The U.S. gift-tax gift: a $5 million exclusion

NEW YORK Mon Feb 28, 2011 12:43pm EST

An employee poses with a 24.78 carat Fancy Intense Pink diamond at Sotheby's in London October 25, 2010. REUTERS/Luke MacGregor

An employee poses with a 24.78 carat Fancy Intense Pink diamond at Sotheby's in London October 25, 2010.

Credit: Reuters/Luke MacGregor

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NEW YORK Feb 28 (Reuters Tax & Accounting) - The big news for estate planners in the U.S. tax legislation passed last year isn't the $5 million estate-tax exemption -- though that number is far higher than expected -- it's the $5 million lifetime gift-tax exclusion. That is so much higher than it has been historically, and provides so many opportunities for estate planning for the ultra-rich, that planners for high-net-worth clients are salivating.

"I don't think anybody in Congress realized this," said Michael Gooen, a tax and estate attorney at Lowenstein Sandler. The point is that not only will the $5 million estate-tax exemption ($10 million for a couple) remove the vast majority of formerly taxable estates from the estate tax, but rather that the higher gift-tax exclusion means that people with far larger estates than that -- think $50 million, $100 million, and up -- have the ability to shift assets out of their estates tax-free while they're alive. "You are going to see a flurry of estate planning," Gooen said.

To understand what a big deal these new rules are, go back to the history of the estate and gift tax. The estate-tax exemption had been steadily rising since the Bush tax cuts went into effect, from $675,000 in 2001 to $3.5 million in 2009; after the oddity of no estate tax in 2010, the tax was due to return with an exemption of $1 million in 2011. The gift-tax exclusion, meanwhile, went from $675,000 in 2001 to $1 million in 2002, and had stayed at that level ever since. In both cases, the maximum tax rates levied on amounts above those figures had dropped from 55 percent to 45 percent in 2009. The gift tax fell further, to 35 percent, in 2010. For 2011 and 2012, the estate tax and gift tax have the same exclusions and rates: $5 million and 35 percent. That means wealthy people, who might face the estate tax in 20 or 30 years, or more, can get vast assets -- and, more importantly, the appreciation on those assets -- out of their estates while they are alive.

"We've started calling it the Christmas miracle. It is unprecedented, and the opportunities that we have for people are spectacular," said Andrew Katzenstein, a partner in the personal planning department at Proskauer in Los Angeles. "It takes everybody closer to estate-tax repeal without using the word 'repeal'."

Consider a few ways this would work:

HOW IT WORKS

One: A wealthy person can now pass down millions of dollars before those assets have appreciated, one of the biggest goals of estate planning. "You can now create a $10 million dynasty trust just by writing a check," Gooen said. "All that appreciation is now locked up in a trust, and you will never pay estate tax or gift tax on it."

The exclusion for the generation-skipping tax -- levied on assets passed down to grandchildren, great-grandchildren and the like -- has also been set at $5 million for 2011 and 2012. That gives a wealthy family even more opportunities for extremely long-term planning. As Katzenstein said: "If my kids are going to live another 40 years, you tell me what $5 million is going to grow to in 40 years? You get a lot of leverage."

Two: It lets you game the federal income-tax rates -- and may let you do the same thing with state tax rates. When the estate-tax exemption was higher than the lifetime gift-tax exclusion -- as it was in 2009, at $3.5 million compared with $1 million, it forestalled parents from giving large income-producing assets to their kids during their lifetimes in order to shift those assets to a lower tax bracket. The new, looser, rules let you do just that. "The ability to income-shift is back," Katzenstein said.

Similarly, the larger lifetime gift exclusion may let the wealthy arbitrage state tax rates with their children. Say, for example, someone with a $10 million estate lives in California, and pays federal tax and state tax at the highest levels. If that person can give some income-producing assets to their lower-tax-bracket kids in Nevada, where there is no income tax, they get a double benefit.

Three: The new rules let wealthy families wrap up estate planning that was previously done with low-interest, intra-family loans at rates set by the Internal Revenue Service. Rates for those loans hit historic lows in December, but have risen somewhat since. For March, they are 0.54 percent for short-term loans (three years or less) and 4.30 percent for long-term loans (10 years or more). But, even with low rates, simply getting the loans off the books can be even better. "We can forgive many of these loans," said Katzenstein, who noted that he has clients that have loaned their kids $1 million to buy a house. "Husbands and wives can forgive $10 million worth of loans with no tax. All these loans that were required to be paid back can now be wiped off the books."

Other planning techniques, such as the oddly named intentionally defective grantor trust, also stand to gain from the higher gift-tax exclusion. In the case of such trusts, which typically rely on loans to transfer gains tax-free, large amounts of existing loans could be wiped out and these techniques could also be used to transfer far larger amounts in the future. Again, it's all about the leverage.

OPPORTUNITY TO CHOOSE POORLY

The caveat to all this, of course, is that even with the smaller lifetime exclusion amount, some estate-planning techniques sounded better at the time than they proved to be in retrospect. Bill Fleming, a managing director in the personal financial services division of PricewaterhouseCoopers, points to gifts of high-tech stocks that subsequently cratered or qualified personal residence trusts (or QPRTs) set up during the real estate bubble. Since part of estate planning requires figuring out which assets are more likely to go up, and which to go down, a larger gifting exemption could simply bring with it more opportunities for choosing poorly. As Fleming said: "Let's not fritter it away like we did with the million-dollar exemption."

Practitioners were surprised that the gift tax exemption rose so substantially as part of the year-end compromise. But the rules put in effect for both the estate and gift tax mirrored those proposed in a tax bill by Senate Minority Leader Mitch McConnell of Kentucky in September. In the swirling array of congressional estate-tax proposals over the past few years, that bill had itself borrowed heavily from a proposal co-sponsored by Sen. Jon Kyl of Arizona. Kyl and fellow Republican Rep. Dave Camp of Michigan represented congressional Republicans in the year-end tax discussions.

Before a bipartisan compromise was reached, the Obama administration had called for a $3.5 million estate-tax exemption, a top estate-tax rate of 45 percent, and no change to the $1 million gift-tax exemption.

Like other pieces of the tax deal the president reached with Congress in December, the estate- and gift-tax provisions are in effect for two years, opening a window to a flurry of activity. What happens after 2012 remains anyone's guess.

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