By now, most of our clients are aware of the current historic opportunity to transfer significant wealth to their heirs free of gift taxes. Not since 1932 have U.S. taxpayers been able to transfer assets of this magnitude without a federal transfer tax.1 Still, some who might benefit hesitate to take advantage because there’s a significant risk to consider: If the investments of gifted assets decline, heirs ultimately could receive less than if no gift were made. The time for clients to make a decision is quickly running out. As estate-planning attorneys well know, current law permits individuals to gift, free of U.S. gift tax, up to $5.12 million ($10.24 million for married couples)—but only until Dec. 31, 2012.2 

Even if clients decide to use their exemption, they have to answer other critical questions, including: Where should the gift ultimately end up, and what is the optimal investment strategy for these assets? 
 
To help advisors assist their clients in deciding whether, how and how much to give now, we examined the risk/reward tradeoffs associated with making a gift using today’s gift tax exemption of $5.12 million, factoring in the probability of the exemption being lost through negative performance and leverage.
 
We reached 10 conclusions, most notably: It’s economically efficient to make a gift using today’s $5.12 million exemption, especially if estate tax rates increase and exemption amounts decrease, as they’re scheduled to do in 2013.
 

Tax Environment Scenarios

Because the future of U.S. gift and estate tax rates and exemption levels is unpredictable, we modeled two scenarios that represent possible extremes: 
 
1. Low tax environment. This scenario assumes that today’s favorable transfer tax regime will be extended indefinitely: U.S. gift and estate tax rates are 35 percent, and the exemptions are $5.12 million per person. 
2. High tax environment. This scenario assumes that the scheduled changes actually occur: The maximum gift and estate tax rate jumps to 55 percent in 2013, and the exemption drops to $1 million per person.
 
There’s some concern that a future drop in the estate tax exemption amount may prompt a recapture of exemption applied to gifts made while the level was $5.12 million. Many practitioners believe that recapture isn’t a likely outcome, but, even if it were, it shouldn’t deter someone otherwise inclined to use his exemption today. (See “Gift Now Despite Possibility of a Recapture Later?” p. 40.)
 
Transfers via gift generally provide more value for heirs as long as investment returns are positive. This is because the appreciation on gifted assets escapes estate taxes that would be due had no gift been made. The higher the total return (from income or growth), the greater the benefit of a gift made today.
 

Tax Environment Conclusions

Here are our three conclusions regarding the effect of the environment on gifting decisions.
 
Conclusion 1: Future estate tax rates and exemption amounts matter. It would be more advantageous to make a gift today were rates to increase and exemption amounts decrease in the future, than if they didn’t. (See “Evidence Supports Gifting Now,” this page.)
 
Conclusion 2: Negative returns could cause the loss of some exemption: Heirs might benefit more from the donor applying the exemption at death.  
For example, in the “low tax environment,” our research shows that if asset values fall by 5 percent per year over 20 years, a $5 million gift today will result in heirs ultimately receiving $1.1 million less than if no gift had been made.
In this example, the donor’s $5 million exemption was used to shield from the estate tax assets that eventually were valued at $1.8 million. Had no gift been made, the exemption could have been used to shield $5 million of other assets from the estate tax. (See the “Low tax environment” section of “Evidence Supports Gifting Now,” this page.)
 
Conclusion 3: The loss of benefits resulting from lower investment returns could be offset by a sufficiently large decrease in the future exemption. For instance, our research shows that the return of estate tax rates and exemption amounts to 2001 levels would still make gifting beneficial, even if asset values fall by 5 percent per year over 20 years. Since the value of the exemption lost by the decrease in asset value is less than the amount of the decrease in exemption, the remaining asset value in excess of the future exemption will still provide a benefit equal to the amount of estate tax that would have been incurred on that excess if no gift had been made. (See the “High tax environment” section of “Evidence Supports Gifting Now,” p. 35.)
 

Leverage Scenarios

Many donors make gifts to trusts, rather than outright, so that assets transferred can be managed and controlled by someone other than heirs. The benefit to heirs can be significantly boosted if an irrevocable grantor trust,3 once funded, buys assets from the donor in a tax-free exchange for a note or borrows and reinvests the loan proceeds. With today’s low interest rates, these transactions can bolster the benefits of gifting. But, how much could using leverage enhance the benefits of gifting? 
 
We examined two scenarios:
 
Four-times leverage. In our first hypothetical, the grantor gives $5 million to a trust and allocates all of her exemption to the gift. She later sells $20 million of her assets to the trust in exchange for a note. 
 
Nine-times leverage. In this case, the grantor gives $5 million, then sells $45 million worth of assets to the trust in exchange for a note. 
 

Leverage Conclusions

Here are our four conclusions regarding the effect of leverage on the amount of wealth passing to heirs.
 
Conclusion 4: Adding leverage as described will generally result in more wealth passing to heirs as long as investment returns exceed the interest rate on the note. 
Unsurprisingly, benefits increase in tandem with greater leverage and higher returns. Today’s low interest rate environment makes the use of leverage even more appealing, because it reduces the investment return threshold required for the strategy to be successful.
 
Conclusion 5: Leverage also increases the risk of wasting the exemption. With direct gifts, the erosion of exemption in the low tax environment occurs only when the transferred assets depreciate. In contrast, using leverage requires positive returns to avoid eroding the exemption. The required return increases in tandem with the amount of leverage, because the portion of total trust assets subject to interest increases. 
 
We analyzed how leverage affects the breakeven return rates required for success, which we define as whether a strategy transfers more assets to heirs than would have been the case had the strategy not been used. In other words, the strategy is successful if, at the end of 20 years, the total asset value in the trust is greater than the exemption available at death. 
 
