Gift Giving as an Estate Planning Tool

Proper estate planning can help protect your assets and can provide your family with significant tax savings at the time of your death.

2010 is a unique year for estate planning. While the federal estate tax has lapsed, we still have a $1 million federal lifetime gift tax exemption. Further, the federal gift tax is at a historically low rate of 35 percent this year (the lowest rate since 1934), but it is scheduled to return in 2011 at a top rate of 55 percent.

This unique combination means that, assuming the law is not retroactively reinstated prior to the end of 2010, George Steinbrenner’s heirs will inherit the $1.1 billion Yankees franchise without paying a dime of federal estate tax. Had he died in 2009, his estate would have been subject to nearly $500 million in federal estate taxes.

Unfortunately, many of us have yet to accumulate that level of wealth. Nevertheless, everyone can benefit from proper estate planning.

The $1 million federal lifetime gift tax exemption allows each U.S. taxpayer to give away up to $1 million in cash or other assets during their lifetime without being subject to tax. However, gifts in excess of $1 million are subject to federal gift tax.

Gift giving during one’s lifetime is a useful estate planning tool because lifetime gifts, up to a total of $1 million, reduce an individual’s taxable estate.


There are several rules that interact when discussing gift taxes and estate planning. Because the estate tax was allowed to lapse this year, the following example uses the tax thresholds from 2009 to illustrate how these complex rules typically work together and how they are expected to resume operating in 2011:

Suppose you give two relatives $20,000 each and give $10,000 to another relative in 2009. Each $20,000 gift is called a “taxable gift” because each exceeds $13,000, which is the threshold for the annual federal gift tax exclusion. Although they are called taxable gifts, you will not actually owe any gift tax unless you have exhausted your $1 million federal lifetime gift exemption. Assuming you have not exhausted your $1 million exemption, the two taxable gifts simply reduce your lifetime exemption by $14,000 [($20,000 – $13,000) x 2 = $14,000]. The $10,000 gift is completely disregarded for tax purposes because it is below the $13,000 annual exclusion.

If you started off 2009 with the full $1 million lifetime exemption, you’ll still have an exemption of $986,000 left at the end of the year ($1 million – $14,000 = $986,000). This remaining exemption will carry forward until the sooner of its exhaustion or the time of your death.

In 2009, the federal estate tax rate was 45 percent and the federal estate tax exemption was $3.5 million. This meant that a person could bequeath up to $3.5 million to friends and relatives free of any federal estate tax. If a person died in 2009 with an estate valued at $4 million, the estate tax due would be $225,000 ((4 million – 3.5 million) x 45% = $225,000).

In addition to reducing your lifetime gift exemption, the two $20,000 taxable gifts made in 2009 would also reduce your estate tax exemption by $14,000 to $3,486,000 ($3,500,000 – $14,000= $3,486,000). The $10,000 gift in 2009 would not reduce your estate tax exemption because it falls below the $13,000 gift tax exclusion threshold.

Benefits of Gift Giving in 2010

While lifetime gifts in any year generally are more tax efficient than bequests at death, this year’s historically low federal gift tax rate and the lapse in the federal estate tax (or generation-skipping transfer tax (“GST”)) provide an especially appealing opportunity for efficient wealth transfer.

Loan forgiveness or direct gifts to grandchildren in 2010 are particularly tax efficient because, not only can the donor take advantage of the historically low gift tax rate, but this also avoids the GST tax that such a transfer to grandchildren would cause in any other year.

While there is still the potential that new legislation will retroactively increase the 2010 gift tax rate or retroactively reinstate the GST tax, this risk significantly diminishes as the year draws to a close (and there are ways to structure gifts so as to attempt to limit the effect of any retroactive legislation).

Tax-exempt Gifts

The following types of gifts are exempt from federal gift tax. A person can make unlimited gifts in these categories without any gift tax or estate tax consequences and without having to file gift tax returns:

• Gifts to IRS-approved charities
• Gifts to your spouse (assuming he or she is a U.S. citizen)
• Gifts covering another person’s medical expenses, as long as you make the payments directly to medical service providers
• Gifts covering another person’s tuition expenses, as long as you make payments directly to the educational institution. (Payments for room and board, books, and supplies do not qualify for this exception, but those costs can be covered by making a direct gift to the student under the annual exclusion.)

