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).
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.