"This is the eighth 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 prior articles, see below.

The Revenue Reconciliation Act of 1990 curtailed various types of estate planning transactions that had been very effective during the 1980s. While curtailing these other types of transactions, the 1990 Act created two primary types of transactions that could be used to reduce estate taxes. These were grantor retained annuity trusts (GRATs) and Qualified Personal Residence Trusts (QPRTs).

QPRTs are relatively painless and very effective at reducing the value of your estate that will be subject to estate taxes. We have created dozens of these trusts for second homes located in other states. However, in 22 years, we have set up less than 20 of these for Tennessee residences. The reason is that our clients would have had to pay Tennessee gift tax in order to put their Tennessee homes into QPRTs. The recent elimination of Tennessee gift taxes now makes QPRTs for Tennessee residences very viable. Since May, several of our clients have established QPRTs or plan to establish them during the next seven weeks to take advantage of their $5.12 million of gift tax exemption in 2012. We expect to help our clients to establish more Tennessee QPRTs during 2012 than we established in the prior 22 years. For clients who have sufficient other assets that are gifting candidates, a QPRT may not be the most effective gift.

Part 1: Use It or Lose It

Part 2: Can You Afford to Make a Large Gift?

Part 3: When Should You Make the Gift?

Part 4: Will a Large Gift Demotivate Your Children?

Part 5: Tennessee Gift Tax Clawback

Part 6: Tennessee Gift Tax Clawback Solutions

Part 7: Life Insurance Can Pay Tennessee Gift Tax Clawback

This is the seventh 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 prior articles, see below.

Two prior articles discussed the Tennessee Gift Tax clawback issue. Last week, I met with a couple to establish a trust for their children. They plan to make a gift of $10.2 million to the trust later this summer. We discussed the Tennessee clawback issue and the potential solutions. The wife is seven years younger than the husband and does not have any major health issues. She will be making the entire gift. Even though this decreases the chances of the gift tax clawback from applying, there is still a chance that the wife could get run over by the proverbial beer truck.

We discussed the possibility of including a contingent marital trust that would make the husband a beneficiary of the trust if the wife dies within three years after making the gift. Since a primary purpose of the trust is to provide an asset base and income for their children, they did not like the option of the contingent marital trust.

We came up with a different solution. The trust will purchase a term life insurance policy on the wife’s life that can be dropped after three years. When the wife makes a gift to the trust, she will require the trustee to assume liability for any Tennessee inheritance taxes that are eventually imposed on the gift. If the wife dies within three years, the trust will collect life insurance and will be able to pay the additional Tennessee inheritance taxes.

          Part 1: Use It or Lose It

          Part 2: Can You Afford to Make a Large Gift?

          Part 3: When Should You Make the Gift?

          Part 4: Will a Large Gift Demotivate Your Children?

          Part 5: Tennessee Gift Tax Clawback

          Part 6: Tennessee Gift Tax Clawback Solutions

This is the sixth 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 prior articles, see below.

The last article explained a potential Tennessee inheritance tax problem if the donor dies within three years after making a large gift. The gift will be added back to your taxable estate for Tennessee inheritance tax purposes. This means that even though you paid no Tennessee gift tax on the gift, you will have to pay Tennessee inheritance taxes on the gift. The problem is most expensive if the donor dies before 2015.

We have come up with two potential solutions for married couples to avoid the tax. First, the healthier spouse can make the gift. If the healthier spouse makes the gift, you reduce the odds that the donor will die within three years. Assume that the healthier spouse makes a gift of $10,240,000 to a trust for your children. For federal gift tax purposes, you can elect gift-splitting and treat the gift as if it was made equally by the two spouses. If the less healthy spouse dies within three years, no portion of the gift will be added to their Tennessee inheritance tax base. On the other hand, if the healthier spouse dies within three years, he or she will have to add back $10,240,000 to his or her taxable estate for Tennessee inheritance tax purposes. This solution is not useful if the plan is for the healthier spouse to be a beneficiary of the trust (which we generally recommend). As a general rule, it will create federal estate tax problems upon the death of a donor if the donor makes a gift to a trust of which the donor is a beneficiary. A future article will explore an important exception to this problem.

