14 March 2011

Estate tax: Keeping the change


In a last-minute tax compromise late last year Congress made unexpectedly generous changes to the estate taxes – at least for now. Savvy families aren’t losing any time taking advantage of the new $5 million exemption for estate, gift and generation-skipping transfer (GST) taxes and the 35% maximum rate for transfers over that amount.

What’s the rush? There are two key factors.

The first is economic. Asset values and interest rates are generally on the rise. Many key planning techniques simply work better when interest rates are low. It establishes a lower hurdle rate to overcome. To take advantage of today’s low rates, clients are going to have to move fast. Many planners expect rates to go up – and to keep going up each month that passes. In fact, the mid-term IRS rate has increased over 70 basis points in the last six months. Asset values also enter into the equation. Transferring assets when values are modest allows for growth to occur within tax efficient vehicles, leaving less wealth to be taxed and more to pass to the family.

The second key factor is politics. “Clients will need to make hay while the sun shines,” according to Linda Beerman, manager of the Wealth Strategies Group at Atlantic Trust’s New York office. The new law is scheduled to expire at the end of 2012, and as Beerman points out, “we don’t know what’s going to happen after that.” The President’s budget proposal has the exemption dropping to $3.5 million and the top rate increasing to 45% in 2013. Then there’s the added complexity of state taxes. For example, Illinois recently reinstated its estate tax, and even Florida has been considering changes that could result in additional estate taxes on non-residents. Connecticut is considering divergent proposals that could either eliminate the tax altogether or lower exemptions to the $2 million mark.

So what do families and individuals need to do now to take advantage of the increased exemptions and lowered rates?

Lifetime Gift Planning for Future Generations

The big news, according to Beerman, is the reunification, for the first time in 10 years, of the estate and gift taxes. That means that all of the $5 million exclusion amount can be used during life. (By contrast, in 2009 up to $3.5 million of property could pass free of federal taxes at death but only $1 million of the exemption could be used for lifetime gifts.) Making the full exemption amount available during life means that significant assets can be moved to younger generations earlier, allowing many years of growth to escape estate, gift and GST tax.

In addition, the 2010 Act did not contain the anticipated restrictions on the use of common estate planning vehicles such as Grantor Retained Annuity Trusts (GRATs) or Family Limited Partnerships and Limited Liability Companies. As a result, clients can continue to use these vehicles to transfer wealth at a lower overall tax cost.

Proposals to require a 10-year minimum term on GRATs are back as part of the Administration’s 2012 budget proposals. This requirement would make GRATs less attractive because of an increased risk of estate tax inclusion (due to the client’s death during the term) and a decreased opportunity to capture volatility. But for now, clients can continue to take advantage of low interest rates and current market volatility, using short-term GRATs to move appreciation out of their estates.

For clients who want to take advantage of the increase in the GST tax exemption as well, gifts and sales to multi-generational dynasty trusts present an incredible opportunity to pass on wealth. Recent Administration proposals would limit the number of years the GST exemption lasts, so it’s important that clients consider multi-generational planning now. Today it is possible to create perpetual or ultra-long term trusts in many jurisdictions. By using the full 2011 exemptions, carefully selecting assets and taking advantage of long-standing valuation rules, over time a married couple should be able to move $100 million or more into trusts that will never be subject to estate, gift or GST tax again, even if the trusts run for ten or more generations. The government is aware of this possibility and so this opportunity may not last for long.

Lifetime giving can also reduce or even eliminate the complexity caused by differing state exemption levels. Since most states don’t have a gift tax, lifetime gifts can help even up the state and federal exemption levels. Cautious clients may choose to include a spouse as a beneficiary to help hedge against an unexpected reversal of fortunes.

Revisiting the Estate Plan

Wealthy clients often have property in many jurisdictions, both foreign and domestic and in numerous US states. Keeping track of the changing tax laws in all of those places may require taking a look at both the assets and the estate plan on a regular basis. As noted above, it’s not just the federal law that is in a state of flux; state laws are changing too. Both can affect whether an estate plan does what a client wants it to do.

Although many wills will not need to be redrawn because of the 2010 Act, it’s far from clear that formula clauses will work as clients’ intended. As an example, clients who defined the amount of property that will pass into a given trust by reference to the exemption available may be unhappy that the gift is 500% larger than it was in 2002. They may be even more disturbed to know that it may cost over $444,000 in state estate taxes to fund that trust.

Given that the federal rules only apply through 2012, and that the state tax systems are changing almost constantly, it’s important to build flexibility into your estate plan. As for the future, most people seem to think the current federal exemptions won’t actually be cut back. After all, exemptions have never really been lowered, but Beerman cautions that expectations have been confounded many times in recent years. “We are out of the predicting business,” she laughs.