By Shari Levitan, Edward F. Koren, and Abigail E. O'Connor
In the final hour of January 1, 2013, Congress passed the American Taxpayer Relief Act of 2012 (Act), which in part addressed the dramatic sunset of favorable federal estate, gift, and generation-skipping tax exemption limits.
During 2012, these exemptions, indexed for inflation, were set at $5,120,000 each, up from $5,000,000 in 2011. In addition, during 2012, the tax law permitted a surviving spouse to use the unused exemption of a deceased spouse (called "portability"). Most importantly, during 2011-2012, the gift tax exemption was the same as the estate tax exemption, so taxpayers could make lifetime gifts that fully utilized their exemptions. Doing so shifted the gifted assets' future appreciation and income out of the donors' taxable estates. The maximum tax rate for transfers in excess of the exemption was 35 percent.
When the ball fell in Times Square on New Year's Eve, the $5,120,000 exemptions were reduced to $1,000,000, and the maximum transfer tax rate was increased from 35 percent to 55 percent. The portability function expired, so a surviving spouse could no longer use a deceased spouse's unused exemption. Moreover, it was uncertain how transfers made prior to 2013 would be treated in the future when the taxpayer died. Would there be a "clawback" to penalize the taxpayer for having taken advantage of the higher exemption limits and lower tax rates prior to 2013? Fortunately, the Act made these changes short-lived.
As a result of the Act, the exemptions for federal estate, gift, and generation-skipping tax transfers will remain at $5,000,000, indexed for inflation. For 2013, the exemption amount will be $5,250,000. The Act retained portability, so a surviving spouse can still use a deceased spouse's unused exemption, provided that an estate tax return is filed and the portability election is made. The maximum transfer tax rate was increased to 40 percent. Because the exemption limits remain at the higher levels, the clawback question is now largely irrelevant.
We have the following observations about the Act:
1. Those who thought they missed the window of opportunity to take advantage of the $5,120,000 exemption with pre-2013 gifts have been given a second chance. While the Act's provisions are stated to be "permanent", this means only that the new provisions will not automatically sunset and revert to a less favorable law. Congress can still change the exemptions or tax rates in the future. Therefore, anyone who did not previously take advantage of the $5,120,000 gift tax exemption should still consider doing so; those who did take advantage of the exemption with pre-2013 gifts should consider whether it makes sense to top off such gifts with the increased exemption available in 2013.
2. You may consider making taxable gifts above the exemption limits. While the transfer tax rate has increased from 35 percent to 40 percent, gifting during lifetime remains a more efficient manner of shifting wealth than testamentary bequests.
To illustrate: If a taxpayer makes a testamentary bequest of $1,000,000, the estate tax, which comes off the top, is $400,000, and the beneficiary receives $600,000. Effectively, the beneficiary bears the burden of estate tax. By comparison, the donor bears the burden of the gift tax. To make an equivalent gift during lifetime, the donor can make a gift of $600,000, which results in gift tax of $240,000. In short, for a beneficiary to receive $600,000, the total outlay is $840,000 when making the lifetime gift, as compared to the $1,000,000 bequest at death. Even better, if the taxpayer lives more than three years from the date the gift is made, the gift taxes paid are excluded from the donor's taxable estate for federal estate tax purposes.
Once the gift is made, all of the appreciation from and after the date of the gift is no longer subject to transfer tax in the donor's estate. Likewise, the income earned on the gifted assets after the date of the gift will be shifted out of the donor's estate for transfer tax purposes. Taxpayers may live in a state that imposes an estate tax, but no gift tax, making lifetime gifting (even above the exemption level) even more tax efficient. Although the tax advantages are clear, taxpayers must consider the lost income from the payment of gift tax as well as the time value of money to determine whether making taxable gifts is appropriate for them.
3. In addition to the advantages stated above for considering making taxable gifts, there is yet another consideration. The 40 percent tax rate, while an increase from the 35 percent rate from 2012, is still much lower than the historical rates prior to 2010. There is always a chance that Congress will revert to a higher rate, such as 45 percent or 55 percent. Making taxable gifts now at a 40 percent rate makes sense, as a way to prepay future tax that may be imposed at a higher rate.
4. Contrary to some prior proposals, the Act does not curtail a taxpayer's ability to take advantage of all of the transfer techniques that have worked so well, particularly in this low interest environment. For example, the Obama administration previously made broad proposals, including requiring a minimum term for Grantor Retained Annuity Trusts (GRATs), substantially revising the so-called "grantor trust rules" (which permit a trust's grantor to make additional tax-free gifts to the trust by paying the trust's income tax), eliminating valuation discounts for transfers between related parties, and limiting the duration of a generation-skipping transfer tax exemption. The Act contained no such limitations. Accordingly, many sophisticated planning techniques remain unaffected by the Act, including short duration GRATs, sales to grantor trusts, loans to family members and trusts at the applicable federal rate (0.87 percent for mid-term loans made in January, 2013), and gifts of nonmarketable minority interests in entities.
