For example, annual exclusion gifts are commonly used in conjunction with family limited partnerships.  The children are given limited partnership interests that already reflect a discounted value.  Over time, the aggregate amount shifted to the children includes far more than the sum of each year’s $13,000 annual exclusion.

Why Most Clients Can Ignore the Annual Exclusion Amount

As mentioned earlier, many people are vaguely aware of these rules and assume that they are absolutely prohibited from gifting more than $13,000 per year. But this isn’t the case. To understand why, you need to understand what happens if the gift exceeds $13,000.

Say that Joel, an unmarried man, has an estate worth $1 million.  In 2012, Joel decides to give his $100,000 vacation home to his daughter Sally.  This gift clearly exceeds Joel’s $13,000 annual exclusion.  Does that mean that Joel or Sally will need to pay taxes on the transfer?

The answer is “no.”  Each person has a certain amount (called the applicable exclusion amount) that he or she can give away during their lifetime and at death without being subject to estate or gift taxes. That amount is currently $5 million.  That means that Joel can give an aggregate of $5 million away during his lifetime or at his death without worrying about estate taxes.  Since Joel’s estate is only worth $1 million he doesn’t need to worry about being subject to estate or gift tax on any lifetime transfers. The gift of the vacation home to Sally will not be subject to gift taxes.

Gifts in excess of the annual exclusion only reduce the overall applicable exclusion amount.  Under current law, each gift in excess of $13,000 will chip away at the $5 million that a person could otherwise transfer free of estate and gift taxes.

In Joel’s case, he gave away $87,000 more than the annual exclusion amount ($100,000 value of home less $13,000 annual exclusion amount).  This $87,000 will reduce his applicable exclusion amount of $5 million to $4,913,000.  Since Joel’s estate is only worth $1 million, his remaining $4,913,000 exemption will easily cover the value of his estate at death.  No estate or gift taxes will be paid on the transfer of the home to Sally.

That isn’t to say that the transfer of the home has no tax consequences, though.  There are two primary effects of the transfer of the home:

• Because the IRS needs to be able to track the reduction of the applicable exclusion amount, Joel will need to file a gift tax return to report the value of the transfer.  This is purely a reporting issue.  No estate or gift taxes will need to be paid.
• Sally will take Joel’s basis in the vacation home.  This means that any appreciation in the home at the time of the transfer will follow the home into Sally’s hands.  When Sally sells the home, she will pay taxes on any appreciation that accrued during her lifetime and any appreciation that accrued while Joel owned the home.  If Joel held the property until his death, any appreciation that accrued during Joel’s lifetime would be wiped out.

These two rules (the need to file a gift tax return for gifts in excess of the annual exclusion and the transferred basis rule) are the only two that most clients need to know.  Because the value of most people’s estates doesn’t exceed the applicable exclusion amount (currently $5 million per person, $10 million per married couple), most people don’t need to worry about paying gift taxes for gifts in excess of the annual exclusion amount (currently $13,000).