The second solution for avoiding the Tennessee gift tax clawback is to make the gift to a trust that provides for a contingent marital trust.  The clause operates as follows: It says that if the donor dies prior to 2016 and any portion of the trust is included in the donor’s estate for Tennessee inheritance tax purposes, then the portion of the trust that is included will be moved to a trust that qualifies for the Tennessee inheritance tax marital deduction. In general, this means that your spouse will be the only beneficiary of the trust during his or her lifetime and must be able to withdraw all of the income earned by the trust during his or her lifetime.

It is not necessary to move the entire trust to the contingent marital trust; you only need to move the portion that is necessary to eliminate Tennessee inheritance taxes.  One option is to give an independent trustee the option to decide how much will be added back to the marital trust. There are also various types of formulas that can be utilized.

In effect, the contingent marital trust allows you to avoid Tennessee taxes if the donor spouse lives at least three years or the surviving spouse lives at least until 2016. Even if the surviving spouse does not live until 2016, there is some benefit if the surviving spouse dies in a later year. This is because the Tennessee inheritance tax exemption increases each year between now and 2016.

We have used contingent marital trusts in irrevocable life insurance trusts for years.  The federal estate tax and the Tennessee inheritance tax both include life insurance in the estate if the policy was transferred to the ILIT within three years prior to death. The contingent marital trust allows you to avoid taxes upon the insured’s death within three years.

The downside of the contingent marital trust is that the children will no longer be beneficiaries of the trust for the remainder of the surviving spouse’s lifetime. 

In summary, there are two options that increase the likelihood that married couples will avoid the Tennessee gift tax clawback. One is for the healthy spouse to make the gift. The second is to include a contingent marital trust in the donee trust. Neither one of these techniques will work in all circumstances. Furthermore, many donors no longer have a spouse or are not willing to include the spouse in the gifting plan (for example, someone in a second marriage when each spouse has children from prior marriages).

Since there is some danger of the tax applying, the donor should consider asking the donee to agree to pay the tax if tax does, in fact, apply. In theory, the donee’s agreement to pay the tax reduces the value of the gift at the time it is made. The problem is that it is difficult to value the liability that the donee is assuming. There is a good chance that the IRS will challenge any reduction that you try to make in the value of the gift due to the potential liability that the donee is assuming. In any event, the agreement to pay taxes is very important when your residuary estate will be distributed to beneficiaries who are different than the donee of the gift. Your residuary beneficiaries may not appreciate paying the clawback tax on gifts made to other beneficiaries.

          Part 1: Use It or Lose It,

          Part 2: Can You Afford to Make a Large Gift?,

          Part 3: When Should You Make the Gift?,

          Part 4: Will a Large Gift Demotivate Your Children?, and

          Part 5: Tennessee Gift Tax Clawback

This is the fifth 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 prior articles, see:

          Part 1: Use It or Lose It,

          Part 2: Can You Afford to Make a Large Gift?,

          Part 3: When Should You Make the Gift?, and

          Part 4: Will a Large Gift Demotivate Your Children?

Two weeks ago, the Tennessee legislature decided to repeal Tennessee gift taxes, effective as January 1, 2012. They also agreed to phase out inheritance taxes over a four-year period. The combination of the total repeal of the gift tax and the phased out repeal of the inheritance tax creates an unintended consequence. Assume that a client makes a gift of $5,120,000 in 2012 and then dies in 2013 owning no assets. There would be no federal or Tennessee gift tax associated with the gift in 2012. There has been some uncertainty regarding the federal estate tax consequences. The majority of commentators assume that there will be no federal estate tax. Nevertheless, some believe that the IRS will try to assess estate taxes even though the estate has no assets. This danger of paying estate taxes based on a tax-free gift is referred to as “clawback”.

Tennessee definitely has a clawback problem. Unlike the federal statute, the Tennessee statute is very clear. When you die, you must add back to your estate gifts made within three years prior to death (other than gifts covered by the $13,000 annual exclusion). This means that the estate will have a phantom asset of $5,120,000 for Tennessee inheritance tax purposes. After subtracting the Tennessee inheritance tax exemption of $1,250,000 in 2013, the estate will owe Tennessee inheritance taxes on $3,870,000. The tax on this amount equals $356,000. Even though there was no tax on the gift when made and the person died with no assets, his or her estate will owe $356,000 of Tennessee inheritance tax.  

You are probably wondering who will pay the tax. There is legal concept called transferee liability that would make the donee of the gift liable for the tax if the estate cannot afford to pay it.

