THE FUTURE OF ESTATE TAXES
It seems that most of the talk in 2011 and now in 2012 is about what will happen with estate and gift taxes in the future. We are often asked, “What will the estate tax exemption amount be in 2013? The only reasonable answer is: we don’t know.
Under the current law, effective January 1, 2013, the estate tax exemption amount and the gift tax exemption amount will be reduced to $1,000,000, from its current $5,125,000. The only way this will not happen is if Congress changes that law before December 21, 2012, which is unlikely to happen because this is not just an election year, it is a presidential election year.
No one knows what Congress will do this year or next year. If they do change the exemption amounts, it will likely be next year and be retroactive to the beginning of 2013 (as was done in 2010), which means that the trusts and estates of anyone dying in 2013 will be frozen (with no administration being done) until either Congress changes the law or 2013 closes without a change in the law.
Senator Max Bauchus’ Proposal for IRAs
A bill was submitted to Congress by Senator Max Bauchus to eliminate the use of stretch IRAs when a person dies.
In general, a stretch IRA allows a child to avoid paying income taxes on the entire inherited IRA when a parent dies and, instead, to withdraw the money over the child’s lifetime, thereby annuitizing the distributions. This allows the IRA to grow faster than the money is withdrawn from the IRA. In addition, since only a portion must be withdrawn each year, the child can potentially pay income taxes at a lower rate and pay over a longer period of time.
Under Sen. Bauchus’ proposal, all the income tax on an inherited IRA would be due within five years of the parent’s death.
It is estimated this proposal would raise $4.6 billion over ten years for the government because all the income taxes on inherited IRAs would be due within five years of a parent dying.
Because of the public outcry over this proposal, it was withdrawn. Yet, this gives us insight into what kinds of techniques the government is looking at for collecting taxes.
President Obama’s Proposals
While there have been many rumors and even some legislation proposed by various Congress people, we now know what President Obama has proposed for changes in the estate and gift tax laws. His proposals were released as part of his 2013 revenue proposals in February 2012 and are summarized below.
Estate, Gift and Generation-Skipping (GST) Taxes
The proposal says “the [current law] provided a substantial tax cut to the most affluent taxpayers that we cannot afford to continue. We need a permanent estate tax law that provides certainty to taxpayers, is fair, and raises an appropriate amount of revenue.”
President Obama’s proposal is to make both the estate tax exemption and the GST exemption amount $3.5 million, and leave the gift tax exemption amount at $1 million. The maximum tax bracket would be 45%.
Therefore, while a person could leave up to $3.5 million estate tax free to his children at death, he could only gift $1 million gift tax free during his lifetime. This is contrary to the current law in which the estate and the gift tax exemptions are the same.
President Obama proposes to make permanent the portability of unused estate and gift tax exclusion between spouses. Portability means that if a spouse dies and is worth less than the amount he or she can leave estate tax free, the unused portion of his or her exemption amount can be used by the surviving spouse at his or her death, subject to certain restrictions.
In order to take advantage of portability in 2011 and 2012, an estate tax return (Form 706) must be filed with respect to the deceased person.
To take advantage of the possibility that portability will be made permanent, it is important that a Form 706 be filed for everyone who dies in 2011 and 2012.
Consistency in Value for Transfers at Death and Lifetime Gifts
In order to make sure that there is consistent reporting for income tax purposes between the estate of a deceased person and beneficiaries, as well as between a person making a gift and a person receiving a gift, the proposal would require that the executor of a deceased person’s estate and a person making a gift provide “the necessary valuation and basis information to both the recipient and the Internal Revenue Service.
A valuation discount is a way of reducing the value of an item (whether real estate, a partnership interest, or some other item) by transferring only a portion of the item. So a transfer of a 10% interest in a piece of real estate would generally be entitled to a discounted value, sometimes as high as 35%. This reduces the amount of the tax the IRS can collect and allows for a transfer of a larger portion of the asset without paying taxes.
The proposal would try to eliminate the discounting in certain transfers between family members.
Grantor Retained Annuity Trusts (GRAT)
A GRAT is an effective way of transferring assets into a trust for a family member, usually at a discounted value, while allowing you to receive back some of the assets in the trust after a specified period of time. Generally, GRATs are used with time periods of one to four years in order to be most effective.
The President’s proposal states that “taxpayers have become adept at maximizing the benefit of [GRATs].”
For example, if an owner of stock knows that such shares will greatly appreciate upon a company’s IPO, he or she can transfer the stock into a 2-year GRAT. When the stock balloons in value, the grantor must only take back the initial value of the stock transferred to the GRAT with interest at the stated IRS rate. The remaining value (i.e., most of the appreciation of the shares) has been transferred out of the grantor’s estate without any gift tax consequences.
In order to effectively eliminate the use of GRATs, the proposal would require a minimum term of 10 years for a GRAT.
It appears that if taxpayers become too good at using a valid tax planning technique that is specifically allowed by the tax codes, the government feels that tax technique should be taken away.
Maximum Period for Generation-Skipping Tax (“GST”) Exemption
The GST exemption amount allows taxpayers to avoid paying estate taxes and GST taxes on assets passing to descendants through trusts.
When the GST was enacted, 47 states had restrictions on how long a trust could exist. The limitation was based on the common law Rule against Perpetuities (“RAP”).
Many states have now repealed or limited the RAP, thereby allowing trusts to continue in effect in perpetuity. If these trusts are exempt from GST in perpetuity, the government will never collect estate or GST taxes on the assets in the trust.
The proposal provides that the GST protection from future estate and GST taxes would terminate on the 90th anniversary of the creation of a trust. Therefore, a trust protected from estate and GST taxes would no longer be protected on the 90th anniversary and the estate or GST taxes would be collected by the government at that time.
The way the estate and income tax laws differ, it is possible to set up a trust where the assets transferred into the trust are not taxed at the transferor’s death, but the assets are subject to income taxes on the transferor’s income tax returns during his or her lifetime.
The income taxes the transferor pays on the trust’s assets are an extra gift the transferor is making to the beneficiaries of the trust, not subject to gift taxes.
These types of trusts are typically referred to as Intentionally Defective Grantor Trusts (IDGTs) and have become a big part of estate tax planning in the last few years.
Under the proposal, IDGTs would now be included in the estate of the person creating the IDGT.
We have no idea what will happen in the next year with respect to estate, gift and GST taxes.
As can be seen from the above proposals, some of the changes relate to a notion of fairness and raising revenues, while other proposals are made because taxpayers have gotten too good at using the targeted tax techniques.
The only thing that can be said with certainty at this time is that everyone should look at their current estate and decide if they want to take advantage of any planning techniques that may not be available after 2012.
2012 is truly a once in a lifetime opportunity to move assets to children while paying considerably less in transfer taxes than ever before in history.