Other Gift and Estate Planning Considerations

GRATs – Provisions restricting the Grantor Retained Annuity Trust (“GRAT”) have been introduced seven times this year. While none of these attempts reached President Obama’s desk, one may eventually be enacted into law. The new law would likely require any GRAT created after enactment to have a term of at least ten years and to result in a taxable gift on creation (the size of the required gift is unclear). Under current law, there is no minimum term and a GRAT can be created with little or no taxable gift.

Intra-family Loans – The IRS-mandated interest rate on intra-family loans is unusually low (for October 2010, the rate is 1.73% for a loan with a term of three to nine years with annual compounding). Low interest rates make this an attractive time to consider using loans as a wealth transfer technique.

Filing Requirements – If you make a taxable gift (one in excess of the $13,000 annual exclusion), you must file Form 709: U.S. Gift (and Generation-Skipping Transfer) Tax Return. The return is required even if you do not actually owe any gift tax because it allows the IRS to track each taxpayer’s $1 million lifetime gift tax exemption.

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Stock Appreciation Rights

Stock Appreciation Rights (SARs) enable a business owner to provide his or her employees with an opportunity to directly benefit from the growth and prosperity of the business.

SARs grant the recipient the right to be paid an amount equal to the difference between the value of the company’s stock price on the date of the grant and the value on the date of exercise. When the payout is made, the value of the award is taxed as ordinary income to the employee and is deductible by the employer.

SARs can be offered to employees instead of stock options or can be used in conjunction with a stock option program. SARs do not necessarily have a specific settlement date; like stock options, employees can have flexibility in when to exercise their SARs.

Three Types of Plans

1. Stock-settled SARs – the employee is paid in the form of shares of the company’s stock. The number of shares distributed to the employee is equivalent in value to the increase in the stock’s value over the life of the SAR.

2. Cash-settled SARs – the employee receives a lump-sum cash payment on the date of exercise equivalent to the amount of appreciation of the company’s stock.

3. Phantom stock plan – technically not an SAR, but very similar; the employee receives a dividend equivalent payment when exercised. These plans often refer to their phantom stock as “performance units” and, generally, condition the receipt of the award on meeting certain objectives, such as sales, profits, or other targets.

Please note that SARs and phantom stock plans can be given to anyone, but if they are given out broadly to employees and designed to pay out upon termination, there is a possibility that they will be considered retirement plans and will be subject to federal retirement plan rules.

Accounting Considerations

For Stock-settled SARs, a liability is accrued for the estimated cost of the plan, which is the present value of the estimated award at the time it is granted. Adjustments to this liability must be made quarterly.

For Cash-settled SARs and Phantom stock plans, the compensation expense for awards is estimated each quarter.

For SARs and Phantom stock plans, the estimated payout is recorded as a liability on the company’s books until it is paid out or it expires.

Valuation and Appreciation

It is important to carefully consider how the company should be valued. For most small businesses, market share price is not available, so a fair market value analysis is often required. As an alternative, it is often best to rely on profit margins, sales numbers or something similar to establish a payout threshold.


Depending on the business owner’s personal goals and the anticipated future of his or her company, the Stock-settled SAR plan may not be a good fit. The effect of this type of incentive plan would be to dilute each investor’s ownership percentage. Further, it may be overly burdensome to account for changes in the present value of the company over time.

The Cash-settled SAR plan is often times not an ideal option for a small business because its accrued cost and ultimate payout is based upon an increase in the value of shares (or ownership equity) of the company. In the absence of shares listed on a stock exchange, this plan generally requires a fair market value analysis, updated quarterly, for the life of the SAR.

A Phantom stock plan, however, is frequently the best option for a small business. With this type of plan, you can establish a dividend equivalent payout that is based upon a benchmark that the owner deems appropriate. As noted above, the owner can condition the receipt of the award on meeting certain objectives, such as sales, profits, or other targets. The characteristics of this type of plan are often closely aligned with the character of the small business; small, privately-held and flexible.

