The 2010 Tax Relief Act provides wealthy individuals with an extraordinary opportunity to significantly reduce confiscatory gift, estate and generation-skipping transfer taxes and allow wealth of a magnitude unimagined by Congress to pass to family and friends transfer tax-free.
The reunification of gift, estate and generation-skipping tax exemptions at $5 million and a reduction in all three rates to 35% for the next two years should result in an avalanche of wealth cascading to younger generations. This is an unprecedented opportunity to escape transfer taxes and direct the tax savings to loved ones and charities. Higher exemptions and lower rates, combined with relatively low asset values and historically low interest rates, create a unique planning opportunity.
The tax act was signed into law only two weeks before the Bush tax cuts-which culminated in a one-year repeal of the estate tax in 2010-were scheduled to expire on December 31, 2010. Had Congress failed to act, the estate, gift and generation-skipping transfer tax exemptions would have returned to $1 million per person and the tax rate would have returned to 55%. The 2010 Tax Relief Act has a December 31, 2012, sunset provision, leaving it up to advisors to encourage clients to take advantage of its benefits.
One reason to act quickly is that nobody knows if the $5 million exemption will be extended beyond 2012. Under the law, the estate, gift and generation-skipping exemptions will return to $1 million dollars in 2013 unless Congress passes a new tax bill. Given the federal deficit, clients and advisors should treat these exemptions as something to "use or lose."
Clients need to quickly transfer assets before they grow in value through a sale, IPO or appreciation over time. This freezes assets at their current, presumably low, fair market values for transfer tax purposes, and lets grantors gift future appreciation out of the estate. This is particularly important when an older family member wishes to transfer a family enterprise to younger family members at the lowest possible transfer cost. "Freeze" planning is perfect for the client who is interested in preserving and maximizing wealth for the family for generations to come.
The following is a brief explanation of two popular freeze techniques and the specific benefit of implementing them within the next two years.
The Grantor Retained Annuity Trust (GRAT)
A GRAT is a trust into which the grantor gifts property and retains the right to receive an annuity payment for a period of years. The value of the gift is the actuarial value of the remainder interest after all of the annuity payments have been paid to the grantor. In recent years, a popular strategy has been to "zero out" GRATs so that, at the end of the trust's term, the sum of the annuity payments is about equal to the principal plus accumulated interest, at a rate set by the IRS. This results in a gift with zero value at the end of the term.
The transfer benefits come into play when the trust's assets appreciate at a higher rate than the presumed IRS interest rate. At the end of the trust's term, this excess growth can be passed on to beneficiaries free of taxes.
This strategy has become so popular that it was widely presumed it would be severely curtailed in any tax reform legislation last year. That did not happen, however, and clients have at least two more years to take advantage of GRAT asset transfers.
This technique works best when interest rates are low. The lower the interest rate, the easier it is for the transferred asset to outperform the IRS hurdle rate. As of February 2011, a GRAT would only need to earn more than 2.8% annually for the planning to be successful. This rate is near historic lows.