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PRESIDENT OBAMA’S BUDGET PROPOSAL
As we discussed in our January Newsletter, the current estate tax laws are more favorable to high net worth individuals than at any time since estate taxes were established. In addition to high exemption amounts, there are tax planning tools which allow significant transfers of wealth to escape gift and estate taxation.
President Obama released his proposed budget for 2014 (the “Proposal”), which takes aim at both the high exemption amounts and many of the common tax planning tools. This Newsletter will outline the proposed changes, which, if passed, would generally take effect on January 1, 2018. It should be noted that the Proposal states these changes are necessary to raise taxes.
Proposed Exemption Amounts
In the Proposal, the exemption amounts would revert back to 2009 levels, which provide for a $1 million lifetime gift tax exemption and a $3.5 million exemption from estate and generation-skipping taxes. The top tax rate on transfers above this amount would be 45%. There will be no indexing for inflation (as is the case under current law), but portability will remain. The chart below highlights the key differences between the current law and the Proposal.
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2012 Law |
Current Law |
President Obama’s Proposal |
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Estate Tax Exemption |
$5,120,000 |
$5,250,000 |
$3,500,000 |
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Gift
Tax Exemption |
$5,120,000 |
$5,250,000 |
$1,000,000 |
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Generation Skipping Tax
Exemption |
$5,120,000 |
$5,250,000 |
$3,500,000 |
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Estate Tax Rate |
35% |
40% |
45% |
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Portability |
Yes |
Yes |
Yes |
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Indexed for Inflation |
No |
Yes |
No |
Grantor Retained Annuity Trusts (GRATs)
President Obama has proposed changes that would effectively eliminate GRATs.
A GRAT is a trust which allows the grantor to transfer an asset into the trust and receive a fixed annuity over a term of years specified in the GRAT. The annuity is approximately equal to the value of the assets transferred into the GRAT, plus an interest rate based on published IRS rates, which are currently very low.
At the end of the term, the annuity has been entirely paid back to the grantor and any appreciation of the assets in excess of what is paid back is transferred out of the grantor’s estate to the beneficiaries.
To highlight how effective this strategy can be, we need to look no further than Facebook’s founder, Mark Zuckerberg. In 2008, Facebook was still a private company, with Mark Zuckerberg owning a large portion of the shares. He placed some of these shares into a GRAT prior to the initial public offering (IPO), at which time they were worth approximately $3 million, based on a Forbes’ magazine estimate.
After the IPO, the shares in the GRAT were worth approximately $40 million. Mark Zuckerberg received his $3 million plus interest back at the end of the term, and over $30 million (not including future appreciation) was transferred out of his taxable estate without paying any gift tax.
The main risk when using a GRAT is not outliving the term. If this occurs, all of the assets, including appreciation, go back into the grantor’s estate and are subject to estate tax. Under current law, there are no restrictions on the how short the term of the GRAT can be.
President Obama has proposed a minimum 10-year term for GRATs. This has two consequences: (1) older individuals will find the strategy too risky, since the planning fails if they do not outlive the term, and (2) the annuity over 10 years becomes so large that it is much harder to rely on appreciation outpacing the annuity payments and providing any estate tax benefit.
Individuals owning an asset they expect to increase significantly in value should consider tax planning using GRATs before the opportunity is gone.
Intentionally Defective Grantor Trusts (IDGTs)
Another tax planning technique that President Obama’s proposal would eliminate is the IDGT.
Generally, if you retain income from an asset you give away, the asset will still be subject to estate taxes at your death. By setting up an IDGT and selling an asset to that IDGT, the grantor can effectively transfer assets out of his or her estate for estate tax purposes while retaining the income.
Here is how the technique works. The grantor sets up the IDGT and then sells an asset such as real estate to the IDGT in return for a promissory note. The IDGT receives the income generated by the property and uses that income to make payments to the grantor under the promissory note.
Under current law, the transfer is respected for estate tax purposes even though the grantor is treated as continuing to own the asset for income tax purposes. This has two important consequences: (1) There is no capital gain to pay on the sale since the transaction is ignored for income tax purposes, and (2) the grantor can continue to pay the income taxes on the income generated by the property even though the income is paid into the IDGT. This is essentially a tax-free gift to the IDGT each year of the income taxes paid.
The Proposal would eliminate this type of planning in its entirety. In the Proposal, any asset which is treated as owned by the grantor for income tax purposes will automatically be included in his or her estate at death. This means that a sale to an IDGT would not accomplish the primary purpose of moving the asset out of the grantor’s taxable estate.
Conclusion
While the current exemption amounts exclude a vast majority of the population from any estate tax liability, the Proposal is a good indication that these exemptions are not guaranteed. A good estate plan should include flexibility, allowing it to adapt to changing estate tax laws and ensure that your wishes are carried out.
The Proposal also demonstrates how the current administration feels about some of the most commonly-used tax planning techniques, including GRATs and sales to IDGTs. Anyone looking to transfer assets using these techniques should consider acting before any of the proposed changes become law.
Even with the current availability of certain tax planning techniques, as interest rates rise, these strategies will become less appealing. The combination of available planning tools and record low interest rates continues to make this a unique time to do estate tax planning. With this is mind, if any of the strategies discussed above would benefit you or your family, it is important to explore them now.
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