What to Do Now to Minimize Wealth Transfer Tax

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With the first third of 2012 now behind us, wealth managers are faced with an all-too-familiar scenario. On December 31, 2012, a host of advantageous tax laws are set to expire, leaving us wondering once again what the next year will bring. This ongoing cycle of uncertainty has paralyzed both advisors and clients when it comes to implementing beneficial wealth transfer strategies. While this unstable environment can make planning very difficult, it’s important to recognize that we have a limited window in which to take advantage of the current law to transfer significant wealth with little or no tax.

What We Know Now

Under the current law, due to expire at the end of 2012, the individual estate, gift, and generation-skipping transfer (GST) tax exemption is $5.12 million, and the top tax rate on any wealth transfer above the exemption amount is 35%. This is the highest exemption amount and lowest transfer tax rate that we have ever seen. (There was, however, a period between 1916 and 1931 when the rate fluctuated between 10% and 40%.) Current law also provides for exemption portability, allowing a surviving spouse to leverage any of the deceased spouse’s unused exemption. 

Absent any legislative action prior to the end of the year, the exemption amount, top tax rate, and portability feature that we enjoy today will all expire, ushering in an exemption amount of $1 million, a top tax rate of 55% and an end to the surviving spouse’s ability to utilize a deceased spouse’s unused exemption.

What We May Know

On February 13 of this year, the White House released a general explanation of the proposed fiscal year 2013 budget. The release contained a number of gift and estate tax provisions, including a permanent reversion of the estate and GST tax exemptions to $3.5 million, a level last seen in 2009. In a departure from the current law, the exemption for lifetime gifts would no longer be unified with the estate and GST exemption and would be reduced to $1 million. The proposal would, however, make portability permanent. 

Other proposed provisions would curtail or eliminate the benefits of some popular wealth transfer strategies. For example, a federal rule against perpetuities would require the termination of a GST trust after a term of 90 years. Another provision would mandate a 10-year minimum for grantor-retained annuity trusts (GRATs) and require that the remainder interest have a value greater than zero upon creation, marking the end of the popular “zeroed out” GRAT technique. Other proposed provisions would restrict the ability to apply a discount to a minority interest in a business entity, such as a family limited partnership or limited liability company, as part of an intra-family transfer. 

Another significant provision relates to coordinating income and transfer tax rules for grantor trusts. Wealth managers across the country have been taking advantage of “intentionally defective irrevocable trusts” for many years, and with good reason. The current rules allow the grantor to create an irrevocable trust whereby transfers to the trust are effective for transfer tax purposes but allow the grantor to remain liable for any income taxes owed on behalf of the trust. The trust is basically ignored for income tax purposes, and all items of income flow through to the grantor. This enables the grantor to make income tax payments without those payments being considered a taxable gift to the trust. The proposed rules would effectively end this type of planning by making the trust corpus includable in the grantor’s estate. 

While these are only proposed rules, I believe they give us a pretty clear idea of the changes the current Administration would like to see.

What Should We Do?

We’re currently in the midst of an election year, and taxes will once again be at the heart of the debate. While we wait for Washington to clarify the wealth transfer situation, I suggest taking action under the laws on the books today.

Your high-net-worth clients have an opportunity to take advantage of the highest estate, gift and GST exemptions, along with the lowest top transfer tax rate, we’ve ever seen. They also have the chance to implement tax-minimization strategies that may not be available in the near future. 

With this in mind, review your clients’ wealth transfer situations. Are any of them in a position to take advantage of current law? If so, it is imperative to begin the planning process immediately. It may be only May, but I assure you that 2012 will be over before you know it.

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