On Dec. 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the Act). Among other things, the Act makes changes in the tax law for calendar years 2011 and 2012 that: (1) increase the applicable exclusion amount for estate and gift taxes, (2) increase the generation-skipping transfer (GST) tax exemption, (3) reduce the top estate, gift and GST tax rates to 35 percent, (4) reunify the credits against gift and estate tax, and (5) create portability of the unused estate applicable exclusion amount of a deceased spouse. These changes have long- and short-term consequences, so advisors must consider the impact of the Act when advising their clients about estate-planning strategies and decisions. Here's an overview of the changes in the gift tax laws, planning opportunities and how those opportunities may be integrated with changes in the estate and GST tax laws.

What's New?

Here are the specifics of the Act:

Exclusion amounts/tax rates — The applicable exclusion amount for estate and gift tax is increased to $5 million per person in 2011 and 2012. The exclusion amount may be increased by an inflation adjustment for calendar year 2012 (Section 302(a) of the Act). The GST tax exemption also is increased to $5 million per person, effective as of Jan. 1, 2010 and may also be increased by an inflation adjustment for 2012. The top estate, gift and GST tax rates are 35 percent (Section 302(a) of the Act).

Reunification — Section 301(b) of the Act “reunifies” the gift and estate tax applicable exclusions by making the gift tax exclusion equal to the estate tax exclusion. If a taxpayer made taxable gifts using his gift exemption when it was $1 million, or even if a taxpayer made gifts greater than that amount and paid gift tax, he still has the ability to gift up to $4 million more without incurring a gift tax. New Internal Revenue Code Section 2001(g) ensures this result.

Portability — Section 303(a) of the Act provides that under most circumstances, any unused applicable exclusion amount remaining at the death of a spouse (who dies after Dec. 31, 2010), can be used by the surviving spouse. Note that it's the unused exclusion amount of the surviving spouse's last spouse that can be transferred — not the unused amount of a prior deceased spouse. For example, if a surviving spouse hasn't used any applicable exclusion and his most recent deceased spouse didn't use any applicable exclusion, the surviving spouse can gift $10 million during his lifetime, and no tax will be due. If a surviving spouse makes a gift of$4 million (exclusive of IRC Section 2503 gifts) during his lifetime, there will be $6 million of unused exclusion amount available at his death for his surviving spouse. Note that portability doesn't apply to the deceased spouse's unused GST tax exemption, if any. (For more information on the portability provisions, see “Bypass the Bypass Trust?” p. 24.)

Planning Opportunities

With the increase in the applicable exclusion amount for gifts (and the possibility of portability of an additional amount) and the reunification of the estate and gift tax credit, clients can more fully utilize well-settled gift planning techniques. Also, clients can consider additional techniques not customarily used because of the prior $1 million lifetime gift tax exemption limit.

The exclusion amount increase promotes the three basic tenets of gifting — using discounts, excluding appreciation from the taxable estate and potentially avoiding state estate tax. Clients can now gift more proactively. To reduce taxable gifts, most gifting techniques contemplate using lack of marketability and minority interest discounts, or leveraging applicable federal rates (for example, the Section 7520 rate). Clients now can gift larger amounts before a gift tax is paid. If the gift tax is due, its top rate is 35 percent, which is the same rate as for 2010, but less than the 2009 rate of 45 percent. The tax exclusive treatment for gift taxes paid by donors living at least three years from the date of the gift (rather than the tax inclusive treatment for estate taxes) continues to make gifting attractive for those who have sufficient liquidity to pay the taxes, especially at a reduced rate of 35 percent.

Moreover, many states don't impose a state gift tax, but do impose a state estate tax. Depending on a client's domicile, he can achieve considerable overall estate tax savings by gifting during his lifetime. For example, if a client gifts $5 million during his lifetime (with no state gift taxes), state estate taxes may be avoided on the amount of the gift that would have been subject to state estate taxes. Federal estate tax will be larger because the deduction for state estate taxes will be less. However, for those clients domiciled in states without a gift tax, making lifetime gifts will reduce the overall combined federal and state estate taxes.

Grantor Trusts

Clients can consider making substantial gifts to grantor trusts for both tax and non-tax reasons. The grantor trust provisions under IRC Sections 671-679 provide for trust income to be taxed to the grantor, not to the trust or its beneficiaries. Thus, trust property or distributions aren't diminished by income tax liability. The provision under IRC Section 675(4)(C) allows the grantor, in a non-fiduciary capacity, to reacquire the trust corpus by substituting other property of equivalent value — this gives significant flexibility that outright gifts don't. A grantor can monitor the assets in the trust and determine on an ongoing basis which assets can be maintained to optimize the trust's objectives. Moreover, the grantor can reacquire assets with a low basis and substitute cash or high-basis assets. At death, the grantor's estate will get a step-up in basis for those low-basis assets. If a client has an existing grantor trust, which is encumbered with debt, a new trust may be preferable so as not to jeopardize newly gifted property to satisfy the debt of the existing trust. Note that clients also must consider state gift tax, if any.

Taxpayers can use the increased exclusion amount to provide additional leverage for gifts to a grantor trust that purchased property from the grantor for a note. An additional gift to the trust allows more property to be purchased by the trust for a note. The larger gift component decreases cash flow requirements caused by a note used in connection with the purchased property. Also, the investment risk generally associated with leverage is reduced. The increased gift amount also decreases the risk that the Internal Revenue Service won't consider the transaction to be a bona fide sale.

Individuals who are holders of notes on intra-family loans (including trustees of their grantor trusts) may decide to forgive all or part of the indebtedness and apply the available exclusion amount. The cancellation can benefit the maker of the note by alleviating cash flow needs to meet the note requirements. On the other hand, cancellation of the indebtedness may not benefit the maker of the note if the rate on the note is below then-current market rates or the principal is successfully invested.

