Gifting offers certainty in uncertain times
Uncertainty about the future of the estate tax makes planning a challenge. Estate-tax-reduction strategies will be unnecessary, for example, if the tax is permanently repealed — though this is highly unlikely.
As of this writing, a 2010-only estate tax repeal is in effect, and the estate tax is scheduled to return in 2011 — with higher rates and a lower exemption. But Congress is expected to take action on the estate tax, perhaps repealing the repeal and extending 2009 rates and exemptions.
Planning based on the exemption amount is difficult when it is not clear what that amount will be. Fortunately, gifting remains a powerful tool that can provide significant benefits regardless of what Congress does. The best strategy is to make the most of tax-free gifts — but even taxable gifts make sense in some cases.
Leveraging the annual exclusion
The annual gift tax exclusion currently allows you to give up to $13,000 per year tax free to any number of recipients without using any of your $1 million lifetime gift tax exemption. If you elect to split gifts with your spouse, the exclusion doubles to $26,000 per recipient. To qualify for the annual exclusion, the transfers must be "present interest" gifts, meaning that the beneficiary has an immediate right to the asset gifted.
These gifts are removed from your estate, so their value (including any future appreciation) is shielded from estate tax on your death regardless of what happens with the estate tax repeal. They are also generally exempt from the generation-skipping transfer (GST) tax, which also has been repealed this year but is scheduled to be reinstated next year along with the estate tax.
Annual exclusion gifts allow you to transfer a substantial amount of wealth tax free. Suppose, for example, that you have three children and six grandchildren. You and your spouse can transfer up to $234,000 tax free this year without using any of your lifetime exemptions.
Using other gifting strategies
If you are uncomfortable making outright gifts to family members, you can put the funds into one or more trusts. To be considered a present interest and therefore qualify for the annual exclusion, such trusts typically include "Crummey" powers (named after the court case in which they were introduced). Crummey powers give beneficiaries the right to withdraw contributions for a limited period of time after they are made (30 days, for example) and require you to notify beneficiaries of this right.
You might also consider setting up a family limited partnership (FLP) or a family limited liability company (FLLC). By placing assets in one of these entities and giving family members minority interests, you may be able to take advantage of valuation discounts to transfer more wealth to your family within annual exclusion limits.
Be aware that, as recently as last year, bills that sought to reduce or eliminate valuation discounts for intrafamily transfers were introduced in Congress, though as of this writing such bills are dormant. If you have an FLP or FLLC, the best defense against an IRS attack is to ensure that your entity is properly created and managed. You should consult your tax attorney about these matters.
Making taxable gifts
Usually, the best approach is to make the most of the annual exclusion and payments of tuition and medical expenses, while preserving your $1 million lifetime exemption. (Use of your lifetime exemption reduces your available estate tax exemption dollar-for-dollar.) If your estate is very large, however, it might make sense to make gifts within, or even beyond, your lifetime exemption.
The top gift tax rate currently stands at 35%, but it may go up to 45% or even 55% next year. (Check with your estate planning advisor for the latest information.) The value of your assets may increase as well. So you may enjoy significant tax savings by making gifts now rather than later, even if you have to pay gift tax on them.
Of course, this strategy could backfire if the estate tax is permanently repealed. Similarly, taxable gifts may lose their advantage if Congress increases the gift tax rate retroactively.
A safe bet
In uncertain times, annual exclusion gifts and direct payments of tuition and medical expenses seem like a safe bet. They offer significant tax savings regardless of what the future holds. Taxable gifts may also provide an advantage, but it is a good idea to consult your estate planning advisor to determine whether they are worth the risk.
Hedging your bets with a QTIP trust
With the estate tax up in the air, now may be a good time for a qualified terminable interest property (QTIP) trust. Such a trust can be used to take advantage of the unlimited marital estate tax deduction at your death while ensuring that the assets remaining at your spouse's death pass according to your wishes — to children from a previous marriage, for example. QTIP trusts can also protect the trust assets from the surviving spouse's creditors or financial shortcomings. When the surviving spouse dies, the assets are taxed as if they were part of his or her estate.
Even if you are not concerned about children from a previous marriage or potential mismanagement, a QTIP trust may be preferable to an outright bequest to your spouse. Why? It provides a way to hedge your bets while waiting for Congress to act. (See main article.)
For a QTIP trust to work, your executor or other personal representative must make a QTIP trust election on your estate tax return. If you die and the estate tax has been reinstated, your representative can make the QTIP trust election to qualify the trust for the marital deduction and avoid estate taxes on your death. (If your spouse is not a U.S. citizen, special rules apply to the marital deduction.) When your spouse dies, the assets will pass to your children or other beneficiaries and will be taxed as part of your spouse's estate.
If you die when there is no estate tax, no QTIP trust election is made. The trust provides for your spouse for life, and the remaining assets pass to your children tax free — even if the estate tax has been reinstated.