At the stroke of midnight on December 31st this year, the $5 million per person Federal Estate Tax “coupon” (exemption) will expire. Starting on January 1, 2013, this will go back to a $1 million “coupon” per person (unless and until Congress and the President enact something different).
This has created an unprecedented Estate Planning and Business Succession Planning opportunity, and we have been receiving a lot of questions about how to address it. This article will summarize how we suggest this be considered by every person who has a net worth exceeding $1 million.
First…How Does The Federal Estate Tax Work?
The key features of the present Federal Estate Tax laws are:
Federal Estate Tax at a 35% tax rate is due at your death on the value of all of your assets (e.g., home, investments, business, real estate, retirement plans, life insurance proceeds, etc.).
For a married couple, the Federal Estate Tax can normally be deferred until the death of both spouses.
To reduce your personal taxable estate (i.e., you future estate tax) each person can make annual tax free gifts of $13,000 to as many persons as you wish (generally to children and grandchildren).
Each person can also, until December 31, 2012, make a total tax free gift (during your life or at death) of up to $5 million. This is $10 million for a married couple. (The precise exemption amount is $5.12 million per person or $10.24 million for married couples). This is the exemption which goes back to $1 million (per person) starting January 1, 2013.
Starting January 1, 2013, the Federal Estate Tax rate increases from 35% to 55%.
What Is The Effect Of Letting Your “Coupon” Expire?
This depends on the size of your total financial net worth. If you can use the full “coupon” and you instead let it expire, the effect is a future Estate Tax increase of approximately $2.2 million ($4.4 million for a married couple). The calculation for this is $5 million – $1 million = $4 million x 55% = $2.2 million extra Estate Tax cost.
The Opportunity Between Now and December 31, 2012.
The $5 million Federal Estate Tax “coupon” can be used before it expires in a number of ways. Some of these are:
Straight Gifts. Liquid investments (such as marketable stocks and bonds), real estate or shares in family or closely held companies can be given outright to children and grandchildren.
Gifts Using A Partnership or LLC. Liquid investments and real estate can be placed into a family partnership or limited liability company (LLC) and then shares of the partnership or LLC can be given to children or grandchildren. This enables you to keep better control and management over the assets (and to better use the exemption through valuation discounts).
Gifts Using A Trust. Liquid investments, real estate and shares in family or closely held companies can be placed into one or more trusts for the benefit of your children and grandchildren. Depending on the terms of the trust, this can have several advantages:
The assets can be protected from financial issues or creditors of your children and grandchildren.
The assets can be used for both existing children and grandchildren as well as for future generations without any future Estate Taxes or Generation-Skipping Taxes (when the trust is set up as what is commonly known as a Dynasty Trust).
The assets of each spouse’s trust can be used for the benefit of the other spouse (subject to certain guidelines). This is what is commonly known as a Spousal Lifetime Access Trust.
The income taxes on the trust income can, if you so choose, be paid by you, which enables you to increase the wealth passed to your family without Estate Tax.
Various Points You Should Consider.
Whenever a gifting program like this is to be discussed, various matters should be considered, such as:
You need to be comfortable that the wealth you retain will be more than sufficient to cover your personal financial needs.
You need to be comfortable that the wealth transferred to your children and grandchildren is under such terms as will not diminish their personal responsibilities or motivation.
Income tax aspects (such as tax basis) need to be considered.
Ongoing control of any family or closely held company needs to be addressed if stock in it is to be gifted.
The stock structure of any company you own can normally be revised (e.g., using voting and nonvoting stock) so you can keep control even if you gift more than half the value.
Any stock in your company which you gift should normally be covered with a Buy-Sell Agreement to help protect your control over present and future ownership.
Any transfers of stock should be in line with your personal Transition Growth Plan (also known as an Exit Plan or Succession Plan).
To be effective in obtaining the benefit from the existing Federal Estate Tax “coupon,” these steps need to be taken before December 31, 2012.
Source: McGrath North Mullin & Kratz, PC LLO