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The "Marriage Penalty"

As we approach the final months of the 2010 wedding season, I have found that newlyweds and the newly engaged have been asking me one question with surprising frequency: “What is the ‘marriage penalty’ and how can we avoid it?”

Like most tax and legal matters, properly discussing the marriage penalty requires a few steps. In this case, the first step is to understand that, if you are married, the combined income of you and your spouse may push you both into a higher tax bracket than either of you would have been in as singles. This feature in the tax law creates a “penalty” for married couples, which gets more severe as the combined level of their incomes rises.

Second, it is important to note that legislation passed in 2003, which eliminated the marriage penalty for many people, is set to expire at the end of 2010. As such, the marriage penalty is scheduled to return for everyone in 2011.

Finally, if you are currently married or you are planning a wedding for the near future, there are options available to help you mitigate the potential impact of the marriage penalty.


Prior to 2003, if both spouses in a married couple had similar levels of income, their combined income would often push them into a higher tax bracket. As a result, they were effectively penalized for being married. The smaller the difference between what each spouse earned, the higher the marriage penalty. However, if one spouse earned a high salary, and the other did not, then they were not necessarily penalized. It was possible, though, for the marriage penalty to affect couples in all income brackets.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the impact of the marriage penalty by equalizing the standard deduction for singles and married couples and increasing the upper income limit of the 15 percent tax bracket for married couples filing jointly. As a result, the marriage penalty in the lower tax brackets was eliminated through 2010 because more married couples were able to remain within the 15 percent tax bracket.

The Marriage Penalty in 2010

If a household has only one source of income, it is generally beneficial for a married couple to go from filing as individuals to filing a joint return. This is because the phase-out thresholds for many tax credits and deductions increase for couples that file jointly. This generally allows for an overall tax benefit for single income households.

If both spouses earn income, there is a strong likelihood that they will be impacted by the marriage penalty. In 2010, the penalty occurs when each spouse earns over $68,650. In this case, the next dollar earned would move the married couple up to the 28 percent tax bracket. In contrast, a single person would remain in the 25 percent tax bracket for another $13,750 of income earned.

The penalty gets more severe for higher income couples. For example, in 2010, if each spouse earns $150,000, they would both be in the 28 percent tax bracket if they were unmarried. Once married, they are pushed up to the 33 percent tax bracket, whether they file a joint return or they file separately.

Please note that higher income taxpayers are not the only ones who are affected by the marriage penalty. For example, if an individual’s income is low enough, that person can often qualify for the earned income credit (a work incentive program that is intended to help low income families reduce their tax liability). Since married taxpayers must report their combined income, it is often more difficult for them to benefit from the earned income credit.

Other Considerations

There a number of other tax and financial issues that are impacted (positively and negatively) by marriage. A few of those issues are as follows:

• Social Security benefits: The tax penalty also affects married people who receive social security benefits. The law often requires that a higher percentage of benefits be subject to income tax.
• Preferential estate-tax treatment: 2010 is a unique year for estate planning purposes (the estate tax lapsed at the end of 2009 and has yet to be reinstated for 2010, but is scheduled to return in 2011 at unfavorable rates). Nevertheless, for all years, regardless of the status of the estate tax, an individual may leave an unlimited amount to their spouse without generating any estate tax.
• Workplace healthcare coverage: Healthcare benefits to the spouses of employees are generally tax-free.
• Lower insurance rates: Married people frequently get a discount on auto insurance and often pay less for other types of insurance.
• Other areas: Differences between singles and married couples also exist in the rules governing capital losses, mortgage interest, and rental property losses, among others.

How to Prepare

Once married, one of the easiest ways to prepare is to request a consultation with us to determine whether your income tax withholding should be adjusted. Even if your adjustment will only affect the 4th Quarter of 2010, this can still make a significant impact on any potential tax liability due in April 2011.

If you are currently planning a year-end wedding, you may want to consider delaying your marriage until next year. We can help you determine whether the marriage penalty affects you, how much it will affect you and what, if anything, you can do to minimize its impact.

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Small Business Health Care Tax Credit

The President’s Council of Economic Advisors estimates that four million small businesses are eligible to claim the new Small Business Health Care Tax Credit.

