In the realm of estate planning, 2012 is either a once-in-a-lifetime tax-saving opportunity or the new normal. We won’t know which until after the November 2012 election — and maybe not until next year, after the new Congress has had time to act. Savvy investors aren’t waiting to find out, and they are acting now to take full advantage of today’s opportunities. The main point of interest is the estate and gift tax exemption. It has been rising steadily since 1981, and it now stands at $5 million (inflation-adjusted to $5.12 million) per taxpayer. But the extraordinary factor that is here […]
In the realm of estate planning, 2012 is either a once-in-a-lifetime tax-saving opportunity or the new normal.
We won’t know which until after the November 2012 election — and maybe not until next year, after the new Congress has had time to act. Savvy investors aren’t waiting to find out, and they are acting now to take full advantage of today’s opportunities.
The main point of interest is the estate and gift tax exemption. It has been rising steadily since 1981, and it now stands at $5 million (inflation-adjusted to $5.12 million) per taxpayer. But the extraordinary factor that is here right now is that the exemption can be used entirely against gifts made during one’s lifetime. Until now, only $1 million of the exemption was allowed to be used against lifetime gifts. This situation allows you to move some pretty big dollars out of your estate.
The main point of urgency is that all this is scheduled to change on January 1, 2013. Unless Congress acts, the lifetime exemption will go back down to $1 million. And, no surprise, the Democrats and Republicans disagree about how Congress should act. That’s why we really can’t predict anything until after the election.
Make $4 million disappear
At the simplest level, an immediate $5 million gift to your children will make $4 million disappear if the exemption goes back to $1 million.
The math is pretty easy to follow. Say you give your $5 million Ferrari California Spyder to your children today. That uses up your exemption, and there is no gift tax due.
If the law reverts to the $1 million exemption next year, you will be deemed to have used that up with the gift of the Ferrari, but no after-the-fact tax will become due. With no remaining exemption, your estate tax will be based upon the full value of your remaining assets.
If you still owned the Ferrari, your estate tax would have been based upon $4 million more — the $5 million value of the Ferrari less the $1 million exemption that you would not have used. The net result of the gift is that $4 million of value simply disappears from gift and estate taxation — producing an estate tax savings of around $2 million.
What if 2012 is the new normal and the exemption stays at $5 million? The gift is still a good tax plan. The Ferrari is likely to continue to appreciate, say to $8 million by the time of your death. The $3 million of post-2012 appreciation never becomes part of your estate because the Ferrari belongs to your children, which produces about $1.5 million in estate tax savings.
If a little bit is good…
If you’re with me so far, let’s step this up a notch or two and leverage the tax savings even more. Let’s say the Cal Spyder is only part of your $7.5 million collection. We can probably use the
$5 million exemption to move the entire collection to your children.
To set this up, you start by transferring the entire collection to a newly-formed limited partnership or LLC, both of which are popularly referred to as Family Limited Partnerships or FLPs. That transaction is tax-free. Next, you give your FLP ownership interests to your children — or to trusts created for their benefit. Say you give one-third ownership to each of your three kids. Under well-established gift-tax rules, each of the three gifts is valued separately, and each is valued based upon the actual legal rights that are transferred to them.
Here’s where the tax savings mount. The gift tax value of each gift is based upon its fair market value, which is defined as what an unrelated third party would pay to purchase the interest. That is actually a pretty complicated concept.
While each one-third ownership interest would stand to receive about $2.5 million if all the cars were sold and the proceeds were distributed to the owners of the FLP, the child would not have the voting power to force that to happen, any access to the cars themselves, any ability to force their sale, or any ability to dictate FLP operations. Further, the child would have a very difficult time finding anyone to purchase the FLP interest if the child decided to sell it.
The lack of control and impaired marketability mean that a third-party purchaser of the FLP interest would pay less than its $2.5 million pro rata value. That means that fair market value — and therefore gift tax value — would be lower. If the difference, or discount, is 33% (fairly strong but not out of line), then the gift tax value of the gift to the child would be $1.67 million.
Add the three gifts together and you end up with $5 million, all of which is sheltered by the $5 million exemption. But your estate is now smaller by $7.5 million (the value of all the cars), and it won’t get larger as the cars continue to appreciate during your lifetime.
Can I borrow the car?
The biggest drawback to this strategy is that the cars now belong to your children, and they don’t have to let you use them. Before you start thinking about ways to get around that, consider that Congress already beat you to the punch. Under the estate tax law, if you transfer assets to your family but retain the right to use them, the assets will still be counted as part of your estate at your death. And you can’t get around that with a nod and a wink. The IRS can look at actual use after the fact to indicate an informal, implied agreement or understanding, which is enough to add the cars to your estate.
But that may not be an insurmountable problem for the collector. There is no clear definition of “use,” but let’s speculate here — it has to involve driving. Sitting in your garage, being transported to Pebble Beach and shown in the Concours, etc., don’t involve driving — and probably shouldn’t be considered “use” for this purpose.
And some driving is necessary just to maintain the cars, which might be more accurately viewed as maintenance rather than personal use.
You can avoid the problem by paying rent to the FLP every time you use any of the cars. That is a theoretically perfect solution, but establishing a market rent can be challenging, since no one ever rents out their Cal Spyder. Also, the rents will constitute rental income to the FLP.
The retained-use concept is a big gray area, and you have to get individualized advice from your tax advisers about how well you can work around the problem.
More complicated, more better
One of today’s hottest sophisticated planning ideas is a grantor trust. A grantor trust is an irrevocable trust. Transfers to it are treated as gifts, and the assets in the grantor trust are not included in your estate.
However, the trust is given a design element that causes it to be treated as a grantor trust for income tax purposes. As such, you are treated as owning (for income tax purposes only) all of the assets inside the trust, and all of its income is taxed to you.
Let’s go back to the $7.5 million collection example, only this time the gifts are made to a grantor trust established for your children. If any of the cars are sold, the sales proceeds stay in the FLP or grantor trust, but the gain on the sale is taxed to you — to be paid out of your other assets.
Paying the income tax on the sale that accrues to the benefit of your children is economically the same as making another big gift to them, but the tax law does not treat it as a gift. So, more comes out of your estate, lowering your estate taxes even more.
A common way to create grantor trust status is to give you the power to substitute other assets of equal value for any of the assets held in the trust. That can be convenient.
If you later regret having transferred all the cars to the grantor trust, you can exercise your substitution right to get them back. Say, when the Cal Spyder has gone up to $6 million, you decide to swap it for, say, a $6 million apartment building — or any other asset of equal value, including cash. This is a non-taxable transaction, as you are treated as the owner of the grantor trust’s assets for income tax purposes and you can’t be taxed when you sell something to yourself. Now, the Ferrari is part of your estate but the apartment building is not, a net change of zero.
As you can see, there are tremendous opportunities to avoid estate tax under today’s law. And, if you are married, all gifts made by either you or your spouse can be treated as made 50% by each. That allows you to effectively double all of the amounts used in the examples. ?
JOHN DRANEAS is an attorney in Oregon. His comments are general in nature and are not intended to substitute for consultation with an attorney.