This is the fifth article of a series dealing with the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Act”). For the first four articles, see:
Part 1 – Charitable IRA Rollovers
Part 2 – Estate Tax/Carryover Basis Election for 2010 Decedents
Part 3 – Temporary $5 Million Estate Tax Exemption
Part 4 – Temporary $5 Million Gift Tax Exemption: Use It or Lose It
The Act temporarily increases the gift tax exemption to $5 million for 2011 and $5 million increased by inflation for 2012. The Act decreases the gift tax exemption to $1 million for gifts in 2013 or later. Our clients are actively considering methods to take advantage of this 2 year window of opportunity to make large tax-free gifts.
The first commandment of gift planning is to take care of yourself. This article will explain techniques for taking advantage of the gift tax exemption without decreasing your cash flow below your comfort zone.
Valuable assets that do not provide much cash flow are good candidates for gifting. Typical examples are stock of a family business that does not declare dividends and real estate that does not generate income.
Personal residences can also be gifted. A Qualified Personal Residence Trust is the favored technique for gifts of a personal residence.
If you are married, you should consider making gifts to a spousal access trust and maintaining a good relationship with their spouse. Spousal access trusts allow distributions to be made to your spouse. Assuming that you can persuade your spouse to use distributions for the joint benefit of the two of you, this gives you indirect access to the trust assets. The flaw with this plan is that your spouse could predecease you. You might hedge this risk by purchasing life insurance on your spouse. Also keep in mind that your expenses will decrease after your spouse dies.
Spouses sometimes ask whether they can set up spousal access trusts for each other. This is dangerous due to the reciprocal trust doctrine. Careful design of the trusts can minimize, though not totally eliminate this risk. Due to the potential estate tax risk associated with reciprocal trusts, I encourage other alternatives.
We generally recommend that gifts be made to “grantor” trusts so that the donor can pay income taxes on the income of the trust. We design these trusts with an escape hatch so that the donor can cease paying taxes if the taxes become too much of a burden. The most common power that we use to make the trust a grantor trust is a power of substitution that allows the donor to swap assets with the trust as long as the swap has equivalent value. Assume that you give a high income asset to a spousal access trust and your spouse predeceases you. You could use the power of substitution to swap low income assets such as undeveloped land for cash in the trust or for the income producing property.
We frequently recommend gifts of non-voting stock in a corporation, non-voting units of an LLC, or limited partnership interests in a limited partnership. Generally, the donor and/or spouse maintain voting control of the entity that is being gifted. By maintaining voting control, they determine who runs the company and a reasonable salary to be paid to the managers of the company. Assuming the donor still participates in management, the company can pay the donor a reasonable salary.
One of our favorite gifting techniques involves a gift combined with an installment sale to a grantor trust. The trust will have an obligation to make payments to your over time. Your continued access to cash flow through note payments makes it more feasible to give assets to the trust.
Another popular gifting technique is a grantor retained annuity trust. These trusts allow you to receive payments from the trust for a period of years.
To this point, I have discussed gifts of non income producing property and methods for obtaining access to cash flow from property gifted to a trust. Other techniques reduce expenses that you would otherwise have to pay, which has the same effect as if you had maintained access to the cash flow.
One type of gift that relieves an expense is a Charitable Lead Trust. Assume that you plan to give at least $50,000 per year to charity for the next 10 years. If you make a gift to a Charitable Lead Trust that pays $50,000 to charity for 10 years, this will reduce the funds that you would otherwise have to spend for the charitable donation. Charitable Lead Trusts represent a fantastic opportunity for leveraging your gift tax exemption, especially when the amount going to charity does not increase.
Another technique for reducing your expenses involves the “leapfrog” (also referred to as “decanting”) power under the Tennessee Uniform Trust Code. The leapfrog power allows a trustee of one trust to make distributions to another trust that benefits the same beneficiaries. Assume that you previously established a life insurance trust (“ILIT”) that requires premium payments of $30,000 per year. If you make a gift to another trust that benefits the same beneficiaries, the trustee could distribute income from the new trust to the ILIT to enable it to pay life insurance premiums. The donor cannot ensure this result because the donor must give up all control over the gift. However, trustees generally can be counted on to assist with an overall plan that helps the beneficiaries of the trust.
There are several methods of taking advantage of the $5 million federal gift tax exemption without decreasing your cash flow. You can give away non income producing property. Some techniques provide cash flow directly to you or your spouse. Others reduce your expenses.