If the client is not married or does not intend to use the marital deduction, making the gift in 2012 will not increase their overall Tennessee taxes as compared to not having made the gift. However, if the client is married and plans to use the Tennessee inheritance tax marital deduction, the 2012 gift can result in a tax when there would not have otherwise been a tax if no gift had been made. If no gift had been made, the client could set aside $1,250,000 in a credit shelter trust, or give it directly to children. The remainder of the estate would pass to the spouse or to a marital trust. Under this no gift scenario, no Tennessee tax would be owed at the death of the first spouse. If the surviving spouse lives at least until 2016, no Tennessee tax would ever be owed. A method for couples to solve this potential problem will be discussed in the next article.

As a practical matter, the danger of owing a tax when you own nothing or plan to give everything to your spouse will dissipate if you survive at least until 2015. In 2015, the inheritance tax exemption will equal $5,000,000, which will almost totally cover a gift of $5.12 million in 2012. In 2016, the problem totally disappears because the Tennessee inheritance tax will be gone.  

The risk of incurring a Tennessee tax should be weighed against the potential reduction of federal transfer taxes by making a gift in 2012. As a general rule, we believe the potential federal tax benefits far outweigh the risk that you will incur some incremental Tennessee inheritance taxes.

In summary, if you make a large gift in 2012 and then die within three years, your estate may owe Tennessee inheritance taxes based on the gift. This danger should not stop you from making a gift that otherwise makes sense.

This is the fourth 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 three articles in the series, see:

          Part 1: Use It or Lose It,

          Part 2: Can You Afford to Make a Large Gift?, and

          Part 3: When Should You Make the Gift?

In addition to tax savings, gifts can provide a lot of positive benefits for the donees. For example, consider a child who is divorced and having to work two jobs to make ends meet. A gift might enable your child to give up the second job and spend more time with your grandchild.

Gifts also have potential downsides. A lot of our clients worry a great deal about the effect that a large inheritance will have on their children. They like the idea of their children being motivated to become productive members of society. They fear that their children may not reach their full potential if they do not have to work.

Heretofore, the primary time when this issue has been relevant was when our clients were planning their estates. Some clients create strict trusts in their Wills that match the child’s earnings from their work. Other clients choose to give most of their entire estate to charity, making only modest bequests to their children.

Our clients have not previously worried much about the effects of a large gift because federal and Tennessee gift taxes stopped them from making large gifts. However, the ability for a married couple to give $10.2 million without paying any federal or Tennessee gift taxes in the calendar year 2012 has caused our clients to focus on this issue.

If you are concerned that a large gift might negatively impact your children, you should make the gift to a trust and/or give noncontrolling interests in business entities. A trust helps in several regards. First, the trustee will be in control of investing the funds and making distributions. Second, Tennessee allows “secret” trusts. Your children do not have to know about the existence of the trust or the assets owned by the trust. You can designate a representative to receive any required notices concerning the trust. Third, if you are married, you should consider making your spouse the primary beneficiary of the trust. Your spouse can also be the trustee of the trust. Your children do not have to receive distributions from the trust. Fourth, your spouse or some other person can be given a power of disappointment that can be used to make changes to the trust in the future. For example, if one of your children “leaves the reservation”, that child could be disinherited as a beneficiary of the trust. Fifth, we generally recommend making the trust a grantor trust for income tax purposes. Even if your child receives a distribution from the trust, he or she will not receive a K-1 which might reveal information about the trust.

Another method for limiting the consequences of a gift is to give nonvoting stock, nonvoting interests in a limited liability company, or limited partnership interests. These assets are difficult to sell. Furthermore, the owners with voting control will determine the distribution policy of the company and the level of salaries paid to key officers. Your children may be rich on paper, but they will need to keep working if they want to put food on the table.  Incidentally, these types of assets typically receive valuation discounts of 35% or more due to illiquidity and lack of control.  The discount allows you to make a larger gift.

Making a large gift may lead to unintended consequences. You can minimize these consequences by giving particular types of assets or by making the gift to a properly designed trust.

This is the third 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 two articles in the series, see Part 1: Use It or Lose It and Part 2: Can You Afford to Make a Large Gift?

