2012 Tax Reduction Gifting – Remaining Opportunities
From the Trust and Estates department of Karr Tuttle Campbell.
|Kirsten L. Ambach||Alan D. Judy||Charles A. Robinson|
|Johanna M. Coolbaugh||Douglas A. Luetjen||James K. Treadwell|
|William J. Cruzen||John E. Poffenbarger||George S. Treadwell|
|Kenneth E. Rekow|
In our January 2011 Alert, we advised our readers of the then recently enacted 2010 Tax Relief Act, its dramatic increases to applicable federal estate, gift, and generation-skipping transfer tax exemptions, and its equally dramatic reductions to the taxes’ maximum rates. As we indicated in that Alert, these modifications were designed to expire on December 31 of this year, unless extended by Congress. To date Congress has taken no such action. Clients who are interested in tax reduction planning and who have not yet taken advantage of the opportunities resulting from these modifications may be wise to do so now.
Transfer Taxation in a Nutshell
Most of our readers are familiar with federal and state transfer taxation. For those who are not, a brief summary follows.
- Federal Estate Tax. Citizens and/or residents of the United States are subject to a federal estate tax on all of their assets worldwide. Prior to the tax cuts that were enacted in 2001 and that were extended though the end of this year via the 2010 Tax Relief Act, the maximum rate had been 55% with an exemption that capped at $1,000,000. The 2010 Act increased the exemption to what is now $5,120,000 and reduced the maximum rate to 35%.
- Federal Gift Tax. As a complement to the federal estate tax, a federal gift tax has long existed. It is complementary in that it imposes a tax on lifetime transfers that otherwise would have been subject to estate taxation at one’s death. Historically, the maximum rate has been 55% with an exemption of $1,000,000, even for those years in which the federal estate tax exemption was at a higher level. The 2010 Act reduced the maximum rate to 35% and, for the very first time, created parity between the federal estate and gift tax exemptions, thus bringing into play what is now a $5,120,000 gift tax exemption.
- Federal Generation Skipping Transfer Tax. In addition to being subject to the federal estate and gift tax regime, assets that skip a generation and assets that reside in trust for more than one junior generation are subject to a federal generation skipping transfer tax. Historically, this has been a flat 55% tax subject to a $1,000,000 exemption adjustable for inflation. As is the case with federal estate and gift taxes, the 2010 Act increased this exemption to what is now $5,120,000 and reduced the flat rate to 35%.
- State of Washington Estate Tax. Washington State is one of a relatively small number of states with a state estate tax that is something more than a simple revenue sharing arrangement with the federal government. The maximum Washington estate tax rate is 19% with a general exemption of $2,000,000. This tax is presently deductable on an estate’s federal estate tax return – mindful that this is a deduction as opposed to a dollar-for-dollar credit. Importantly, Washington State does not have a gift tax.
- Other State Estate Taxes. Residents of states other than Washington State or Washington State residents owning real estate in other states may be subject to state estate taxation outside the state of Washington.
The Fate of the 2010 Tax Relief Act
It bears repeating that the provisions of the 2010 Tax Relief Act expire on December 31 of this year at which time the federal transfer tax law will revert to what it would have been prior to the tax cuts that were enacted in 2001. What will happen between now and
December 31, 2012 is an open question. The Obama administration is currently proposing a $3,500,000 exemption moving forward. Still, in the Democratic caucuses of both chambers of Congress there is significant opposition to anything other than a restoration of the pre-2001 exemption amounts and tax rates. There is a real chance that as a result of congressional deadlock, the exemptions and maximum rates will revert back to their historic levels and will attain a measure of staying power in doing so.
Planning Considerations and Opportunities
Taking advantage of what may prove to be a temporary exemption bubble is not relevant to all taxpayers. For high net worth taxpayers it is certainly a matter worthy of consideration. Even for taxpayers of moderate wealth, the use of a portion of this increase could prove beneficial without undermining their financial base. At the same time, the existence of this bubble highlights the benefits of structured asset transfers that are worthy of consideration in all circumstances. Set forth below is a nonexclusive list of opportunities that may be of relevance to the reader.
- Outright Gift or Gift in Trust. There are two components to the transfer tax savings that can result from a gift of property, whether made directly to a recipient or in trust for the benefit of the recipient. First, because Washington State has no gift tax, the transferred assets are removed from the state transfer tax base both at the time the gift is made and subsequently at the taxpayer’s death. The transferred assets are likewise removed from the federal transfer tax base to the extent of the $13,000 per recipient annual exclusion. Second, though a lifetime gift beyond the annual exclusion does not remove the gift amount from the federal transfer tax base, all post-gift appreciation is removed.
