As 2012 draws to a close, estate planners are suggesting—and many clients are contemplating—giving away significant portions of their estate before the $5.12 million gift tax exemption expires and returns to $1 million in 2013. Many clients don’t want to do so, while others realize it makes tax sense and do so in trust.
For many people, those assets are difficult to part with because they were hard to come by over the course of a lifetime. Sacrifices were made to keep them. Watching them diminish in bad markets in recent years has been an ordeal. So it is not easy to embrace the concept of giving assets away on short notice. This is especially true when the motivating factor is not based on a firm and reliable tax code system with known rules, but rather on the expiration of one favorable set of rules and the uncertainty of what may follow.
Making a significant year-end gift in 2012 may be a lot easier for someone who is extremely wealthy. It is easier to justify giving away 10% of your assets than 50%. Making a significant gift is also easier if the donor is retaining sufficient assets to maintain the same lifestyle, income, and control over business interests.
However, logic may not enter into every situation. For example, Donor M, age 85, decided to set up an irrevocable trust for his grandchildren so that some of his assets could be moved out of his estate for transfer tax purposes, as well as for pre-Medicaid qualification purposes. The trust was set up and some assets were moved into the trust. But, at the last minute, Donor M refused to transfer $500,000 of assets. The reason? He wanted to be able to directly control how the assets were invested. It did not matter that the trustees would do exactly as Donor M told them. It did not matter that the assets in question were in long-term municipal bonds that Donor M never reinvested anyway. Having an irrelevant level of control was more important to Donor M than reducing future transfer tax liabilities.
Pondering Gifting Outcomes
What level of tax savings are at stake with a year-end gift in 2012? Must the gift be $5.12 million to obtain the full advantage? Or should a wealthy married couple transfer $10.24 million collectively?
Example #1: If all the stars were aligned for a grantor in 2012 and $5.12 million was given before year’s end with 1) no prior gifts having been given; 2) a reversion in 2013 to the $1 million exemption for gifts and estates; 3) no “claw back” recapture of taxes saved by the 2012 gift; 4) no subsequent increase in the estate tax exemption before the grantor’s death; 5) no use of annual gift tax exclusions or other estate planning techniques; and 6) an applicable tax rate of 55% based on the grantor’s taxable estate, then the net outcome would be the exposure of $4.12 million of funds (assuming no appreciation or depreciation from those funds) to a tax rate of 55%.
So a maximum gift in 2012, with all conditions being exactly right, could have a maximum savings of $2,266,000.
Example #2: Now let’s change the assumptions so that the ultimate exemption turns out to be $3.5 million with a top estate tax rate of 35%, i.e., one of the more plausible scenarios. If the grantor maximized his 2012 gift, an extra $1.62 million would be transferred and would avoid a 35% estate tax, saving $567,000.
A number of other benefits apply:
- Transferred assets continue to generate income that is taxed to a beneficiary who is in a lower income tax bracket.
- There is an additional appreciation of value on the gifted assets that is also excluded from the donor’s estate.
- This gift can also be given to grandchildren and can qualify for the generation skipping transfer tax exemption for 2012.
- The gift can be part of an FLP and Family Trust that provides asset protection benefits.
Example #3: Here is another example with more realistic conditions. The grantor has a more modest estate and makes a 2012 gift of $3 million. The estate and gift tax exemption reverts briefly to $1 million, but Congress ultimately sets the exemption at $2 million and keeps the estate tax capped at 35%. In this scenario, the grantor would be able to gift $3 million instead of the ultimate limit of $2 million. His extra $1 million gift would avoid estate tax of 35% or $350,000.
Example #4: The grantor hears what he wants to hear about the gift tax exemption expiring at the end of 2012 and gifts $2 million before year’s end. The gift tax reverts to $1 million. For argument’s sake, let’s assume that Congress breaks up the gift and estate tax credit again and has a $3.5 million estate tax exemption, even though the lifetime gift tax exemption remains at $1 million. In this scenario, the grantor would have hedged his bets a bit. He would have given away more during his lifetime than the ultimate limit, but would not have been prejudiced entirely by holding his assets due to the ultimate estate tax exemption.
Donor’s Remorse
What could go wrong with an accelerated gift?
- Opportunities may be lost for the donor who could have invested funds that were transferred. Once funds are distributed among various beneficiaries, they may not be conserved and invested effectively and may simply be spent.
- Transferred assets may be wasted by the beneficiaries, exposed to creditors, split up during divorces, and eroded away.
- Appreciated assets that are transferred may subsequently trigger capital gains instead of being transferred with a stepped-up basis at death.
- A donor at 72 may greatly underestimate his life expectancy; upon living to 92, he may wish he had some of that money he gave away in 2012.