If you plan to make a gift this year, there are three competing factors you need to evaluate relative to the timing of your gift. First, the sooner you make the gift, the sooner the donee can receive income and appreciation from the gift. Second, Tennessee gift taxes may be repealed. If you make the gift now, you would be sorry if Tennessee gift taxes are repealed for gifts made later this year. Third, we don’t know for sure that the $5.12 million federal gift tax exemption will remain intact for the remainder of the year. Therefore, waiting for a potential change in the Tennessee gift tax laws or for other reasons carries some minor risk that the federal law will be changed before you make the gift. You may remember a rumor last year that caused some of our clients to make their gifts prior to November 23, 2011.

The benefit of making the gift sooner rather than later has been recognized by a couple whom I assisted with an $8 million gift last fall. They have received the 2011 Tennessee gift tax bill from their CPA. It is approximately $737,000. Ouch!

About the time they received their gift tax returns, my clients heard the rumor that Tennessee is considering a repeal of its gift taxes. They were somewhat disappointed that they had not considered delaying their gift, though no one had any idea that Tennessee might repeal its gift taxes during 2012 when my clients made their gifts. However, a closer analysis showed that the family will be considerably better off by having made the gift last fall even if Tennessee repeals its gift taxes. The gift constituted interests in an LLC that primarily owned marketable securities. Due to extraordinary returns in the stock market, the value of the gift has increased from $8 million to $9.2 million, or an increase of $1.2 million. If Tennessee repeals its gift taxes later this year and my clients had waited until that time to make an $8 million gift, the trust for their children would only have $8 million rather than $9.2 million. Especially since the trust is a grantor trust, the extra $1.2 million is likely to increase more between now and the time of death of my clients. If my clients had waited to make the gift, they would have received the $1.2 million of income and appreciation, and they would not have paid the $737,000 of gift taxes. Thus, their personal net worth would be $1,937,000 larger. If you assume a 40% death tax rate on this $1.9 million at the time of the death of the survivor of my client, the children will end up in about the same place. However, this does not take into account the additional earning power of the trust for the children having $9.2 million as compared to having $8 million. This could provide a substantial benefit between now and the time of death of the survivor. Even though my clients’ timing may have been too quick due to Tennessee gift taxes, it was just right from the point of view of appreciation. This was not an accident. My clients suspected that stocks might be poised for a rally when they pulled the trigger on their gift.

The current advice that we are giving is to wait and see if the Tennessee legislature makes a change to its gift tax laws. We expect to know the answer by the middle of May. Meanwhile, there does not appear to be any movement at the federal level to repeal this year’s large federal gift tax exemption. This advice changes for clients who are able to make gifts that do not require the payment of Tennessee gift taxes and for clients who have an asset that may appreciate rapidly in the next few weeks.

When it comes to making a large gift, timing is everything. If you are ready to make a large gift, you should be making preparations but should consider delaying the gift until the Tennessee legislature concludes its legislative session for this year.

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.

In the calendar year 2012, individuals can give away as much as $5,120,000 without paying federal gift taxes. This amount is reduced by taxable gifts that were made in prior years. The gift tax exemption will decrease to $1 million on January 1, 2013, unless Congress changes this law. President Obama favors the planned reduction to $1 million. 

If you fail to make a gift this year and the exemption reverts to $1 million as scheduled, there are 2 unfavorable consequences. First, you hamper your ability to help your children without paying federal gift taxes. Second, you may owe significantly more estate taxes upon your death or upon the subsequent death of your spouse.

During 2011 and for the first two months of 2012, we have been working with a number of our clients regarding this opportunity. The process involves much more than just writing a check. Among the issues that our clients are grappling with are the following:

  1. Can you afford to make the gift? Said differently, is there a chance that you will run out of money if you make the gift?
  2. Are you prepared to pay Tennessee gift taxes? There are several ways to make gifts without paying Tennessee gift taxes; however, these techniques are often impractical.
  3. What impact will the gift have on your children?
  4. What assets should be given?
  5. Are you willing to give up control of the assets you are transferring?
  6. Should you transfer “discounted” assets such as fractional interests in real estate or interests in corporations, LLCs, or limited partnerships?
  7. Should you make the gift to a trust rather than directly to the recipient? Most of our clients have decided to use a trust.
  8. If you use a trust, what are the provisions regarding trustees and distributions?
  9. If you use a trust, should you allocate generation-skipping transfer tax exemption to the trust? The answer is usually yes.
  10. How will the gift impact your overall estate plan?
  11. When should the gift be made?

Even though our clients have unique circumstances, we have seen patterns emerge as to how they have chosen to deal with these various issues. We will be publishing a series of articles that will hopefully help you to navigate these issues.