Conclusion 6: The threshold rate required for a strategy’s success is lower in the high tax environment. Because the trust’s total assets need to exceed the exemption available at death for the strategy to be successful, a relatively lower total return on assets is required in the high tax environment, where the exemption available at death is only $1 million. (See “Threshold for Success,” p. 37.)
 
Conclusion 7: The band of annual asset returns resulting in the exemption being partially lost is much narrower in the high tax environment. 
While the threshold rate required for success is lower in the high tax environment (Conclusion 6), the threshold rate required to avoid wasting the entire exemption is the same in both tax environments. This happens because the entire exemption would be lost only if there are no assets left, which doesn’t depend on the assumptions used for future estate tax rates and exemption amounts. (See “Threshold for Success,” p. 37.)
 

Likelihood of Success?

Connected to the question of threshold rates for each strategy is the likelihood of success, which depends on the probability of reaching the threshold rates of return. 
The probability of reaching a given rate of return depends on what kind of assets a donor transfers. Because success can only be measured at death, managing the risk of a given strategy being unsuccessful is particularly important when one considers the uncertainty created by mortality.
 
Using J.P. Morgan’s proprietary Morgan Asset Projection System (MAPS),4 we’re able to compare the range of values left in the trust for three different strategies and three different funding assets, each with a different expected return and volatility. MAPS provides a Monte Carlo simulation showing the range of wealth produced by different asset allocation profiles. 
 

Success Conclusions

Here are our two conclusions regarding the likelihood of success for each strategy. 
 
Conclusion 8: Not surprisingly, less volatile assets produced a range of wealth much narrower than that produced by more volatile ones. Higher leverage also resulted in a much wider range of wealth values. (See “Range of Potential Trust Values,”  p. 38.)
 
Conclusion 9: For each strategy, the median trust values in Year 20 decreased as volatility increased. The upside potential of the volatile assets was much greater; but so too was the downside. 
 
This means that while the more volatile assets provide a much higher upside, there’s a higher probability they will produce less wealth. (See “Likelihood of Wasting Exemption,” p. 39.)
 
Conclusion 10: Applying lifetime exemption magnifies after-tax returns. Asset appreciation in an estate tax-exempt trust provides value not only from an investment standpoint, but also from a tax-savings perspective. However, asset depreciation is detrimental in that same trust because, in addition to the value of the asset itself, the exemption may be lost—both would diminish the ultimate amount of assets passing to heirs.
 

Alternative Strategies

Prospective donors should understand the trade-off between: 1) the higher probability of losing the exemption, and 2) the potential that a much greater amount of wealth will be transferred to heirs if assets outperform. Yet, because trusts funded with highly volatile assets have greater risk, grantors may want to consider alternative estate-planning strategies for those assets. Grantor retained annuity trusts (GRATs) can be structured without using a donor’s gift tax exemption; they also capture a significant portion of the tax savings benefit when assets appreciate. Placing more volatile assets in a structure such as a GRAT preserves the gift tax exemption for the transfer of other, less volatile assets.
 

Other Considerations 

There are, of course, other factors affecting decisions regarding today’s $5.12 million exemption. The most obvious is a potential donor’s actual wealth. Donors with smaller estates may not want to use all $5.12 million during their lifetime, especially as the future estate tax exemption may be $5.12 million or more, even if the gift tax exemption decreases. 
 
State and local transfer taxes should also be considered. Lifetime transfers certainly make sense in states that have independent estate taxes, but impose no tax on lifetime transfers, especially when many of those states’ estate tax exemption amounts are less than $5.12 million.
 
Also, whether a trust is a grantor or a non-grantor trust can have a significant impact on any gifting strategy. Grantor trust status can enhance the value of assets in a trust considerably over time and increase the likelihood of success, because these assets essentially grow income tax-free. Indeed, the benefit that accrues to trust beneficiaries is as much a function of the allocation of income tax liability as it is the trust’s asset allocation. Finally, in selecting assets for gifting, a donor should favor those with a high cost basis. Since donees receive a carryover cost basis, capital gains tax on asset sales will detract from the economics of the gift.5
 

Endnotes

1. The federal gift tax was first enacted in 1924, repealed in 1926, and reintroduced in 1932. In 1932, the gift tax exemption was $50,000. It never exceeded $1 million until 2011, when it jumped to $5 million. The gift tax rate of 35 percent in 2011 and 2012 is the lowest since 1934, when the maximum rate was 33.5 percent. See www.treasury.gov/resource-center/tax-policy/tax-analysis/documents/ota10... (Department of the Treasury).
2. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 indexed the exemption amounts by inflation so that on Jan. 1, 2012, an individual’s exemption rose to $5.12 million and a married couple’s exemption became $10.24 million.
3. Income taxes attributable to a grantor trust are paid by the grantor, not the trust itself.
4. Morgan Asset Projection System (MAPS) is a proprietary tool that allows the comparison of investment portfolios in dollar terms. 
5. In considering the material contained herein, the practitioner should be alert to developments in the law subsequent to its publication, which might have a bearing on the material. The material contained herein is provided for educational purposes only, doesn’t constitute legal or accounting advice and contains modeling that shouldn’t be construed as predictions of future returns. For more information about this forward-looking analysis, please review the disclosures herein and consult a J.P. Morgan representative. Although care is taken to present the material accurately, JPMorgan Chase & Co. disclaims any implied or actual warranties as to any materials herein and disclaims any liability with respect thereto.