This is the second article of a series designed to provide guidance for those individuals who are considering making a large gift in 2012 to take advantage of the $5.12 million federal gift tax exemption that will expire at the end of the year. For the first article in the series, see Part 1: Use It or Lose It.
Prior to 2011, clients seldom made gifts of several million dollars unless they were very wealthy. Due to the temporary expanded gift tax exemption, clients who are not so wealthy are considering gifts worth several million dollars. If you have $100 million, you might not miss the income that you will lose if you make a gift of $5 million. However, what if you have $20 million, or $8 million? The income you lose from a gift of $5 million might easily impact your lifestyle choices. Everyone has their breaking point.
Several of our clients who really cannot afford to lose the income from a gift have nevertheless made large gifts to take advantage of the temporary higher gift tax exemptions. In order for the gift to be prudent, our clients have taken several different approaches. One approach is to create more cash flow from another source prior to making a gift. Assume that you are 85 years old and you would like to have guaranteed cash flow of $200,000 per year. Also assume that your children, or a trust that you previously established for their benefit, are financially secure. You could transfer $1,157,000 of cash to your children or the trust in exchange for their obligation to pay you $200,000 per year for the remainder of your life. This transaction will not be considered a gift because the present value of the annuity payments that you are receiving equals the amount of property you are transferring to your children. After implementing the private annuity, you are then free to make a gift of other assets without worrying about losing the income from the assets that you gift.
Many of our clients have given away nonvoting interests in entities such as limited liability companies, limited partnerships, and corporations. By retaining voting control of these companies, our clients have the ability to pay themselves reasonable salaries for the services that they provide to the companies.
A very popular approach that our clients are using is to make a gift to a spousal access trust. There are two general types of spousal access trusts. One is a trust which includes your spouse and descendants as discretionary beneficiaries of the trust. Often the spouse serves as the trustee of the trust. Since your spouse has the ability to access income from the trust, you should be more comfortable about making gifts.
The other type of spousal access trust is a marital trust, which does not include your descendants as beneficiaries. As will be discussed in a later article, this trust can also be used to avoid the payment of Tennessee gift taxes on the trust.
The “flaw” with gifts to spousal access trusts is the danger that your spouse could predecease you. In that case, income from the trust will not be available for your benefit. Some of our clients have been willing to take the gamble that their spouse would not predecease them by a long period of time. Perhaps the donee spouse is younger and/or in better health than the donor spouse. Another factor to keep in mind is that your expenses will go down when one spouse dies because there is only one mouth to feed.
Another option when the donee spouse is young enough and healthy enough is to purchase life insurance on the life of the donee spouse. If the donee spouse dies too soon, the life insurance could provide a source of funds for the donor spouse.
Another hedging technique is to have each spouse make a gift to a spousal access trust for the other spouse. There is a tax concept known as the reciprocal trust doctrine, which requires careful planning if both spouses intend to establish spousal access trusts.
Another aspect of increasing your cash flow is to decrease your expenses. A lot of our clients have established grantor trusts that allow them to pay income taxes on income earned by the trust. This basically allows them to make tax-free gifts to their children. Generally, these grantor trusts have been designed to allow the grantor to discontinue paying income taxes in the future. When you have the opportunity to “turn off” a grantor trust, you need to factor this into your cash flow planning.
Another factor that affects your expenses is whether you will pay Tennessee gift taxes. Future articles will discuss various ways to make gifts without paying Tennessee gift taxes. When there is pressure on your cash flow, it might be preferable to make gifts in a manner that does not require you to pay Tennessee gift taxes. The Tennessee gift taxes “saved” can be used to shore up the income lost from the assets that you give away.
Before making a large gift, you need to be totally comfortable with your future access to cash flow.