04.23.2012 Wealth Transfer Planning in 2012: Perfect Storm of Opportunity


2012 may present the single greatest opportunity for wealth transfer planning in recent memory.  A $5.12 million gift tax exemption, combined with low interest rates and historically low valuations for many asset classes, creates an ideal environment for wealth transfer planning.  The window of opportunity, however, may close at the end of 2012.  The $5.12 million gift tax exemption is scheduled to expire at the end of the year and will drop to $1 million in 2013.  The following discussion reviews the changing tax and legal landscape and highlights the planning opportunities for this year.


Tax Relief Act of 2010


On December 17, 2010, President Obama signed the Tax Relief, Unemployment Insurance Authorization, and Job Creation Act of 2010 (the “Tax Relief Act”).  The Tax Relief Act reinstated the Federal estate tax and the Federal generation-skipping transfer (GST) tax, which had been temporarily repealed in 2010, with a $5 million exemption and a 35% tax rate.  Significantly, the Tax Relief Act also reunified the gift tax exemption with the estate tax exemption at $5 million.


In 2012, the $5 million exemption amounts are indexed for inflation at $5.12 million with the same 35% tax rate.  The provisions of the Tax Relief Act, however, are only effective through December 31, 2012.  In 2013, the exemption amounts for each of the Federal estate, gift, and GST taxes will be only $1 million and the top tax rate will be a staggering 55%.  The immediate past, present, and future of the wealth transfer tax exemptions and rates (for 2010 to 2013) are summarized below: 



1 GST Exemption Indexed for Inflation; 5% Surtax for Estates $10-17 Million.


Obama Administration Proposal


In its 2013 Budget proposal, the Obama Administration called for a return to the 2009 tax rates with a $3.5 million estate and GST tax exemption, a $1 million gift tax exemption, and a 45% maximum tax rate.  Given the backdrop of the Presidential election and Congressional elections, we think that it is unlikely that Congress will act on any tax law changes before the race for the White House and control of Congress is decided.


In addition, the White House’s budget proposal for 2013 includes several provisions that would greatly limit the efficacy of many of the planning opportunities discussed in this alert. Specifically, the White House proposal would negate the planning opportunities offered by grantor retained annuity trusts (GRATs), dynasty trusts, grantor trusts, life insurance trusts, and valuation discount planning.


2012 Window of Opportunity – Large Exemption, Low Rates, Low Valuations


For a number of reasons, we believe that 2012 is a perfect storm of opportunity for wealth transfer tax planning.  First, as discussed below, the large gift tax exemption creates a number of significant avenues for meaningful planning.  Second, many planning techniques are driven by interest rates, which currently are at an all-time low.  Third, many asset classes, especially real estate, are valued well below historical norms.  Finally, the expiring tax provisions create urgency to act in 2012. The discussion that follows is a review of the planning opportunities that many clients should consider in 2012.


Make Lifetime Gifts to Use the $5.12 Million Exemption in 2012


With the increase in the gift tax exemption from $1 million to $5.12 million per person, clients now have the ability to reduce their estate simply by making direct gifts to children, descendants, or other beneficiaries (or to trusts for children, descendants or other beneficiaries). In fact, a married couple can gift $10.24 million without paying gift tax.  For those clients who have consumed their $1 million gift exemption prior to 2011, an additional $4.12 million ($8.24 million for a married couple) remains available to them in 2012.


A client who makes lifetime gifts not only reduces his or her estate by the amount gifted, but also by all of the appreciation on that gift over time.  For example, if a client makes a $5 million gift this year and dies twenty years from now, the value of that gift, including all appreciation, will be over $13 million, assuming 5% annual growth.  Lifetime gifts do not need to be made in cash or marketable securities. Clients can gift illiquid assets, such as interests in closely held businesses, corporations, partnerships, or limited liability companies (LLCs), or real estate.  In addition, in the event that you made loans to family members, you may wish to consider using your new gift tax exemption to forgive those notes.


Make Gifts in Trust


Outright gifts to family members are quite simple, but forgo many of the advantages afforded by a gift in trust.  Gifts to trusts for the benefit of your descendants allow you to allocate your GST tax exemption to that trust.  Allocating your GST tax exemption to the trust enables the funds in the trust, plus all future growth, to pass to your descendants without the imposition of any estate or GST tax at each beneficiary's death.


