New Tax Law Offers Unprecedented Planning Opportunities

Wealth managers can help clients take advantage of this short, but clear, tax-planning window

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On December 17, 2011, wealth managers received an early holiday present. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 was signed into law, providing the wealth management community with much-needed clarity. For years, advisors across the country were left to speculate about the uncertain direction of tax rates as January 1, 2011, crept closer. With 14 days to spare, President Obama signed a tax law that presents unprecedented opportunities for clients.

There’s just one hitch: The law’s provisions are set to expire on December 31, 2012, which means you have a relatively brief window of time to help your clients reap the potential tax benefits.

Highlights of the Tax Relief Act of 2010

Before delving into the tax planning opportunities the Tax Relief Act presents, let’s review some of its key provisions:

  • Extension of the Bush tax cuts (no change to marginal income-tax and capital-gains rates)
  • Reunification of the estate and gift taxes
  • $5 million exemption per individual for gift, estate, and generation-skipping transfer taxes
  • A top tax rate of 35 % for gifts, estates, and generation-skipping transfers above the $5 million exemption amount
  • Return of the step-up in tax basis for certain inherited assets
  • Portability of the $5 million estate exemption (opportunity to transfer an unused exemption to a surviving spouse)
  • For deaths occurring in 2010, an option to file the estate-tax return under the modified carryover basis law or the newly enacted law
  • For clients age 70½ and older, an extension of the qualified charitable distribution from IRAs up to $100,000
  • Continued repeal of the personal exemption phaseouts and limitations on itemized deductions

Planning opportunities

As you can see, 2011 and 2012 offer unique planning opportunities for clients who are concerned about reducing taxes on transfers of wealth to family members. Consider, for instance, that families whose net worth is less than $10 million will be given a reprieve, although possibly a temporary one, from estate taxes. Families whose net worth is expected to climb above the $10 million mark in the future can make significant tax-free gifts to reduce or “freeze” their estates at a level where estate tax is no longer a threat. When reviewing your clients’ financial and estate plans this year, be sure to consider whether any of the following tax planning strategies may be advantageous.

Gifts.Prior to 2011, the gift tax exemption was $1 million per individual. Now, under the Tax Relief Act’s $5 million lifetime gift tax exemption per individual, a married couple can make an outright transfer of assets with a total value of $10 million from their estate without incurring any gift tax. This provision enables wealthy clients to more easily and tax-efficiently fund trusts to enhance their estate plans. An irrevocable life insurance trust (ILIT), for example, can be a great way to take advantage of a client’s gift-tax exemption. Through the purchase of life insurance, an ILIT pays an income and estate tax-free death benefit to the trust and, ultimately, the trust beneficiaries.

Clients can further leverage the increased gift tax exemption by using discounted interests in a business entity, such as a family limited partnership, to transfer wealth. Grantor-retained annuity trusts (GRAT)and sales to anintentionally defective grantor trust (IDGT)continue to be worthy strategies for transferring wealth while reducing the amount of the lifetime gift exemption used. The $5 million exemption coupled with an ILIT, GRAT, or IDGT strategy can result in an unprecedented tax-free transfer of wealth for your clients.

Credit shelter trusts. A credit shelter trust (CST) is a common strategy for preserving the estate tax exemption of the first spouse to die. The Tax Act of 2010 introduced a portability provision, by which a deceased spouse can transfer the unused portion of his or her estate tax exemption to the surviving spouse. Given this new feature, you might assume that CSTs are no longer needed or useful. While portability has certainly simplified the process for using a deceased spouse’s exemption, there are still plenty of worthwhile reasons to consider a CST, including:

  • Control from the grave.Unlike an outright bequest to the surviving spouse, a CST dictates how the deceased spouse would like his or her assets to be distributed.
  • Shelter from estate tax.A CST shelters the appreciation of the trust-owned assets from future estate tax, whereas assets appreciating in the hands of the surviving spouse may push his or her taxable estate above the total available exemption.
  • Asset protection.If structured properly, a CST can protect assets from the creditors of the surviving spouse while giving him or her access to income and principal through discretionary distributions by an independent trustee.
  • State tax protection.Because some states have decoupled from the federal estate tax, a CST may be necessary to shelter all or a portion of a decedent’s assets from estate taxes at the state level.

Qualified charitable distributions. The qualified charitable distribution (QCD) provision, also known as a charitable rollover, has been extended through 2012. It allows clients age 70½ and older to distribute up to $100,000 directly to a public charity without reporting the distribution as income. For charitably inclined clients who don’t rely on their required minimum distributions for retirement income, QCDs may be an excellent way to meet charitable goals.

Other considerations

It’s important to note that the Tax Relief Act is specific to federal taxes. Advisors shouldn’t neglect to take state taxes into account when reviewing clients’ plans. For example, while a majority of states mirror the federal estate tax, several states have their own versions of the law, which may place a heavy tax burden on a decedent’s assets. Now is the perfect time to review clients’ estate plans to ensure that they are maximizing their efficiency under both federal and state law.

Finally, while the recent change in law presents great opportunities, remember that the new tax provisions are set to expire at the end of 2012, which just happens to coincide with the next presidential election. Expect plenty of debate over tax laws as 2012 approaches. Who knows what changes may lie ahead?

For more on tax and estate planning from AdvisorOne.com, please see:

Estate Tax and Gift Plans Can Greatly Reduce Tax on Wealth Transfers

Tax Alert: IRA Direct Contributions to Charities for 2010

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