What tax loopholes should our wealthier clients take advantage of the next two years thanks to the Tax Relief Unemployment Insurance Reauthorization and Job Creation Act (2010 Act) signed into law Dec. 17, 2010? If they simply wait until the end of next year, unprecedented estate and business benefits may be lost only to be replaced by steeper estate and gift taxes.
So, what should they do now before being confronted by higher taxes? In short, they should consider shifting wealth to their heirs. Yes, gift certain assets to take advantage of the two-year tax loopholes of this 2010 Act. The most advantageous areas of gifting are now with real estate, business assets and whole, universal and variable life insurance policies with high cash values.
Real Estate
Prior to the 2010 Act you could not gift more than $1 million during your lifetime. Pursuant to present law, the gift exemption returns to $1 million again in year 2013 and there may be much political and economic pressure to keep the gift exemption at that $1 million level.
But, for this and next year that figure has jumped to $5 million. At the same time, values of real estate and family-owned businesses are now at or near all-time lows. What does this mean — in plain language? It means that for this year and next year only, clients can put more of their residential, non-rental real estate (second homes) into trusts (called QPRTs) while the real estate values are low and the gifting threshold is high.
Properly drafted, the transfer will not diminish their use of the home transferred to the trust. The reason to make the transfer into a trust is to eliminate its present value — and appreciation — from their estate to avoid estate taxes. This move could avoid likely estate taxes of anywhere from 35 percent to 60 percent, depending upon the estate tax rates Congress will likely alter at the end of next year. If Congress does nothing, the estate and gift tax rates will increase up to 55 percent (with an added 5 percent to the estate tax rate for estate values over $10,000,000).
Businesses
Likewise, it is a perfect time for clients to finally make the move to form and implement a thorough review of their business’s succession plan and to gift closely-held business interests to the next generation(s) of family members. Values are low, interest rates that determine the “gift” amount of the transferred interest are low and the gift threshold is temporarily high. Thus, they now can transfer more business interests, and thus more taxable wealth, to other family members to avoid estate taxes. Properly drafted, the transfer will not diminish their control over the business.
Besides gifting business interests to family members, the review of their business plan should include a look at buy-sell provisions and their valuation formulas in case of their or a co-owner’s departure from the business, either voluntarily, by death or disability. It is also a good opportunity to integrate business assets into their estate plan using family generational (or dynasty) trusts.
Recently, President Barack Obama has indicated his desire to cap the term of any dynasty trust to 90 years. Before Congress imposes a cap in a dynasty trust’s term and while the gift threshold is temporarily high, clients may put more assets into such trusts for the benefit of their descendants and si-multaneously further reduce their taxable estate. In addition, the trusts will provide asset protection for their descendants, and depending upon the jurisdiction of the trust, the client too.
Remember, business entities must adhere to the statutory mandates of operating a business – proper records, timely meetings and their minutes, etc. All of these matters should be reviewed as part of an estate and business review with the goal to lower taxes, provide a smooth transition of management/ownership and protect assets. Consider a couple, both age 65, with a taxable estate. They own their own business and a second home in Florida worth $1 million. Presently, they each own 50 percent of their business estimated to be valued at $5 million. They have two adult children. How can they avoid or limit estate taxes?
Real Estate Example
1) A February, 2011 transfer of the $1 mil- lion Florida home into a trust (QPRT) yields the following:
Value of gift, which is subtracted from the $5 million gift threshold $241,320
Value that passes outside of their estate with no gift tax consequences: $758,680
Appreciation also avoiding estate taxes assuming a 5 percent growth over 20 years: $1,653,298
Tax savings – assuming death at age 85 (after 20 years) and a 35 percent estate tax: $844,192
Tax savings – assuming death at age 85 (after 20 years) and a 55 percent estate tax: $1,326.588
Gift of Business Example
2) They could also shift some of their business interest to their children.
A gift of 10 percent of the business stock to each child would be worth $500,000 each. However, under present law, one could apply a discount to that value for lack of marketability by about 25 percent, and lack of control for another 25 percent, thus reducing the taxable value of the gift further to $250,000 to each child. This gifted value is removed from the parents’ gross taxable estate upon death.
Remember, this includes 10 percent of the appreciated value of the business over the next 20 years too. Also, consider that Congress now must have revenue off sets with every enacted tax savings provision, so discounts for lack of marketability and lack of control — perceived “loopholes” — may become old law come the end of next year.
People who have had their estate and business estate planning intentions limited by the previous $1 million gift tax exemption, definitely should consult their estate planning attorney to consider gifting this and next year before these benefits become lost opportunities. People with real estate, business interests and multi-generational gifting desires will benefit the most.
Life Insurance Trusts After the Indiana appeals court decision In Re Stuart Cochran Irrevocable Trust, trustees of a life insurance trust (ILIT) have clear notice of their fiduciary responsibilities in managing trust assets even if it is only the life insurance policy on the maker’s life. After this first-of-its-kind case, trust beneficiaries may now be able to sue trustees for failing to employ a “prudent process” in managing the trust assets.
Too many of us do not consider our life insurance policy after purchasing it. How- ever, life insurance is an asset class like any other in a client’s portfolio that needs to be reviewed and monitored. Substantial premiums may be preserved as a result.
Having policies reviewed by an outside, independent entity, that has no financial stake in the review process may be the best means to prevent a court decision that a trustee did not fully and adequately manage and protect trust assets. A trustee’s duty to manage trust assets includes determining if an existing life insurance policy should be exchanged for a new policy that minimizes costs and maximizes benefits.
For example, one of our clients recently engaged a life insurance advisory firm that does not make in-house determinations of suitability (as oft en is the case with many agents/brokers), but instead buys independent pricing and performance research reports from theinsuranceadvisor.com. One of the holdings in this client’s portfolio was a $30,000,000 policy from an A++ rated in- surer. We asked local agents of this advisory firm, Steven Zeiger and David Buckwald, who both subscribe to a “prudent process” that includes suitability determinations from this outside, independent entity and who had no financial stake in the review process, to help our client understand these pricing and performance research reports. Based on the independent research from theinsuranceadvisor.com, the agents helped our client understand for the first time what he was actually being charged relative to both industry average pricing and best-available rates and terms. Because the original selling agent who placed this policy provided the client with only an illustration of hypothetical policy performance, thus a comingling of actual policy charges and assumed investment performance, the client was oblivious to being overcharged by almost 40 percent.
As a result of this review, our client not only understood the true costs of his old policy but learned that he could exchange his old policy for a new one with either $12 million of additional coverage for the same premium, or reduce his premium by over $100,000 for the same coverage.
With mortality tables and interest rates recently modified and the message of Cochran, it is critical for our clients to have their life insurance policies reviewed to compare their existing policies and their costs, with like policies and their costs across the entire industry. The tax advantages discussed in this article are probable targets for congressional change/elimination, which Congress does not have to wait until the end of next year to implement. Even without congressional action, the gift and estate tax exemptions automatically decrease back to $1 million in the year 2013. Thus the prudent course is to advise clients to take action now to investigate estate and business options that may soon disappear.