Gifts in trust also provide an additional opportunity for the trust’s income to be taxed to you instead of to the trust or the trust beneficiaries.  This lets you, in essence, make additional tax-free gifts to the trust that are equal to the amount of the tax that the trust otherwise would pay.  This type of trust is known as a grantor trust. 


Furthermore, gifts in trust are protected from claims by the beneficiary's creditors, including spouses, and ensure that the assets do not pass outside the family bloodline.  These benefits apply at every generation for the longest period allowed under law.


Lifetime Family Trusts


Let’s face it, many clients do not want to give away their assets.  They are concerned that they may want or need the assets in the future.  At the same time, they do not want to waste the opportunity and tax savings afforded by the $5.12 million gift tax exemption in 2012.  So, what can be done?


Here is one solution that several clients already implemented in 2011.  A married client can create a trust for the benefit of his or her spouse.  The assets transferred to that trust, along with any growth, pass free of estate and gift tax.  If assets from the trust were needed, the trust could simply make a distribution to the spouse. Your children and descendants can also be included as beneficiaries, and the trust could also make gift tax free distributions to them.  It is possible, with careful planning, for each spouse to create a trust for the benefit of the other spouse, thereby doubling the tax benefit.  Care must be taken to avoid application of the “reciprocal trust doctrine”—a judicial doctrine used by the IRS to negate the tax benefits of such an arrangement—but this can be done with proper planning.  This type of trust can also be used to guard against the possibility that the gift tax exemption will be lowered in future years.


Self-Settled Spendthrift Trust


Another type of trust, a self-settled spendthrift trust, can offer the best of all worlds. It will allow a client to transfer assets in trust, remove the assets from his or her estate for wealth transfer tax purposes, but retain access to the assets in the trust through a discretionary beneficial interest. This type of trust is not currently authorized under Virginia law, but a recently approved statute that permits this type of planning will become available on July 1, 2012. This is a very exciting development that creates enormous planning opportunities. We will review the benefits of this form of trust planning in greater detail in an upcoming Alert.


Life Insurance Trusts


Often, clients acquire life insurance policies through an “irrevocable life insurance trust.”  The benefit of such a trust is that the proceeds of insurance can be excluded from the client’s estate for estate tax purposes.  One of the burdens associated with the ongoing funding and administration of an ILIT is the need to contribute premiums in a manner that qualifies for the gift tax annual exclusion. This is often accomplished through the use of so-called “Crummey” withdrawal powers that are intended to qualify gifts to the trust for the gift tax annual exclusion.


In 2012, many clients are making large gifts to their ILITs for the purpose of pre-funding multiple years’ worth of insurance premiums.  A large gift will consume a portion of the client’s $5.12 million exemption, but it will (i) preserve the exemption in 2012, while using the dollars in future years to pay insurance premiums, and (ii) avoid the need to prepare “Crummey” withdrawal notices when trust funds are used in future years to pay premiums. 


Example:  Charles gifts $26,000 per year into an ILIT for the benefit of his children Alexander and Olivia.  Each year, the Trustee sends a notice to Alexander and Olivia notifying them of their right to withdraw $13,000 each.  In 2012, Charles decides to gift $260,000 to his ILIT.  The first $26,000 of this gift will qualify for the gift tax annual exclusion but the next $234,000 will consume a portion of Charles’s $5.12 million gift tax exemption. For the next 10 years, the Trustee of Charles’s ILIT will use the cash held in the ILIT to fund the premium payments with no need to prepare additional notices.


In addition, many clients who financed insurance premiums through intra-family loans or “split-dollar” insurance arrangements are simply forgiving these loans and treating them as an additional gift to the trust.  The forgiveness will be treated as a gift and will consume a portion of the gifting party’s $5.12 million exemption.


Dynasty Trusts


Many clients who choose to take advantage of 2012’s window of opportunity are electing to structure their trusts as “Dynasty Trusts.”  A Dynasty Trust is a trust that waives the application of the “Rule Against Perpetuities.”  The Rule Against Perpetuities is a common law rule that limited the duration of trusts to “lives in being plus 21 years”—generally 90 to 120 years.  Virginia is one state where the Rule Against Perpetuities can be waived and, as a result, the trust can continue indefinitely.  The benefit of such a trust is that the assets in the trust can pass from generation to generation without successive applications of the estate tax.


