Prepared by Lindsay A. Martin and R. Bradley Fletcher

This year the gift, estate tax, and generation skipping tax rate is 35%, with each person having an exemption from these transfer taxes of $5.12 million for transfers during life or at death. By way of this exemption an individual can give away $5.12 million transfer tax-free.  Barring Congressional action, these rates increase to 55% and the exemption amounts decrease to $1.0 million beginning January 1, 2013.  What will happen to transfer tax rates and exemptions is anybody's guess. What many clients don't realize, however, is that in addition to the uncertainty about transfer taxes themselves, legislative proposals exist to eliminate some highly useful and fairly common estate planning techniques.  Some planning approaches that might be taken off the table are:

Sale To Grantor Trust: For owners of closely held businesses or other income-producing assets, a very effective estate planning approach is the sale of those assets to a "grantor trust." 

A common way this technique works is for a client to make a cash gift to an irrevocable grantor trust created by the client (the gift is usually 10% of the value of the asset to be sold to the trust). Then the trust buys from the client, at arm's length, his interests in the business, or the other assets the client does not desire to retain in his estate. Under current rules, such a sale does not trigger capital gains, and puts in trust for children and grandchildren assets that could appreciate in value. This kind of sale results in a removal of the asset from the client's estate in exchange for a promissory note from the trust. The result is an "estate freeze."

A client establishing this kind of trust will have to pay all the income taxes that will be owed by the trust.  This is the trade-off for not having to pay capital gains on the sale to the trust. You can look at the income tax payments as an added gift to the trust for kids and grandkids. Any future appreciation is out of the client's estate and can be shielded in trust from the tax on transfers to grandkids. Some practitioners call this a "sale to an intentionally defective grantor trust," or a "sale to a grantor trust."  In the alternative, the sale could be made to a non-grantor trust resulting in the client having to pay capital gains on the sale rather than paying the trust's income taxes, but the appreciation is still out of the client's estate.

This kind of planning is very powerful, but it's in danger. Recent proposals would re-characterize the sale transaction as a gift subject to gift taxes.

Taxable Dynasty Trusts?  Many states like  Delaware, Nevada, Alaska, and Colorado, have effectively repealed the "Rule Against Perpetuities" allowing clients to set up trusts for their families that can last for a 1,000 years --or forever. Under current law, clients can earmark up to $5.12 million as exempt from the "generation skipping transfer tax" by allocating his or her exemption to a gift to a trust during life or at death. Under current law, no matter how much that $5.12 million appreciates in the future, it's immune from the generation skipping transfer tax, which is currently imposed at 35% rate.

A proposal to change federal law would limit the number of years such a gift to trust would be exempt from this tax to just 90 years. So while a "dynasty trust" might still last forever, under the proposal distributions to grandkids and future generations would be subject to taxation after 90 years.

No more short-term GRATs? Grantor Retained Annuity Trusts are an estate planning technique specifically blessed by Treasury Regulations issued by the IRS. The idea is that a client gifts to a trust for his kids an asset anticipated to grow in value, while the client retains an annual payment of a fixed amount for a term of years, usually a short-term such as 1 to 3 years.

If the asset appreciates more than the actuarial value of the annual payment, the balance passes free of gift tax. For clients who are anticipating a spike in value on an asset, such as an initial public offering, this technique provides a lot of leverage.

New proposals limit this technique because they require that a GRAT must last at least 10 years making the GRAT technique less attractive.

Valuation Discounts...Discounted. One common estate planning approach involves the transfer of assets into a business entity such as a limited partnership or LLC.  Gifts of interests of the entity are then made to family members.  In valuing these transfers for transfer tax purposes, discounts in value are applied for lack of control over the business, or lack of marketability.  These kinds of discounts are a cornerstone of many estate plans because they serve to reduce the value of gifts to future generations of assets that are effectively controlled by parents or grandparents by virtue of controlling the limited partnership or LLC.  

Some recent tax proposals do away with these discounts, meaning that the use of business entities to suppress values may be eliminated. Thus, limited partnerships or LLCs may no longer help to reduce the transfer tax if the proposal goes through. 

Examining Your Current Plan. In light of these proposals, we recommend that you consider examining your current estate plan - even if your plan has recently been redone. Our estate planning professionals can explain in more detail how recent changes and proposals might shape your plan and your decisions for yourself and your family. 

If you have any questions regarding this newsletter, please contact the authors at lindsay.martin@strasburger.com and brad.fletcher@strasburger.com.  To learn more about Strasburger's Tax Group, click here.