It would not be surprising to see some of the administration's prior proposals reappear in further tax reform. It would be unlikely, though not impossible, for any such legislation to be retroactive. Taxpayers who have not made use of these beneficial transfer opportunities might consider doing so early in 2013, so that if adverse legislation is introduced, such gifts may be grandfathered. This will bear careful watching.
5. The Act does raise ordinary income and capital gains tax rates for wealthier taxpayers. While grantor trusts are often helpful because the grantor pays the tax, with the new tax rates, this approach may be counterproductive for some families. For instance, if the beneficiaries are in a lower tax bracket, it may make sense to terminate grantor trust status if the grantor's spouse is not a co-beneficiary of the trust, and make distributions to beneficiaries that will carry out the taxable income. Such planning would take advantage of the beneficiaries' lower brackets, but the purpose of the trust and financial acumen of the beneficiaries should be reviewed.
On the other hand, if the grantor's taxable income is below the $400,000-$450,000 threshold for the maximum 39.6 percent rate under the Act, the family's overall income taxes may be reduced by retaining the grantor trust status. This analysis also will need to take into account whether the grantor, beneficiaries, or the trust are subject to state income taxes. Given this added complexity, it will make sense to review existing grantor trusts to determine the best approach.
6. The effect of the increase in capital gains tax should be considered when gifted assets are sold in the future. For assets transferred at death, the basis is reset for income tax purposes to the asset's value at date of death. Because assets generally appreciate, this often results in a step-up in basis, which reduces the effect of the capital gains tax. There is no basis reset for assets transferred during lifetime. Assets transferred by gift retain the donor's basis (although adjustments are made if gift tax is actually paid).
Even worse, if the asset value on the date of gift is less than the donor's basis, a little known rule gives the beneficiary a split basis, which prevents the donor from realizing the income tax benefits of a full loss on the sale of the asset. Taxpayers who have made gifts to grantor trusts of assets with a fair market value less than basis, or of low basis assets generally, might consider substituting higher basis assets to minimize potential adverse income tax consequences to the trust and its beneficiaries in the future.
Completing Gifts by Year-End 2012 Was Worthwhile
Some have asked whether all the rush to complete gifts by year-end was worth it, given the ultimate action by Congress. The short answer is a resounding "yes." No one knew for sure until after 11:00 p.m. on January 1, 2013, that the legislation would pass. On New Year's Eve, the prognosis for a compromise was tentative at best, and in fact, the old law with its $1,000,000 exemption and 55 percent maximum rate actually became effective for twenty-three hours. That legislation could have just as easily been limited to adjustments in income tax rates, and few (if any) were willing to bet on Congress.
Second, transactions in 2012 will benefit from some protection that will not be afforded to transactions in 2013. For those who created grantor trusts, as noted above, there may be renewed scrutiny over the grantor trust rules, and the rules could change as early as this year. Grantor trusts created in 2012 are probably safer from this change than trusts created or funded in 2013. Some people gifted interests in entities that made year-end distributions to avoid the increases in income tax. By doing so, they leveraged the distributions beyond just the value of the gifted interests. In addition, those who created spousal limited access trusts (where the spouse is a co-beneficiary) have the added benefit of creating some creditor protection while still providing access for cash flow needs. This may help in the event of a challenge by a creditor, and this benefit is still available for 2013 transactions.
Finally, transactions completed in 2012 will have had the benefit of already starting the clock on the three-year statute of limitations for timely filed returns with adequate disclosure. The three-year statute of limitations begins as soon as the return is filed, so for 2012 gifts, the statute of limitations for timely filed returns ends in 2016, whereas 2013 gifts will have an audit period that will not expire until 2017. Moreover, it is possible that the retention of high lifetime gift exemption limits will reduce the likelihood of audit that may have resulted had the exemption reverted to the prior $1,000,000 level.
Aside from the Act, one last piece of good news for taxpayers is that the annual exclusion has increased from $13,000 to $14,000 in 2013. These annual exclusion gifts to trusts may require allocation of generation-skipping tax exemption, which courtesy of the Act, remains at the elevated level.
For questions about any of these issues or the Act itself, please contact the authors of this alert:
- Shari Levitan, (617) 854-1405, [email protected]
- Edward F. Koren, (813) 227-6655, [email protected]
- Abigail E. O'Connor, (863) 499-5330, [email protected]