Taking Advantage of the New Gift and Estate Tax Law

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1 product resource Taking Advantage of the New Gift and Estate Tax Law summary tra 2010 in brief Congressional debate about whether to extend tax cuts put into place during the Bush administration came to at least a temporary halt last year with the passage of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRA 2010). This legislation, which expires on December 31, 2012, enables you to make annual gifts of up to $13,000 a year ($26,000 for married couples) to each of your children, grandchildren or any other person you wish without incurring gift tax. In addition, the lifetime gift tax exemption has increased from $1 million to $5 million ($10 million for married couples). This means that you now have an unprecedented opportunity to remove assets from your estate through gifting strategies that can help reduce estate taxes and provide your loved ones with a more substantial legacy. Lifetime gift and estate tax exemptions are unified. That means you are eligible for a total exemption of $5 million, regardless of whether you apply it to your estate or use it to make tax-free gifts. For example, if you give $2 million to loved ones during your lifetime, at your death, the remaining $3 million can be applied to your estate. Lifetime gift tax exemption Estate tax exemption Lifetime Generation-Skipping Tax exemption Annual gift tax exclusion Maximum gift and estate tax rate 35% Portability Step-Up 2011 and 2012 $5 million $5 million $5 million $13,000 to each individual Any unused portion of your $5 million lifetime gift or estate tax exemption may be available for use by your surviving spouse, depending on his or her future marital status. Any unused portion of your $5 million generation-skipping tax exemption is not available to your surviving spouse. The cost basis of assets in your estate are stepped up to their value on the date of your death.

2 product resource / gifting strategies Why give assets away? C ertainly, giving assets to loved ones while you are alive can prove deeply satisfying, especially if those assets are used to pay for meaningful financial objectives like starting a business, purchasing a home or educating a grandchild. In addition, every gift you make removes assets from your estate and may help you achieve some of the following objectives: Reduce estate taxes: A married couple giving $26,000 annually to their three children over the next 30 years will have given away $2,340,000. At today s 35% estate tax rate, that represents a tax savings of $819,000. Transfer appreciation: If most of your assets are invested in stock or real estate, you may experience substantial appreciation over your lifetime. Assets of $5 million appreciating at a hypothetical rate of 5% annually, for example, would grow to over $13 million in 20 years. At today s 35% tax rate, your estate tax liability would be more than $4.5 million. By implementing gifting strategies, you can remove both assets, as well as potential appreciation, from your estate. Conceivably, you could freeze the value of your current estate and transfer potential appreciation to your heirs. Keep your estate intact: A large, unexpected estate tax bill can force family members to sell real estate or other valuable assets that they would rather keep. A well-conceived gifting strategy can provide the funds necessary to meet estate tax liability and keep your assets where they belong with your loved ones. Keep a family business thriving: The opportunity to gift stock or ownership interest in a closely-held family business is another gifting strategy that can remove substantial assets from your estate. The value of giving $13,000 annual gift tax exclusion x 35% maximum estate tax rate = Potential estate tax savings of $4,550 A $13,000 annual gift can provide: Number of recipients Total annual gift After 1 year After 10 years After 20 years 2 $26,000 $9,100 $91,000 $182,000 4 $52,000 $18,200 $182,000 $364,000 6 $78,000 $27,300 $273,000 $546,000 A $26,000 annual gift can provide: Number of recipients Potential Tax Savings Potential Tax Savings Total annual gift After 1 year After 10 years After 20 years 2 $52,000 $18,200 $182,000 $364,000 4 $104,000 $36,400 $364,000 $728,000 6 $156,000 $54,600 $546,000 $1,092,000 Hypothetical returns for illustrative purposes only. Not representative of any specific investment product. 2 morgan stanley smith barney 2011

