When President Barack Obama signed the 2010 tax relief act into law in December, he opened the door to significant wealth transfer opportunities. The lifetime tax exemption on gifts-which had been $1 million-jumped to $5 million, making it possible for couples to give away $10 million without incurring any gift tax.
But since these new limits expire at the end of 2012, the clock is ticking for people looking to make use of what may be a temporary tax advantage. Indeed, many savvy taxpayers have already started exploring the possibilities, recognizing that crafting a good gifting strategy may be a complex undertaking, particularly when multiple generations are involved.
Other aspects of the new law make it important for the wealthy to consider how these new provisions work together for maximum benefit. For example, the law reunifies the estate tax and the gift tax, setting the exemption at $5 million for any wealth transfers made before or after death. It also includes a "portability" provision that allows a surviving spouse to make use of any exemption amounts not used by the husband or wife before death. And while portability was not extended to the generation-skipping tax-imposed on any wealth transfers that jump a generation-the GST exemption was boosted to $5 million.
The new law set both the gift tax and the estate tax rate at 35% for any amounts above the $5 million exclusion. This rate is significantly lower than gift and estate tax rates levied by the federal government over the past 30 years. That makes this an attractive time for those wishing to lock in this relatively low tax rate, making additional gifts that exceed current exemption levels.
These provisions are particularly advantageous to families with $10 million to $20 million of net worth. Previously, these families would have turned to complex trusts and partnerships to reduce the taxable value of their assets and thus trim any tax due on significant transfers of wealth. Now these families can, if they wish, avoid the more complicated estate planning vehicles and give their assets away in a much simpler fashion.
The tax law changes have less impact on wealthier families, who will find that the higher limits still allow them to shift only a small fraction of their assets to kids and grandkids. Nonetheless, taxpayers can leverage these higher exemption amounts by taking advantage of a wide range of well-established planning techniques. Indeed, any transfer techniques that made sense last year still make sense; they are now simply easier to use effectively. With gifting limits having increased fivefold, there is greater opportunity for creativity as well as philanthropy. With less tax going to the government, the family has more latitude to redirect those dollars as they see fit. Using a charitable trust to further leverage this new opportunity for income tax savings could be the perfect solution for many philanthropically inclined families.
Good planning is a critical first step in taking advantage of the new law. Clients may need help in defining exactly what they hope to accomplish with their gifts. Sometimes people may agree in principle with the idea of passing significant wealth tax-free to the next generation. Yet when it actually comes time to make such a gift, it may be hard to relinquish control. Because such gift decisions are irrevocable, it is not uncommon for clients to worry about finding themselves short on cash, ending up living a more modest lifestyle, handing assets over to kids who lack adequate preparation or creating an unfair distribution. So they often procrastinate, sometimes going so far as having legal papers drawn up but never actually signing them.
One way to prevent such foot-dragging is to address these concerns through financial planning. Clients need to understand not only what they are giving away, but also what they will retain. Projections of future income that adequately cover a family's lifestyle, for example, are a critical part of assuring people that they won't feel financially strapped if they give away a major part of their wealth.
In some cases, the gifts themselves can be structured in a way to make sure that it is the wealth-not the decision-making power-that gets passed to the next generation. Family limited partnerships, for example, can be structured so that children and grandchildren get non-voting shares, while the parents retain the voting shares. Or trusts can be used to gradually transfer control from the parents to the children and even the grandchildren through the effective use of co-trustees and trust-protectors.
Flexibility is a key consideration. Gifting strategies that create pools within a trust can accommodate transfers of money to both the second and third generations. And because money from these trusts can flow to the grandkids while the children are still alive, it often makes sense to allocate a portion of the $5 million GST exemption to these structures.