The Time to Gift Is Now: Take Advantage Of the Expiring Estate Tax Law

Just days before Christmas last year, Congress gave wealthy families an early present by increasing the estate and gift tax exclusion amount to $5 million ($10 million per couple).  In just over a year, the exclusion amount returns to $1 million ($2 million per couple with proper planning) and the maximum estate tax rate increases to 55%.  To put this in perspective, while there will be no estate tax on a $10 million estate through December 31, 2012, the estate tax on the same estate on January 1, 2013 will be $4.59 million.  What a difference a day makes!

The future of the estate tax is uncertain.  Few of my colleagues expected that Congress would fail to act in 2009 when the estate tax was set to expire.  Of course, that is exactly what happened; many families (most notably the Steinbrenner’s) benefited tremendously.  The difference is that if Congress fails to act this time, the consequences are hugely negative for even modest estates, particularly for small business owners.  It is always possible that Congress will extend the current law, or enact an exclusion of $3.5 million.  However, expecting that any new law will get passed in an election year is not a bet I would be willing to make.

A possible reduction in the estate tax exclusion to $1 million could be especially harmful to small business owners.  In many cases, a business owner has relatively minimal liquid investments and savings; the primary asset is the business itself.  In the case of a $5 million estate, the estate tax in 2013 would be almost $2.4 million.  Even though the IRS allows this amount to be paid in installments over 15 years, a reduction in cash flow of $160K per year may be difficult for many families to handle.

Fortunately, since the estate and gift tax rules are combined (under a concept called the “unified credit”), individuals can take advantage of the current law to transfer assets out of their estates by gifting assets to their children or trusts for their benefit.  In many cases, individuals are hesitant to transfer assets out of their estate because they do not want to relinquish control over these assets or give their children access to significant amount of money at this time.  These concerns can be easily addressed through proper planning with estate planning vehicles such as “defective grantor trusts” or “family limited partnerships” and should not impede a gifting strategy that will eliminate potentially millions in taxes.

If gifting is not a viable option (e.g., if the size of the estate is too small to comfortably transfer assets that may be needed for future expenses), it is imperative to try to obtain life insurance to provide estate tax liquidity.  It is always possible to let the premiums lapse if the estate tax exemption is increased.  Other tools, such as a testamentary HEET (“health and education exclusion trust”), can also help reduce the ultimate tax liability to the estate when lifetime gifting is not possible.

Once it is decided to proceed with a gifting program, the key is to maximize the efficiency of any gift.  In order to achieve maximum efficiency, assets that (i) will appreciate in value and (ii) are subject to large valuation discounts, should be transferred to maximize the amount of value removed from the taxable estate.  Certain classes of assets are viable candidates for gifting.  Any life insurance owned directly should be transferred to an irrevocable life insurance trust (“ILIT”) since the face amount is often many times the current gift tax value.  Real estate and closely held stock are also very efficient assets since they are subject to significant discounts for lack of control and lack of marketability.   In many cases, the value of these interests can be discounted by 30%-40%.  On the other hand, transferring cash is very inefficient since it is not subject to any discounting and will certainly not appreciate in value.

Even simple planning can pay huge dividends.  Real estate and/or closely held stock with an undiscounted value of $15 million could be subject to a 33% valuation discount for gift tax purposes.  If the assets appreciated 6% per year for ten years (increasing in value to almost $27 million), the estate tax savings ten years later would be over $14 million as compared to a cash gift.  The savings can be increased even more if transfers are made to trusts for grandchildren which would avoid not only the estate tax but also generation skipping transfer tax (“GST Tax”) which effectively doubles the tax due on transfers that “skip” a generation.

It is unlikely that the current $10 million per couple exclusion will be here to stay.  Moreover, a return to the $1 million per person ($2 million per couple with proper planning) exclusion appears very possible.  Just as George Steinbrenner’s family was lucky that 2010 was a year with zero estate tax, we are lucky to have this opportunity now to take advantage of the current tax law.  Unfortunately, failure to plan now could be a multi-million dollar mistake.