- Formation of a Life Insurance Trust. A feature of the federal tax system that can mitigate the overall benefit of making a gift is that the recipient may eventually have to pay a capital gains tax on the disposition of the transferred property, a tax that would not otherwise have been payable had the property been inherited. An important exception has to do with life insurance, the amount paid out at the insured’s death being insulated from capital gains and income tax as a general rule. On account of this and other beneficial features of life insurance, it is not at all uncommon for trust funds to be used to purchase life insurance policies.
- Sale to a Grantor Trust. In this kind of arrangement, property is transferred to a trust in exchange for the trust’s obligation to make specified payments to the taxpayer over a defined period of time. The trust’s obligation is documented either by a promissory note or by way of an annuity contract. The arrangement is designed to make use of statutory interest rates that are far below what the anticipated income and growth of the transferred assets are assumed to be. The trust is designed to qualify as a “grantor trust” for income tax purposes, in consequence of which no taxable income is realized on either the transfer of the assets to the trust or the payments made on the trust’s obligation to the taxpayer. The buildup in the trust resulting from the excess of the assets’ total return over the low interest rate associated with the payment obligation passes estate tax free.
- Formation of a Qualified Personal Residence Trust. This kind of trust involves a transfer of one’s residence under an arrangement whereby the taxpayer retains the right to live in the residence rent-free for a prescribed period such as 10 years. Provided the taxpayer outlives the rent-free term, this arrangement can result in a significant discount of the estate tax value of the residence – often a discount well in excess of 50%. At the end of the rent-free term the taxpayer’s heirs would be the beneficiaries of the trust and rent payments would commence – payments that would constitute transfer tax free transfers of funds for their benefit. As the trust would be designed to qualify as a “grantor trust” for income tax purposes, these rent payments would likewise constitute income tax free transfers of funds for the benefit of the taxpayer’s heirs.
- Formation of a Charitable Trust. Two forms of charitable trusts have evolved which preserve wealth for the taxpayer’s family, reduce taxes, and endow charities. They are the charitable lead trust and the charitable remainder trust. The charitable lead trust creates a flow of income for a charity for a prescribed number of years then passes the subject property over to the taxpayer’s heirs either directly or in further trust at reduced estate tax rates—in some instances, estate tax free. The charitable remainder trust preserves a flow of income for the taxpayer or the taxpayer’s family for a prescribed number of years and then passes the subject property over to charity. The charitable remainder trust is particularly attractive where appreciated property is concerned, given the fact that the trust does not have to pay a capital gains tax on a sale of the property.
- Formation of a Family Holding Company. The family holding company is a vehicle that can be put into place to hold family capital in a fashion that fosters common stewardship by senior and junior generations, that facilitates orderly management succession, and that brings into play a significant measure of asset protection. A handsome byproduct of such an arrangement can be the realization of significant valuation discounts for transfer tax purposes. This entity can be and often is the centerpiece of a global arrangement wherein ownership interests in the family holding company are the subject of transfers to various of the above entities.
Making Use of the Exemption Bubble
The employment of the above techniques invariably involves the recognition of one or more gifts. Given the absence of a Washington State gift tax, there is virtually no ceiling on the amount of transactional gifts insofar as concerns Washington State transfer taxation. On the other hand, aggregate taxable gifts in excess of the federal exemption will result in the imposition of an immediate federal gift tax – a tax that, in the absence of the two-year bubble, is imposed on the aggregate of lifetime taxable gifts over $1,000,000 with a top marginal rate of 55%. Again, between now and December 31 of this year the exemption amount is $5,120,000 and the top tax rate is $35%.
We would be happy to work with our clients and the other members of their financial and estate planning teams in assessing their situations and giving consideration to the array of significant tax reduction opportunities that have been enhanced, if temporarily, by the 2012 Tax Relief Act. To arrange a consultation, please contact any of the Karr Tuttle Campbell Trusts and Estates attorneys or your personal Karr Tuttle Campbell attorney, all of whom may be reached at (206) 223-1313 or by visiting the firm’s website at www.karrtuttle.com.
IRS Circular 230 Disclaimer: To ensure compliance with requirements imposed by the IRS, we inform you that to the extent this communication contains advice relating to a federal tax issue, it is not intended or written to be used, and it may not be used for (i) the purpose of avoiding any penalties that may be imposed on you or any other person or entity under the Internal Revenue Code or (ii) promoting or marketing to another party any transaction or matter addressed herein.
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KARR TUTTLE CAMPBELL