Example:  In 2012, Andrew and Betty gift $10 million ($5 million each) to a trust and allocate their combined $10 million of GST exemption to the trust.  Assuming the assets grow at an annual rate of 5%, the following chart illustrates the results (and the corrosive effect of estate taxes) over the next four generations or 120 years if (i) the assets are subjected to a 45% estate tax every 30 years or (ii) they are held in a Dynasty Trust that passes free of estate tax. The numbers (and differences) are staggering, but they illustrate the point. Taxes make a difference!



The White House budget proposal would limit the benefit of this planning by creating a Federally prescribed 90 year term for the duration of the trust without a subsequent reallocation of GST exemption.


Take Advantage of Historically Low Interest Rates


Right now, interest rates are at historic lows.  This is great news for estate planners, as many tax planning techniques are driven by and benefit from low interest rates. Here are a few planning ideas.


Make or Refinance Intra-Family Loans


Many clients have made loans to family members to assist them in financing or acquiring assets, such as real estate or an interest in a closely held business.  Many of these loans were financed at the “applicable federal rate” or “AFR,” which is the lowest IRS permitted interest rate between related parties, such as family members, without creating adverse income and gift tax consequences.  Currently, the AFR is at an all-time low, so we are encouraging clients to make loans to their children or other family members at these low rates and to refinance existing loans to take advantage of the lower rates.


The following chart illustrates the significant drop in interest rates.  



Annual Rates for December of Each Applicable Year Listed Except 2012; April 2012 Rates Used;  Short-Term Rate Used for Loans of Less 3 Years; Mid-Term Rate Used for Loans Between 3 and 9 Years; Long-Term Rate Used for Loans Greater Than 9 Years.


Sell Assets to a Trust


Many clients, especially owners of closely held businesses and real estate investment partnerships or LLCs, are selling interests in their businesses to trusts for the benefit of their family members in exchange for promissory notes.  These trusts are often designed as grantor trusts, as discussed above, to avoid any income tax or capital gain recognition on the sale of the interest to the trust.  In exchange for the business interest, the client will receive a promissory note at the AFR.  This effectively “freezes” the value of the business and allows all future appreciation to escape estate tax for the benefit of future generations.




A “GRAT” is an acronym for a Grantor Retained Annuity Trust.  GRATs provide clients with the opportunity to transfer substantially appreciating assets to their children and other family members with little or no gift tax cost.  A GRAT is typically structured as a two- or three-year trust in which the client retains a series of annuity payments equal to the initial contribution, plus an assumed rate of return that is determined by the IRS each month.  To the extent that the asset outperforms the IRS assumed rate of return, the excess value is transferred to the client’s children gift tax free.  In April 2012, the IRS hurdle rate is 1.4%.  So, to the extent that a client can fund a trust with an asset that produces an annual rate of return in excess of 1.4%, the excess value is transferred to the client’s children gift tax free.


Example:  Assume that George creates a two-year GRAT in April 2012 and funds it with $1 million.  The IRS assumed rate of return for April 2012 is 1.4%; however, the actual investment return is 20%.  At the end of Year 1, George will receive an annuity payment of $510,517.  This payment will first be satisfied by any income earned during the year, and, to the extent insufficient, the Trustee will distribute assets, in kind, to make up the difference.  At the end of Year 2, George will receive an annuity payment of $510,517.  At that point, the remaining assets, calculated to be $316,863, will pass to George’s children (or a trust for the benefit of George’s children) gift tax free.



As mentioned above, the White House budget proposal would require a 10-year minimum term for GRATs and a required remainder interest.  These changes would inject a significantly higher level of tax, investment, and mortality risk into this planning technique.  The White House proposal would only be effective for future GRATs, so GRATs created prior to the effective date of any such legislation would be grandfathered.


Charitable Lead Annuity Trusts


A charitable lead annuity trust or “CLAT” is a trust that provides for a series of payments to a charitable entity or organization for a term of years, with the remainder passing to the client’s children or other beneficiaries.  From a wealth transfer tax perspective, the present value of the annuity stream to charity is subtracted from the gift, and only the remainder is treated as a taxable gift to the children.  For clients who are charitably inclined, but also wish to transfer assets to their children, a CLAT can present a valuable planning tool.  CLATs are even more compelling in the current low interest rate environment.