For tax years beginning in 2010, eligible small businesses and tax-exempt organizations may claim a tax credit for a portion of the cost of either (1) maintaining their current health insurance coverage or (2) beginning to offer health insurance coverage to their employees.

In 2010, the maximum credit is 35 percent of premiums paid by eligible small businesses and 25 percent of premiums paid by eligible tax-exempt organizations. In 2014, the maximum credit will increase to 50 percent and 35 percent, respectively.

A small business will be considered a “qualified employer” and, therefore, eligible for this credit if:

1. It has fewer than 25 full-time equivalent employees (“FTEs”) for the tax year;
2. The average annual wages of its employees is less than $50,000 per FTE; and
3. It pays its health insurance premiums under a “qualifying arrangement.”

A qualifying arrangement is one in which the employer pays at least 50 percent of the total premium cost for each employee.

The employer may claim this non-refundable credit on its annual income tax return. Any unused credit may be carried back for one year (with the exception of credits that could have been claimed in 2010) or carried forward for 20 years. The credit may only be used to reduce income tax – it cannot be used to reduce an employer’s employment tax obligations.

This credit is intended to exist alongside the employer’s deduction for the cost of health insurance premiums. However, it should be noted that the employer’s deduction must be reduced by the amount of the credit claimed.

In the near future, the IRS is expected to provide additional guidance on how tax-exempt employers may claim the credit.

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IRAs and a New Tax Savings Opportunity

A client recently asked me about converting a traditional IRA to a Roth IRA. As I was researching the issue and writing my response (which, I’ll admit, snow-balled on me…), I thought you might also be interested in my explanation of this great tax savings and financial planning opportunity.

Beginning in 2010, there is a loophole in the tax code regarding IRAs. A brief background on the two most common types of IRAs:

Traditional IRAs: Contributions are often tax-deductible, all transactions and earnings within the IRA have no tax impact (earnings inside the IRA are not subject to tax), but withdrawals at retirement ARE taxed as income.

Roth IRAs: Contributions are not tax-deductible, all transactions within the IRA have no tax impact (earnings inside the IRA are not subject to tax), and withdrawals are NOT usually taxed as income.

Please note that there are income level ceilings and contribution limits on both types of IRAs. For the sake of keeping this email relatively straight forward, I’m not going to discuss those limits at this time.

Prior to January 1, 2010, anyone with annual income over $100,000 could not convert a traditional IRA to a Roth IRA. This meant that these individuals could not convert their traditional IRA to take advantage of the long-term tax savings provided by a Roth IRA.

THE LOOPHOLE: During 2010, the $100,000 income ceiling has been eliminated. This means that anyone can now roll-over a traditional IRA to a Roth IRA regardless of his or her income level. As noted above, the benefits are that the growth inside the Roth IRA over the next 20 or 30 years would occur tax free and the qualified distributions (e.g. after age 59 1/2) would also be tax free. To the contrary, if the funds remained in the traditional IRA, they would continue to grow tax-free, but would be fully taxable upon distribution. The downside is that a portion of the roll-over amount may be subject to tax. How much of this roll-over amount is taxable at the time of conversion depends on the character of your past contributions.

If your past contributions to the traditional IRA were non-tax deductible (the contributions were not deducted from your gross income prior to tax being withheld from your paycheck) then only the income earned on those non-tax deductible contributions would be subject to tax at the time of conversion.

If your past contributions to the traditional IRA were tax deductible (or, “pre-tax”), then the entire amount of the roll-over would be taxable at the time of conversion.

You may be asking yourself, why would anyone intentionally cause themselves to suffer a taxable event? The answer is that the taxable amount at the time of a conversion during 2010 would be, by design, substantially less than the taxable amount available for distribution from your traditional IRA after 20 or 30 years of growth. By making the conversion during 2010, you will save yourself a significant amount of money over your lifetime.

Finally, there is a special rule in place for 2010 only, which serves as an additional incentive to making this conversion this year. This special rule allows you to either recognize 100% of the conversion income in 2010 or split the recognition of the income equally between the next two tax years (2011 and 2012). With proper planning, your tax liability from such a conversion can be greatly mitigated.

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