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Estate Planning In An Uncertain Environment

A few years ago, I was working with a client, a retired executive, to update his estate plan. Like most retirees, he enjoyed playing golf and spending time with family and friends much more than working through his estate plan.

His aversion was magnified because he just wasn’t comfortable with the important decisions that had to be made. We’d talk on the phone about the next steps; he’d meet with an attorney to draft documents; we’d discuss other options; and the cycle continued.

One Sunday in the middle of summer, I received a call on my cell phone from one of my client’s sons to let me know that his father’s health was deteriorating. It wasn’t clear how much time was left, and his son asked that we move forward with the planning as best we could. Over the next few weeks, we worked to implement documents. Early in September, I spoke with the client from his hospital room, where he was scheduled for surgery, and we made some more decisions. The following weekend, he died.

I believe that if he had the opportunity to do his estate planning again, he would have made those important decisions earlier. And I’m pretty sure that if he knew I was sharing his story, he would say, “Thanks, kiddo.”

In the uncertain world of estate planning, the only sure thing is that no one lives forever. But almost as certain is the likelihood of political change that will affect estate planning. While death may be the ultimate deadline, even young, healthy individuals face a fast-closing window this year as a result of tax-law provisions scheduled to expire on Dec. 31.

The three main transfer taxes - gift tax, estate tax and generation-skipping transfer tax - have been subject to dramatic legislative shifts over the last several years. After the November election, we’ll have a better idea of what might happen, but by then, it may be too late to use some of the powerful planning strategies available now. The volatility that makes planning difficult also presents opportunities. As financial planners, we want to ensure that you take advantage of all the tax benefits you can.

That said, there is no perfect estate plan. It’s a fluid process with many moving parts. The essential thing is to have a good plan and the ability to alter it when new circumstances arise.

Many clients like to go slow as they create gifting strategies and implement them. However, we don’t always have the luxury of time; too often, deliberation becomes procrastination.

On Dec. 17, 2010, President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (also called the 2010 Tax Relief Act). This law covered income and estate tax provisions for about two years. Some were for only one year, or were more beneficial in one year than in another. The act provided some certainty for tax planning in 2011 and 2012, particularly regarding individual income tax rates, capital gains and dividend tax rates, and the estate tax.

Of course, “certainty” must be used loosely, since the law merely deferred a decision on the ultimate fate of the Economic Growth and Tax Relief Reconciliation Act (EGTRA) - most commonly referred to in the media as the Bush-era tax cuts.

The 2010 legislation kept the top income tax rate from reverting to 39.6 percent on Jan. 1, 2011, as it would have otherwise done. It also extended all individual rates at 10, 25, 28, 33 and 35 percent. And the law extended current income tax rates for trusts and estates. President Obama said he intended to make the sunset of the two highest income tax rates an issue in the 2012 presidential campaign, so we can expect to hear more about those in the months ahead.

Further, qualified capital gains and dividends continue to be taxed at a maximum rate of 15 percent. Without action, that rate would have risen to 20 percent for capital gains and 39.6 percent for qualified dividends in 2011. The law extended other tax provisions: the repeal of the itemized deduction limitation for high-income taxpayers; the repeal of the personal exemption phase-out; and marriage penalty relief. Various business incentives were also allowed to stand, including bonus depreciation and Section 179 expensing, both of which allow enterprises to more quickly deduct the cost of equipment they acquire.

On Jan. 1, 2010, the federal estate tax was repealed. I can assure you that few tax professionals believed this complete repeal would happen. The 2010 Tax Relief Act reinstated the estate tax for decedents dying in 2010, though with a higher applicable exclusion and a lower tax rate than scheduled. There was also the option for the estates of 2010 decedents to pay no tax and be subject to the carryover basis rules, or use the revived estate tax for 2010 created under the new tax act.

The act also created portability, allowing a surviving spouse to take advantage of the unused portion of the estate tax applicable exclusion, at least until the provision expires on January 1, 2013. The maximum tax rate of 35 percent, with an applicable exclusion of $5 million, remains in place until December 31, 2012.

