1 Private Wealth Management Trust & Estate Insights March 2011 In This Issue Taking Advantage of the Increased Gift Tax Exemption Key Takeaways: The federal gift tax exemption has risen from $1 million per donor to $5 million per donor, dramatically increasing the ability of a wealthy family to reduce overall transfer taxes through lifetime giving. The increase in the exemption may be short lived: The new tax law is scheduled to "sunset" at the end of Accordingly, wealthy families should strongly consider taking advantage of the increased exemption before the end of next year. There is some uncertainty over what will happen to an individual who has made a substantial gift if the new tax law sunsets and the exemption decreases. In most cases, however, a sunset is likely to leave the donor's estate in no worse a position than if the gift had not been made (and may leave it in a substantially better position). For many wealthy families, some of the most important changes made by the recently enacted Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the "TRA") concern wealth transfer taxes. Among other things, the TRA decreased the top transfer tax rate to 35% and increased the federal estate, gift, and generation-skipping transfer ("GST") tax exemptions to $5 million for 2011 and 2012 (increased for inflation in 2012). In particular, the increase in the gift tax exemption from $1 million to $5 million (or $10 million for a married couple) dramatically increases the ability of a wealthy individual (or couple) to minimize transfer taxes through lifetime gifts. These gifts could include an outright gift, a gift to a "dynasty trust," or the transfer of a valuable residence to a "qualified personal residence trust." In addition, the increase presents an unprecedented opportunity to make a significant gift to an "irrevocable life insurance trust" to pay the premiums on a substantial insurance policy. Unfortunately, the ability to take advantage of the increased exemptions may be fleeting: The changes made by the TRA are scheduled to "sunset" at the end of Absent legislation to extend the TRA, the gift tax exemption will revert to $1 million in 2013, and the top federal tax rate on estates and gifts will revert to 55%. This strongly suggests that many wealthy families should take advantage of this "window of opportunity" by making substantial gifts before the end of next year.
2 How Lifetime Gifts Can Reduce Estate Taxes In considering the impact of lifetime gifts on overall transfer taxes, it is useful to understand exactly how gifts can reduce transfer taxes, and what complications may arise if the TRA sunsets after the gift is made. To understand how lifetime gifts can reduce estate taxes, it is necessary to examine the somewhat complicated way that the federal estate tax is calculated. One reason this calculation is complicated is that the $5 million estate and gift tax exemption is really a "shorthand" way of referring to the amount that one can transfer taxfree by reason of something known in the law as the "applicable credit amount." Under the TRA, the applicable credit amount is $1,730,800, which equals the tax on a transfer of $5 million. 1 (If the TRA sunsets, the applicable credit amount will decrease to $345,800, which is the tax on a transfer of $1 million.) The second reason the calculation is complicated is that it is designed (1) to tax the estate at the highest estate tax brackets under the estate tax rate table, taking into account lifetime gifts; and (2) to account for the applicable credit amount that a decedent has already "used up" on lifetime gifts. This is accomplished under a three-step process: (1) A "tentative tax" is calculated on the sum of the decedent's estate and lifetime gifts. (2) The gift tax that would have been payable on the lifetime gifts (using the rate table in effect at the decedent's death) is subtracted from the tentative tax computed in step 1. Importantly, in determining how much gift tax would have been payable, the available applicable credit amount at the time of the gifts must be used. (3) The full applicable credit amount at the individual's death is subtracted from the amount computed in step 2. Here's an example: Assume that an individual with $15 million makes a lifetime gift of $5 million in 2011 and dies later that year. The gift is completely sheltered under the gift tax exemption and no gift tax is due. The following is the estate tax computation: Tentative tax on sum of. estate ($10,000,000) and (Step 1) Less applicable credit amount at time of gift (Step 2) (Step 3) $1,730,800 $5,230,800 $1,730,800 $0 $1,730,800 Estate tax $3,500,000 What is important to note is that if the decedent had not made the gift, the estate tax would have been exactly the same: $3,500,000. The decedent would have had an estate of $15 million, and the estate tax on a $15 million estate is $3,500,000. The reason there is no difference is that -- as the example illustrates -- lifetime gifts are considered in computing estate taxes. Put another way, the decedent "used up" his $5 million exemption on the lifetime gift. As a result, it was not available to reduce estate taxes at his death. The main point: A lifetime gift that uses exemption does not in and of itself -- reduce estate taxes. So why make lifetime gifts? The primary reason is that, although a lifetime gift is considered in the computation of estate taxes, any future growth of the gifted assets is not. 1 This figure ignores (1) any adjustment to the applicable credit amount beginning in 2012 as a result of inflation and (2) any potential increase in the applicable credit amount as a result of the unused exclusion amount of a deceased spouse. Private Wealth Management Trust & Estate Insights 2