An Unconventional End Game
Conventional year-end financial planning may not fit every person’s circumstances this year because 2013 could bring higher federal, state, and local taxes. The composition of the Federal Congress is changing, but even knowing the outcome and proposals cannot help fully anticipate the potential deals or gridlocks that will affect tax rates or deductions. Based on revenue constraints, the default setting of the Bush tax cuts expiring, and the new healthcare law surtaxes, one can anticipate higher tax rates in 2013 while deductions would be cut back. If this holds true, then several strategies would follow:
- Normally, those who can control the timing of when they receive income generally defer income so that it is taxed in the following year. With higher taxes coming next year (potentially), the reverse would be true and income should be accelerated to 2012. This may also make sense based on the security of the source of income. These days, one should seize his or her income before sources run out of funds.
- Bunching deductions to meet the 25%-of-income threshold continues to be a useful strategy. Deferring deductions to next year could be risky if the particular deductions are those that could be eliminated. For higher income taxpayers, itemized deductions and personal exemptions could be phased out in 2013, making them more valuable in 2012. On the other hand, if income is accelerated to 2012 and next year’s income and the 2% threshold is lower, that may be a better time to utilize deductions.
- Aside from the lifetime gift tax exemption, there is the annual gift tax exclusion, in which every donor can make annual gifts to an unlimited number of donees. For 2012, the exclusion is $13,000. With gift splitting, a husband and wife can give $26,000 to every donee. That works out to about $52,000 to each child and his or her spouse. So if a couple has two married children who each have two children, an annual gift program to all eight donees can transfer $208,000 every year, free of gift tax. Over 10 years, that amounts to more than $2 million. Set up properly in a trust with Crummey powers, life insurance purchasing designs, and other planning techniques, simple annual gifting can provide a powerhouse of planning without incurring transfer tax liabilities.
- Capital gains have been an endangered species for the last few years; when one has any actual gains, realizing them by selling that asset almost feels like shooting the last white rhino. But taking a gain also provides an opportunity to sell off a bad investment and neutralize the gain.
- Capital gains might be better taken in 2012, even if there aren’t offsetting losses because of higher tax rates on capital gains that would apply starting in 2013. The anticipated rate would be a return from 15% to 20%. For those who want to retain certain investments, it is possible to sell the position in 2012 and wait 30 days prior to repurchasing the security to comply with “wash sale” rules.
- Businesses set up as C and S corporations that pay dividends, which are currently taxed at 15%, should consider accelerating dividend payments in 2012 to avoid having those same dividends taxed at the highest marginal tax rate of 39.6% and being potentially subject to the additional 3.8% Medicare surtax.
- Where businesses set up as LLCs generate more than $250,000 to owners, the potential of having additional income subject to Social Security taxes may be reason to consider changing to a Subchapter S business entity.
- Business asset expensing is also a critical category. There is a 50% bonus depreciation that is expiring, and the section 179 deduction that allows certain assets to be expensed instead of depreciated will be reduced from $139,000 in 2012 to $25,000 in 2013.
What’s Next?
There are expiring provisions of the tax code that could lead to higher individual tax rates. Overall, the top rate may return to 39.6%. This is noteworthy for small business owners who operate pass-through entities, such as LLCs, where income is taxed at the owner’s individual tax rate.
The coming year is scheduled to have some new taxes as well. Under the new health care law, a new 3.8% Medicare surtax will apply to net investment income for taxpayers with adjusted gross income exceeding $200,000 ($250,000 for married couples filing jointly). There will also be an increase in the employee Medicare tax of 0.9%.
| 2010-2012 | ||
|
Income Tax Rate |
Short-Term Capital Gains Tax Rate |
Long-Term Capital Gains Tax Rate |
|
10% |
10% |
0% |
|
15% |
15% |
0% |
|
25% |
25% |
15% |
|
28% |
28% |
15% |
|
33% |
33% |
15% |
|
35% |
35% |
15% |
| 2013 (Potential) | ||
|
Income Tax Rate |
Short-Term Capital Gains Tax Rate |
Long-Term Capital Gains Tax Rate |
|
15% |
15% |
10% |
|
28% |
28% |
20% |
|
31% |
31% |
20% |
|
36% |
36% |
20% |
|
39.6% |
39.6% |
23.8% |
Careful planning for business owners and individuals is needed before year’s end, and the process should incorporate legal and accounting advice. A flexible plan with alternatives is the ideal approach where possible.
TO THE EXTENT THIS ARTICLE CONTAINS TAX MATTERS, IT IS NOT INTENDED NOR WRITREN TO BE USED AND CANNOT BE USED BY A TAXPAYER FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON THE TAXPAYER, ACCORDING TO CIRCULAR 230.
RANDALL A. DENHA, J.D,, LL.M. is principal and founder of the law firm of Denha & Associates, PLLC with offices in Birmingham and West Bloomfield, MI. He is recognized as a “Super Lawyer” by Michigan Super Lawyers in the areas of Trusts and Estates. Mr. Denha can be reached at (248) 265-4100 or by email at rad@denhalaw.com.