The federal gift tax was reunified with the estate tax, with the same top rate of 35 percent and also with a $5 million exclusion. The generation-skipping transfer tax is also set at this same exclusion and top rate.

After this article appears, you will have about eight months to take advantage of the current gift tax and generation-skipping transfer tax provisions. In 2012, $5.12 million can be transferred tax-free, less any amount previously transferred to your heirs. I strongly suggest that you make the gifts if you have the funds. The earlier you start working with a tax professional, the more time you will have to use creative strategies to maximize your wealth transfer.

The easiest way to transfer assets is to write a check or transfer money from one investment account to another. You can transfer these assets directly to an individual, or transfer them to a trust or LLC. Other options to consider include leveraged gifts, grantor retained annuity trusts (often called GRATs), and intentionally defective grantor trusts (often called IDGTs).

A leveraged gift is, in simplest terms, any gift where more value may be transferred than must be accounted for under tax law. Giving a minority interest in a family business or an interest in a limited partnership generally comes with discounts as a result of lack of marketability and lack of control. If, for example, you own a timber farm but plan to eventually transfer the farm and its management to your children, you can maximize the amount you can transfer free of gift and estate tax by making a leveraged gift. The strategy would work like this: First, transfer the timber farm to an LLC, and subsequently transfer interests in that LLC to your heirs. The transferred interests would be discounted because of their lack of marketability and lack of control. Let’s assume the timber farm is worth $10 million and the discounts for these market deficiencies are 20 percent each. If you transfer a 25 percent interest to each of your three children, you will remove $7.5 million from your estate at a taxable value of about $4.8 million.

Other leveraged gifts might include gifts of life insurance or remainder interests.

A grantor retained annuity trust is a specific option for a leveraged gift. In such a trust, you (as the grantor) receive a yearly payment from the trust; the minimum amount of this payment is determined by using a figure the Internal Revenue Service calls the 7520 rate. Assuming that the grantor sets the annuity to equal the 7520 rate exactly, all the assets in the trust will theoretically go back to the grantor over the life of the trust, effectively making the value of the gift to the trust’s beneficiaries equal zero or close to zero. If the trust’s return is better than the 7520 rate, which is quite likely, especially as the rate is currently so low, the beneficiaries receive their gifts more or less gift tax-free.

Another way to maximize the effectiveness of gifted assets is to use an intentionally defective grantor trust. The “defect” is that the trust is intentionally constructed so that the grantor continues to pay income tax on assets transferred to the trust. This scenario ensures that the trust doesn’t have to cover those taxes, leaving more for the beneficiaries one day and, consequently, faster asset growth.

The appreciation on all assets given as gifts will also remain outside of the transferor’s estate, reducing the estate’s value for federal and state estate taxes.

Now is an attractive time to make gifts because of a combination of factors: an increased exemption; a low interest rate environment; and the abundance of assets that remain undervalued since the financial market collapse of 2008. In fact, it is possible that there may never be a more opportune time for complex estate and gift planning than 2012.

Besides the economic and tax environments, other things to consider when deciding on a gifting strategy include family values, charitable intent, total net worth and asset liquidity. At Palisades Hudson, as in everything we do, we do not consider a gifting strategy in isolation, but rather in tandem with a client’s income tax considerations, investment management situation and family dynamics.

Estate planners, no matter how well informed, can only speculate about possible tax considerations in the future. Perhaps we should adopt a tenet from the investment arena - past performance is not a guarantee of future results - and apply it to estate taxes. Congress has extended tax breaks in the past, but that’s no guarantee it will continue to do so. Thus, individuals and their estate planners must plan in the present and remain flexible for the future.

Senior Client Service Manager Rebecca Pavese, based out of Atlanta, contributed several chapters to our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 2, “Relationships With Adult Children”; Chapter 3, “Planning For Incapacity”; and Chapter 7, “Grandchildren.” She was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.
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