Example.  Assume that in April 2012 a client establishes a 20-year CLAT, funded with $1,000,000, with a $57,500 annual payout to charity.  Further assume that the underlying assets earn 8% per year during the term of the trust.  Upon creation of the trust, the client is treated as having made a charitable gift of $996,998. Depending on whether the trust is structured as a grantor or a non-grantor trust, as discussed below, the client can receive an income tax deduction for this contribution.  In addition, the client is treated as having made a taxable gift of $3,002 to the client’s children.  This will consume a portion of the $5.12 million estate and gift tax exemption amount.  Each year during the term of the trust, a $57,500 payment will be made to one or more charities. Upon the expiration of the 20-year term, the remaining assets, calculated to be $2,029,644, will be distributed to the children free of any additional estate and gift tax.




The CLAT can be structured as a grantor trust or as a non-grantor trust.  If the CLAT is a grantor trust, the client will receive an immediate income tax deduction in the year of creation equal to the present value of the annuity stream to charity.  The downside is that, in each successive year, the income of the CLAT will be taxed to the client, who will not be entitled to an additional charitable income tax deduction thereafter.  With a non-grantor trust, the client will not obtain a charitable income tax deduction upon creation of the CLAT, but the client will not be taxed on the CLAT’s income thereafter.


The current low interest rate environment makes CLATs quite compelling. The following chart illustrates the required annuity amounts and the amounts distributed to beneficiaries upon termination of the CLAT, assuming that the CLAT is structured with a 25-year term and the assets grow at 8% per year.



Annual Rates for December of Each Applicable Year Listed Except 2012; April 2012 Rates Used.


Take Advantage of Lower Valuations


Finally, now is a great time to gift assets that may have dropped in value, relative to their historical norms.  Many asset classes, especially real estate, have not recovered, and we think it is an excellent time to consider giving them to family members or trusts for family members at depressed valuations.


Gifts of Limited Liability Company (LLC) and Limited Partnership Interests


An outright gift of real estate is a simple and effective wealth transfer planning technique.  Many clients, however, often consider placing real estate in an entity, such as a limited partnership or LLC, and gifting partnership or LLC interests to family members.  A gifting program that uses an entity structure can be more efficient because multiple deeds do not need to be prepared; rather, simple assignments of partnership or LLC interests can accomplish the transfers.  In addition, management of the real estate can be consolidated and coordinated through the entity.  Finally, interests in a limited partnership or LLC are eligible for valuation discounts for lack of marketability and lack of control.  As a consequence, it may be possible to gift an interest at a lower valuation, and thus, lower gift tax cost, because the interest is discounted by 25% to 35%.


Qualified Personal Residence Trusts


A qualified personal residence trust or “QPRT” is a planning tool that also facilitates the transfer of a personal residence to children at a significantly reduced gift tax cost.  A QPRT typically provides that the client will transfer his or her residence in trust and will retain the right to live in the residence for a term of years.  After the expiration of the term, the residence is transferred to the client’s children.  Because the gift to the children is deferred until the expiration of the term of years, the gift is discounted to its present value.  This produces a significant reduction in the gift tax cost.  In addition, if the residence appreciates in value, the appreciation escapes estate taxation.


Example.  David, age 65, transfers his residence, valued at $1 million, to a QPRT in April 2012 with a 15-year term.  David will be treated as making a gift of $501,720.  Upon the expiration of the QPRT’s 15-year term, the residence, assuming that it appreciates at 3% per year, will be worth $1,557,967 when it is transferred to his children.  Therefore, for a “gift tax cost” of $501,720, David will essentially transfer an asset worth $1,557,967.


If the client wishes to reside in the residence after the expiration of the QPRT term, the client can rent the residence from the children.  While this may seem odd or distasteful, it actually presents a planning opportunity to transfer additional assets out of the estate, without paying gift tax, by paying “rent” to the children. 




We believe that 2012 presents the single greatest opportunity for wealth transfer planning to date.  As this Alert has discussed, there is no shortage of planning techniques and tools available to clients who are interested in mitigating their wealth transfer tax liability.  The uncertainty surrounding the fall Presidential and Congressional elections and the specter of legislative changes threatening the continued viability of highly favored planning techniques, such as GRATs, dynasty trusts, grantor trusts, irrevocable life insurance trusts, and valuation discounts, suggests that now is the time to act.




To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.


For more information about this topic, please contact the author or any member of the Williams Mullen Private Client & Fiduciary Services Team.