3 Using trusts to secure your gift U nless you have a pressing reason for making an outright gift and/ or believe your recipient is capable of managing substantial assets proficiently, you might consider using trusts as part of your gifting strategy. Many people believe that with great wealth comes great responsibility. A young beneficiary with unlimited access to significant wealth may make questionable choices just because they lack the experience to make appropriate choices. As grantor or creator of a trust, you can establish the terms and conditions under which the assets you transfer to the trust may be invested. You may also determine how those assets will be distributed to the trust s beneficiaries. Finally, you can choose a trustee who is responsible for managing trust assets and determining if or when distribution of those assets is appropriate. Significantly, a trust can: Protect assets from the claims of a beneficiary s creditors, such as a plaintiff in a lawsuit, a business creditor or a spouse in a failed marriage Provide for family members who may lack the maturity, judgment or financial expertise to manage substantial assets on their own Ensure that your assets are distributed and used according to your wishes A grantor may use trusts to reinforce his or her value system by influencing beneficiaries to behave in a certain manner. Making a conditional gift through incentive trusts You dearly love your children or other potential gift recipients, but you have concerns about how they might receive and manage the assets you have accumulated. By establishing a trust with specific conditions for distribution of assets, you can provide incentives to beneficiaries and reward their achievements. These incentives can be critically important in protecting and preserving your assets. For example, your trust may direct its trustee to: Provide beneficiaries with only as much interest and principal as they earn from gainful employment Reward beneficiaries for finishing college or graduate school Make distributions when a beneficiary enters a worthy profession that doesn t pay particularly well Provide seed capital that encourages beneficiaries to go into business and focus on projects deemed acceptable by the trustee morgan stanley smith barney

4 product resource / gifting strategies Maximizing your gift through life insurance C learly, you can gift stock, real estate and other assets to implement your gifting strategy, but for many affluent individuals, life insurance is a preferable choice. Unlike assets that can fluctuate in value, many life insurance policies enable you to leave your beneficiaries a specified amount of money. What s more, that amount will likely be considerably more than the premiums you pay to maintain your policy. In addition, the death benefit offered by life insurance is income tax-free. However, the death benefit is not estate tax-free. Your policies are part of your estate and subject to the same maximum 35% rate as the rest of your assets. As a result, you may choose to: Transfer ownership of any life insurance policies you own to an Irrevocable Life Insurance Trust (ILIT), with the understanding that you must survive the transfer by at least three years or the policy will remain part of your estate Purchase a new policy but name the ILIT as owner and beneficiary Both strategies enable you to remove the value of the policy from your estate but continue to retain control over how the proceeds of the policy are distributed and perhaps even used. how ilits work: The policy insures your life or the lives of you and your spouse but is owned by the ILIT. The ILIT serves as beneficiary. By using your annual gift tax exclusion or lifetime gift tax exemption to gift assets tax-free to the ILIT, the ILIT then purchases life insurance on your life and uses your gifts to pay the premiums. At your death, the policy s death benefit passes to the ILIT free of estate and income taxes. ILITs in Action Imagine your estate is $12 million, including a $2 million life insurance policy. If you own the policy, look what happens to your estate: Now imagine your $2 million life insurance policy is not owned by you, but rather by a trust that you established for the benefit of your loved ones. Because you no longer own the policy, here s what happens: Value of estate $12 million Value of estate $12 million Estate tax exemption ($5 million) Life Insurance Policy ($2 million) Taxable estate $7 million Value of estate without life insurance policy $10 million Tax rate 35% Estate tax exemption ($5 million) Estate tax due $2.45 million Taxable estate $5 million Tax rate 35% Estate tax due $1.75 million 4 morgan stanley smith barney 2011