GRATs and CLATs

Clients still should consider using zeroed-out grantor retained annuity trusts (GRATs) and charitable lead annuity trusts (CLATs). These techniques don't reduce applicable exclusion amounts so other funds can be used for future gifts or at death. If a client has funded a grantor trust with the available exclusion amount, he may want to consider having the remainder interest in the GRAT or CLAT pass to a grantor trust to continue the benefit provided by a grantor trust.

Life Insurance

Now that applicable exclusion amounts are increased and transfer tax rates are decreased, there's a certain irony when considering whether to use life insurance primarily to pay estate taxes — as planning opportunities are greater now, while the need for insurance may be less. Nonetheless, it will be easier to fund a life insurance trust created to own a policy and receive insurance proceeds. Clients may want to use part of their applicable exclusion amount and contribute funds to the trust to pay premiums. Using the exclusion amount obviates the need to use annual exclusion gifts and issue Crummey withdrawal notices. Donees can use annual exclusion gifts for their current needs. And clients can avoid the complexity and consequences of “hanging powers” (that is, when a donee has the right to withdraw the greater of $5,000 or 5 percent of the trust assets to avoid a taxable transfer on a lapse of a withdrawal right). Also, consider having the insurance trust as a remainder beneficiary of a zeroed-out GRAT.

The applicable exclusion amount can also be used as an exit strategy from a split-dollar loan. Additional funds can be applied to pay all or a portion of the outstanding loan. The ability to pay down the loan reduces the risk that the loan interest will exceed the policy's performance and undermine the plan.

Unitrusts

A charitable remainder unitrust (CRUT) isn't usually considered for children or grandchildren. However, a CRUT remains an income tax efficient way to diversify out of a low basis and highly appreciated concentrated position. Grantors typically name themselves and their spouses as the unitrust beneficiaries to avoid a taxable gift. However, with the increased applicable exclusion amount, a CRUT can be an effective way to provide an income stream to children and grandchildren with the remainder distributed to a public charity, donor-advised fund or private foundation. The applicable exclusion amount can be applied to the present value of the children's or grandchildren's unitrust interests. This technique can be effective in a rising public market environment, while not being negatively affected by increases in the IRS discount rates. Note that the Section 7520 rate has a neutral effect on CRUTs and charitable lead unitrusts (CLUTs).

Secondarily, a grantor can receive an income tax deduction for the present value of a charity's remainder interest. The unitrust term can be coordinated with the balance of the estate plan to either supplement or be supplanted by other gifts or bequests.

The additional exclusion amount also creates added flexibility for charitable lead trusts. The increase can be used in conjunction with the increased GST tax exemption for a CLUT. The GST tax exemption can be allocated at the time the CLUT is funded. The term of the lead interest and the payout rate can be adjusted to address the benefits of the charitable gift tax deduction and fund a favorite charity, while providing for children and grandchildren to receive the remainder interest outright or in future trust at a suitable time.

Given the increase in the GST tax exemption, clients have greater opportunities and flexibility to coordinate their multi-generational planning. These opportunities may include transferring larger amounts into GST tax-exempt trusts.

The increased exclusion and exemption amounts require clients and their advisors to review and possibly revise existing documents that were drafted contemplating significantly lower exclusion amounts and higher tax rates. Advisors may need to incorporate greater safeguards into their clients' trust documents because potentially more property can pass to future generations.

Risks

Making gifts using the new $5 million gift tax exemption isn't without its risks. If a client makes a gift using the full $5 million exemption, and at the time of his death the estate tax exemption has decreased to $3.5 million, his estate will owe tax on the additional $1.5 million that he originally gifted free of tax. This tax liability results because the tentative estate tax is based on the sum of the lifetime taxable gifts and the taxable estate, and then the applicable exclusion amount is applied. Thus, the amount of the gift that exceeds the exclusion at death is “recaptured.” If the exclusion amount is only $3.5 million, the exclusion won't fully offset the tentative tax on the prior gifts, leaving $1.5 million subject to estate tax — even if the entire estate otherwise passes to a surviving spouse or charity. In effect, the risks are that the estate tax is due sooner than it would otherwise be (at the first spouse's death), or the tax would be due in instances in which there otherwise would be no tax (such as with the residue to a spouse or charity). If the client leaves his estate to the donees of his gift, there's no detriment.

But there are multiple benefits to making such gifts despite the potential for recapture. First, the post-gift income and appreciation on the gifted assets escape estate tax (and recapture). Second, if the gift is made to a grantor trust, the grantor's payment of income tax reduces the estate and thus benefits the trust. Third, if GST tax exemption is allocated to the trust, it remains GST tax-exempt. If the donor doesn't use the $5 million GST tax exemption and it's decreased at his death, his opportunity to use it is lost. Finally, donees have the use of the gifted funds.

This article is designed to provide general information about ideas and strategies. It is for discussion purposes only since the availability and effectiveness of any strategy are dependent upon your individual facts and circumstances. Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate-planning strategy. The content represents thoughts of the authors and does not necessarily represent the position of Bank of America. U.S. Trust, Bank of America Private Wealth Management operates through Bank of America, N.A. and other subsidiaries of Bank of America Corporation. Bank of America, N.A. Member FDIC.

Douglas Moore, far left, is a managing director of U.S. Trust Family Office, U.S. Trust, Bank of America Private Wealth Management in New York and co-chair of the Trusts & Estates Estate Planning & Taxation Committee. David A. Handler is a partner at Kirkland & Ellis LLP in Chicago and a member of the Trusts & Estates Estate Planning & Taxation Committee

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