3 Consequently, all income and appreciation on the gifted assets is removed from the donor's estate and escapes estate taxes at the donor's death. 2 This can save a substantial amount of tax. For example, assume again that an individual with $15 million makes a lifetime gift of $5 million in In this example, however, he survives for an additional twenty years. During that period, both the gifted assets and his remaining assets appreciate at a rate of 6% annually. At his death, his estate would be worth approximately $32 million, and the gifted assets would be worth approximately $16 million. The following is the estate tax computation (assuming no sunset of the TRA): Tentative tax on sum of estate ($32,000,000) and Less applicable credit amount at time of gift $1,730,800 $12,930,800 $1,730,800 $0 $1,730,800 3 Estate tax $11,200,000 If the decedent had not made the gift, his estate would have been worth $48 million (i.e., $32 million estate plus $16 million gifted assets), and the estate tax would have been $15,050,000. Accordingly, the gift saved $3,850,000 in taxes, (i.e., 35% of the growth of the gifted assets). 4 Estate Tax "Recapture" Although the benefits of lifetime giving can be substantial, there is some uncertainty over what will happen to an individual who has made a substantial gift if the TRA sunsets and the gift and estate tax exemption decreases. Absent additional legislation or administrative action by the IRS, the answer is that there would be a "recapture" of the benefits of the higher exemption under the TRA at the individual's death. (There would not, however, be any retroactively imposed gift taxes.) Put another way, an individual would receive only the benefit of the exemption applicable at his death. For example, assume an individual with $15,000,000 makes a gift of $5,000,000 in 2011 and dies after sunset in 2013 (when the exemption is only $1,000,000 and the top rate is 55%). The gift is completely sheltered under the gift tax exemption and no gift tax is due. The following is the estate tax computation: 5 Tentative tax on sum of estate ($10,000,000) and Less applicable credit amount at time of gift (assuming $5,000,000 applicable exclusion amount and 55% table) $2,390,800 $7,890,800 $2,390,800 $0 $345,800 Estate tax $7,545,000 2 Other ways in which lifetime gifts can reduce estate taxes include the following: (1) gifts of certain types of assets (e.g., minority interests in a closely held business) may be subject to "valuation discounts" for gift tax purposes, using less exemption than if the whole business was transferred at death; (2) gifts may reduce state estate or inheritance taxes, even if the gifted property does not increase in value after the gift; and (3) the gift may be made to a "grantor trust," which is a trust all of the income of which is taxed to the grantor; the grantor's payment of this income tax reduces his estate (and allows the trust assets to grow income taxfree). Although beyond the scope of this article, a donor should also bear in mind that the first $13,000 (indexed for inflation) of annual gifts to a donee qualify for the gift tax "annual exclusion" and, therefore, do not use up any gift tax exemption. Accordingly, an annual exclusion gift removes from the donor's estate not only the future growth of the gifted assets, but also the assets themselves. 3 Ignores any indexing for inflation. 4 Of course, the opposite is also true: If the gifted assets had decreased in value, and that decrease otherwise would have occurred in the donor's estate, the estate taxes payable at the donor's death would have been lower if he had not made the gift. 5 For the sake of simplicity, all remaining examples (1) ignore the 5% "surtax" that would apply when the sum of the estate and lifetime gifts exceeds $10 million if the TRA sunsets, and (2) assume no change in the value of any assets between the date of the gift and the date of death. Private Wealth Management Trust & Estate Insights 3
4 . The estate tax is $7,545,000. If the gift had not been made, the estate would have been $15 million, and the estate tax would have been the same $7,545,000. Accordingly, making the gift did not cost any additional tax. The estate tax on just the $10 million estate would have been $4,795,000. Therefore, there is $2,750,000 of tax attributable to the $5 million gift (i.e., $5,000,000 x 55%). This is the "recapture." Notably, some planners believe that if the exemption decreases in the future (e.g., because the TRA sunsets), there will likely be legislation or administrative action eliminating any "recapture." If so, it will be extremely valuable to take advantage of the temporary increase in the exemption. For example, assume an individual with $15,000,000 makes a gift of $5,000,000 in 2011 and dies after "sunset" in 2013 (when the exemption is only $1,000,000 and the top rate is 55%). The gift is completely sheltered under the gift tax exemption and no gift tax is due. The following is the estate tax computation if there is no "recapture": Tentative tax on sum of estate ($10,000,000) and lifetime gift ($5,000,000) Less applicable credit amount at time of gift (assuming $1,000,000 applicable exclusion amount and 55% table) $2,390,800 $7,890,800 $345,800 $2,045,000 $345,800 Estate tax $5,500,000 The estate tax is only $5,500,000. If the gift had not been made, the estate would have been $15 million, and the estate tax would have been $7,545,000. Making the gift saved $2,045,000 of estate tax. This is because the gift completely removed $4 million from the estate tax calculation. 