5 Combining life insurance and trusts s our ILIT example illustrates, the A combination of life insurance and trusts can help minimize your taxes and maximize your gifts. Depending on your specific needs, you may find one or more of the following strategies to be worth your consideration: You want the flexibility to access your life insurance policy s cash value on occasion. You can create a trust commonly known as a Spousal Lifetime Access Trust (SLAT). With a SLAT, you can: Maintain a life insurance policy outside your estate Provide your spouse with access to withdrawals or loans from the policy when required Like an ILIT, a SLAT is irrevocable. You use your annual gift tax exclusion or lifetime gift tax exemption to gift assets to the SLAT that are owned solely by you. Your trustee uses the assets to purchase a life insurance policy on your life. The SLAT, however, is the owner and beneficiary of the policy, while the loved ones of your choice are the trust s beneficiaries. During your lifetime, the trustee has the discretion to take loans and withdrawals from the policy s cash value. The trust may then make distributions to your non-insured spouse. Those gifts may be income tax-free under certain conditions. Consult your tax or legal advisor. Your children are already wealthy. You want to leave substantial assets to your grandchildren or future generations. In addition to gift and estate taxes, a third type of transfer tax is imposed on gifts to grandchildren and great grandchildren (and others who are significantly younger than the donor of the property). This additional tax is called the federal generation-skipping transfer (GST) tax. When people leave assets to their children, the transfer is generally subject to estate tax. When the children eventually die, the assets that they leave to their children are also subject to estate tax. By leaving assets directly to your grandchildren, you bypass one of these estate tax collections. As a result, the IRS imposes a GST tax at a flat 35%, in addition to the normal gift and estate tax. Thanks to the recent tax legislation, however, you have a lifetime generationskipping tax exemption of $5 million until December 31, That means you can give up to $5 million to grandchildren and other young recipients before that date without incurring either gift or generation-skipping tax. Rather than making an outright gift, you might consider establishing a Dynasty Trust and funding it with life insurance. As its name implies, a Dynasty Trust may be created to last for several generations, often years or more, depending on the laws of the state where it is domiciled. Dynasty Trusts enable you to remove substantial assets from your estate as well as the future estates of children, grandchildren and even great grandchildren. Moreover, they shelter assets, including appreciation and income generated by those assets, from estate and generation-skipping taxes. While Dynasty Trusts can be funded with a wide variety of assets, certain types of life insurance polices are a popular choice because their death benefit is neither subject to market fluctuations nor income tax. A Dynasty Trust operates similarly to the other trusts discussed earlier: You establish a Dynasty Trust to be both owner and beneficiary of a life insurance policy insuring either your life or the lives of both you and your spouse. You transfer cash or other assets to the trust, so the trustee can pay policy premiums. These transfers can be gift and generation-skipping tax free if you use your lifetime exemptions or annual gift tax exclusions. Generations of tax savings through Dynasty Trusts Assume you use your lifetime gift and generation-skipping tax exemption to make a $5 million gift to a Dynasty Trust. Also assume a hypothetical 5% annual rate of return. Now assume you do not establish a Dynasty Trust, but make a $5 million gift directly to your children. Also assume that the gift grows at 5% annually and that every 30 years, the gift transfers to the next generation, with a 35% estate tax applied. After 90 years, here s a comparison of the two strategies: Estate with Dynasty Trust: $403,651,825 Estate without Dynasty Trust: $170,547,221 Hypothetical returns for illustrative purposes only. Not representative of any specific investment product. morgan stanley smith barney

6 product resource / gifting strategies Beyond trusts and life insurance ere are a few more issues to consider H as you plan your gifting strategies over the next two years: You can pay medical expenses or tuition on behalf of another individual without incurring gift tax. That means you do not have to use your annual gift or lifetime exemption when making gifts for these purposes. You do have to pay health care providers and educational institutions directly. And in the case of health care institutions, you can pay for the following expenses without tax consequences: Diagnosis, care, mitigation, treatment and prevention of disease Transportation and lodging related to medical care Qualified long-term care services Some health insurance premiums In addition to life insurance, you can gift stock, real estate or other assets. In fact, you may wish to gift assets that have declined in value and have not yet bounced back to the price at which you acquired them. You can't take the losses for tax purposes, but you get to take advantage of today s higher gift and generation-skipping tax exemptions, while reducing your estate and transferring future appreciation to your heirs. your window is open... but not indefinitely. When the current tax legislation expires on December 31, 2012, Congress may keep exclusion and exemption limits where they are, raise them, lower them or eliminate them. The current gift and estate tax regulations, however, represent a major opportunity for you to reduce your estate and provide your loved ones with gifts that will make a difference in their lives. Your Morgan Stanley Smith Barney Financial Advisor will work closely with you and your attorney to develop and implement suitable gifting strategies. If you decide that life insurance should play an important role in your plan, you will find that your Financial Advisor has access to multiple products from a wide variety of respected insurers and can help you choose the ones that offer the optimal combination of cost and benefits. If your strategy includes the establishment of trusts, your Financial Advisor can arrange discussions with Personal Trust Services professionals to determine whether impartial corporate trusteeship and expert administration and investment management might help you realize your objectives. Your Financial Advisor is your link to the vast resources of Morgan Stanley Smith Barney. He or she can enlist the assistance of knowledgeable professionals in a wide variety of financial disciplines to review your specific situation and develop strategies best suited for you and your family. 6 morgan stanley smith barney 2011

7 Insurance products are offered in conjunction with Morgan Stanley Smith Barney's licensed insurance agency affiliate(s). Trust and fiduciary services are provided by Morgan Stanley Private Bank, National Association, Purchase, New York. Morgan Stanley Private Bank, National Association is an FDIC-insured national bank that is regulated by the Office of the Comptroller of the Currency. Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Smith Barney Financial Advisors do not provide tax or legal advice. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals are urged to consult their personal tax or legal advisors to understand the tax and legal consequences of any actions, including implementation of any estate planning strategies, or investments described herein. morgan stanley smith barney

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