2010 was a difficult year for tax planning. The federal estate and generation-skipping taxes were repealed, but the gift tax exemption was stuck at $1m to keep people from taking too much advantage. Plus, there was talk all year long about a retroactive reimposition of both taxes. We saw an epic battle over the continuation of the Bush Tax Cuts, which morphed into a battle over the Bush Tax Cuts for the Wealthy–even though no one seemed bothered by the Bush Tax Cuts for the Not So Wealthy, even though they represented 75% of the tax expenditures. The impasse grew stronger […]
2010 was a difficult year for tax planning. The federal estate and generation-skipping taxes were repealed, but the gift tax exemption was stuck at $1m to keep people from taking too much advantage.
Plus, there was talk all year long about a retroactive reimposition of both taxes. We saw an epic battle over the continuation of the Bush Tax Cuts, which morphed into a battle over the Bush Tax Cuts for the Wealthy–even though no one seemed bothered by the Bush Tax Cuts for the Not So Wealthy, even though they represented 75% of the tax expenditures.
The impasse grew stronger as the election neared, and we all faced the strong likelihood that 2011 was going to dawn with a reversion to a 10-year-old law with its $1 million estate tax exemption and higher income tax rates.
At the very end of December, the unexpected suddenly happened. Facing an incoming Republican House of Representatives, President Obama wanted to ratify the START Treaty, eliminate the Don’t Ask Don’t Tell policy, and extend the Bush Tax Cuts for the Not So Wealthy.
So, President Obama struck an unexpected deal with Congress, and the tax situation became clear. At least for two years, anyway.
Estate tax good times
All of a sudden, we have a $5 million estate tax exemption and a 35% estate tax rate. That’s enough to make most people think they are immune to estate tax –as the government projects that only about 2,500 estate tax returns will be filed each year, which is far less than 1% of decedents.
In addition, we have a totally new concept called “portability.” The way that works is that, if you leave everything you own to your spouse at your death, you owe no tax and your spouse ends up with a $10 million estate tax exemption. In essence, your unused exemption transfers to your spouse.
But before you stop reading and start using $100 bills to light your cigars, consider one thing: This is only a two-year deal. In 2013, we go back to the $1 million exemption, 55% estate tax rate, and no such thing as portability.
So, unless you and your spouse are both planning to die really soon, recognize that late 2012 is likely to be a repeat of late 2010. The law that will apply in 2013 will be unpredictable, and it will depend greatly upon the outcome of the November 2012 elections.
Meanwhile, the U.S. Treasury continues its assault on our favorite tax planning techniques—grantor retained annuity trusts and family limited partnerships—and hopes to legislate them out of existence.
Amazing gift tax opportunities
Probably the most amazing aspect of the 2010 legislative compromise is that we now have a totally unprecedented $5 million gift tax exemption. This creates an array of tax-planning opportunities for the car collector.
In anyone’s book, $5 million is a substantial amount of wealth. And when you combine it with your spouse’s $5 million exemption, that adds up to $10 million in asset value that can be moved to your family without paying federal gift taxes.
So, this is the time to make some really big estate planning moves. We don’t have room to go into detail this month, but family limited partnerships, fractional interest gifts, sales to grantor trusts, and short-term GRATs are all available to add even greater financial benefits.
“Legal Files” will address some of these techniques in detail in future columns, but for now, just remember that it is a great time to talk to your estate planning attorney about what to do with all those old cars you’ve been keeping in your garage.
Give the kids your cars
Here’s a little example to get you thinking: Say you have a $10 million car collection. You can transfer all the cars to a family limited partnership or to a family limited liability company (also known as an FLP) in a tax-free transaction.
Second, you give 50% ownership to your spouse, which is another tax-free transaction. Third, you and your spouse gift your FLP interests to your kids or to trusts for their benefit. These gifts are subject to gift tax, but they are sheltered by your $5 million gift tax exemptions.
To ice the cake, the FLP interests given to your kids or their trusts are not valued at $10 million. The kids get minority interests that lack control and marketability, so they should be valued on a discount basis for gift tax purposes. Say, the value is $7 million—that means you and your spouse still have $3 million of gift tax exemption available for other uses.
Nonetheless, your kids own the FLP. (Yes, it’s up to them to decide whether you can borrow the Ferrari, but we can work on that problem.) The upshot is that the car collection is out of your estate once and for all—no matter what happens in 2013. If the collection appreciates to $20 million over time, all that appreciation belongs to your kids, not you—and escapes gift and estate tax completely.
Income tax opportunities
The most significant portion of the extension of the Bush Tax Cuts is the continuation of the 15% income tax rate on long-term capital gains. Say you sell your $3.5 million McLaren F1 that you purchased years ago for $1 million. Your $2.5 million gain will produce a federal income tax of just $375,000. Or is it $700,000?
“Legal Files” has written about this before. The capital gains rate is generally 15%, but it is 28% for “collectibles.” Is a collector car treated as a “collectible”? Before scoffing and pointing out that playing word games like that is one of the things that make people hate lawyers, consider the technical details.
In the tax law, it doesn’t matter how common sense, Sports Car Market, or your collector car insurance policy describes your car. The only thing that matters is how the Internal Revenue Code defines the term. Fortunately, the code gives us a very specific definition. “Collectibles” are specifically defined as any work of art; any rug or antique; any metal or gem; any stamp or coin; any alcoholic beverage; and a catch-all—any other tangible personal property specified as a collectible by the Secretary of the Treasury.
Do you see cars on the list? The most common concern is that a collector car might be an antique, which is not defined in the tax law. But any dictionary you look at will define antiques as really old works of art, furniture, and furnishings.
Which cars—if any—get a break?
Within the car hobby, “antique” cars are generally the oldest cars. The Classic Car Club of America has defined a “classic car” as one manufactured between 1925 and 1948, which is generally consistent with the view that “classic” cars are not as old as “antique” cars. Keith Martin’s Guide to Car Collecting categorizes “antique” cars as pre-1905 vintages. Many states provide special licensing categories for “antique” cars, but their standards vary considerably without consistency.
Viewing some cars as antiques would lead to unfair results—a taxpayer who recognizes a $500,000 gain on a 1953 Ferrari could be taxed the Collectible rate of 28%, while a taxpayer who recognizes a $2,500,000 capital gain on a 1995 McLaren F1 would be taxed at 15%. Finally, the tax law refers to “any rug or antique,” suggesting that Congress had household items in mind.
Of course, the Secretary of the Treasury has the power to add automobiles to the definition at any time; that just hasn’t happened yet. Maybe tomorrow, but not yet, and it can’t be done by an IRS agent auditing your return.
As logical as that sounds, “Legal Files” has learned that many tax preparers are unwilling to use the 15% rate. That is understandable, as the law is not 100% clear either way and tax preparers are subject to stiff penalties for taking improper tax return positions.
If your tax preparer balks, the best approach is to have a tax attorney give you a written opinion that the 15% rate applies. The tax preparer can rely upon that opinion without worry—and so can you. If you are audited and the IRS claims that the 28% rate applies, your reliance on counsel should protect you from penalties.
Action item
Simply stated, the sun is shining—so go make some hay! This is a tremendous time to be doing some tax planning, and it is possibly the best planning climate we will see in our remaining lifetimes. Take the initiative to get professional guidance—and do all you can before the end of next year.