6 Possible Additional Complications As noted above, even if a gift is subject to "recapture" because the TRA sunsets, it generally leaves an individual's estate in no worse a position that if he had not made the gift. Moreover, it can achieve the significant benefits of making a lifetime gift, including removing the income and appreciation on the gifted assets from the estate. In many circumstances, therefore, making a gift could be a free shot: a big potential win if there is no "recapture," and no harm done if there is "recapture." But In certain cases, "recapture" could result in significant consequences that the donor does not intend. For example, assume that an individual with $15 million makes a gift of $5 million in 2011 to a trust for his children, and dies after "sunset" in 2013 (when the applicable exclusion amount is only $1 million and the top rate is 55%). The gift is completely sheltered under the gift tax exemption and no gift tax is due. He leaves his entire remaining $10 million estate outright to his wife. Because of "recapture," some of that $10 million must be used to pay the estate tax attributable to the lifetime gift. As a result, the entire $10 million cannot qualify for the marital deduction. This results in estate tax, which further reduces the marital deduction (because it does not pass to his wife), which further increases the estate tax, and so on. This is known in estate tax jargon as an "interrelated" or "circular" computation. 6 As the example illustrates, this is technically accomplished by computing the gift taxes that would have been payable on the gift using the exemption available at the individual's death (i.e., $1 million), rather than at the time of the gift (i.e., $5 million), and subtracting the gift tax that would have been payable (i.e. $2,045,000) from the tentative estate tax. Private Wealth Management Trust & Estate Insights 4
5 Tentative tax on taxable estate ($4,566,666) and. The taxable estate is $4,566,666 because that is the estate tax payable from the $10,000,000 passing to wife that cannot qualify for the estate tax marital deduction. Less applicable credit amount at time of gift (assuming $5,000,000 applicable exclusion amount and 55% table) $2,390,800 $4,902,466 $2,390,800 $0 $345,800 Estate tax $4,566,666 In this case, even though the individual leaves his entire estate outright to his wife, there is still $4,566,666 of estate tax payable at his death. The wife is left with only $5,433,334. (The estate tax at her death would be $2,283,334, and the total tax over both estates would be $6,850,000.) Assuming instead (1) that the individual had given the $5 million to a trust for his children at his death and the balance of his estate to his wife, and (2) that the estate tax was paid out of the gift to his children, the estate tax would have been only $2,045,000. As a result, there would have been $2,521,666 less estate tax, and the wife would have received the full $10 million, though the trust for the children would have received the somewhat lesser amount of $2,955,000. (The estate tax at the wife's death would be $4,795,000. Therefore, the total tax over both estates would be virtually the same as in the prior example: $6,840,000). 7 Conclusion Making lifetime gifts is one of the best ways to minimize estate taxes. An important reason is that the gift removes all of the future income and appreciation on the gifted assets from the donor's estate. The increase in the gift tax exemption under the TRA to $5 million presents wealthy individuals with a tremendous opportunity to make significant lifetime gifts. Unfortunately, under current law, the TRA sunsets at the end of next year, and the exemption reverts to $1 million. In most cases, it makes sense to consider taking advantage of the increased exemption before the TRA expires because a sunset will generally leave the donor's estate in no worse a position than if the gift had not been made (and may leave it in a substantially better position). However, it has the potential in some cases to result in significant unintended consequences. Accordingly, one should always consult with a tax or legal advisor in advance of making any substantial gifts. UBS Private Wealth Management Senior Wealth Strategists Ann Bjerke, Director Jeff Brooks, Director Joyce Crivellari, Director Jeffrey Gaccione, Director David Weinreb, Director Erin Wilms, Director 7 Of course, the individual could also have decided to give only $1million to his children at death and the remaining $14 million to his wife. This would eliminate all federal estate tax at his death, but would result in $6,995,000 of tax at his wife's death. Consequently, the total tax over both estates would be about $145,000 greater. UBS Financial Services Inc. does not provide legal or tax advice. Any discussion of tax matters contained herein is not intended to be used, and cannot be used or relied upon, by any taxpayer for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or tax-related matter(s). Private Wealth Management Trust & Estate Insights 4
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