Under the U.S. tax laws, gifts you make during your life, and the amount of your estate at death, are taxed as one bundle under a “unified system.” With the tax legislation enacted at the close of 2010, every individual has a $5 million exemption from the estate/gift tax. But we only have it for sure until the end of 2012.
To most American families whose wealth doesn’t come near $5 million, this kind of talk is irrelevant or even absurd. But for families of great wealth the $5million exemption may actually be woefully inadequate. Wherever you stand on the wealth spectrum, using the exemption sooner rather than later is to your advantage.
To fully appreciate this government largesse, let’s put it in perspective. Prior to 2011, under previous versions of the same “unified” system, the top estate tax rate was 55% and the maximum exemption was $3.5 million. When these generous provisions sunset at the end of 2012, like Cinderella finding a pumpkin instead of a carriage at midnight, we’ll be left with a $1million per individual exemption and 55% estate tax rate.
But there is a glass slipper. Unique planning opportunities are created.
- Wealthy folks who had maxed out their $3.5 exemption under prior law now have an additional $1.5 exemption that should be used to remove appreciating assets from their estates now.
- Married couples can now use each other’s unused exemption. Your testamentary documents (wills and trusts) should be reviewed to insure the exemptions are maximized in both estates
- With the increased exemption it’s easier to “gift” more assets now with no current tax cost.
While clients are sometimes concerned about future financial security and use that as a reason to not make lifetime gifts, we can achieve optimal tax results and preserve your assets with a variety of sophisticated estate planning tools. While taxes are a “necessity” of life, clients sometimes don’t realize how much of an estate can be lost to taxes if proper planning isn’t implemented. Following is a dollar and cents example to illustrate how expensive it can be if you fail to plan:
Let’s say you own an original Picasso valued at $3.5 million, which is likely to continue to appreciate at a high rate. Your child loves it and you want them to have it….eventually!
- What Happens When the Gift is Made: If you make an outright gift of the art now, either outright or in trust, you can use a portion of your exemption amount, if available, to shield yourself from paying a current gift tax of $1,225,000 ($3.5M x 35%). Special rules permit the value of the gift to be discounted for tax purposes if it is made using a tax advantaged vehicle such as a grantor retained income trust (GRIT), or other variations such as part sale/part gift, or gift to a grantor trust are used. If you avail yourself of a strategy which creates a discounted value for the gift, you either use less of your $5 million exemption or pay less gift tax at the time the gift is made.
- What Happens Down the Road: If you make the gift now, upon your passing the asset and its appreciation are out of your estate and not subject to further taxes. If the artwork doubles in value to $7 million at your passing, the additional appreciation ($3.5 million) escapes estate tax. However, if you fail to make a gift, and the art remains in your estate valued at $7 million, your estate tax bill will be $2,450,000, for that asset alone and that’s at today’s 35% rates. At the promised 55% rates (set to pop back up in 2013), the tax bill will be $3,850,000. If you don’t have cash in your estate to pay the taxes, your child may be forced to sell the artwork to come up with tax monies.
- Bottom Line: By making the gift now, even with a value of $3.5 million: (1) you avoid estate tax on the other $3.5 million of appreciation (i.e., you save $1,225,000 based on today’s low 35% rate) and (2) you likely preserve more of your $5 million exemption to shield other assets from estate and gift tax.
Leveraging the exemption and creating valuation discounts are the best tools we have now to maximize use of your exemption, and reduce your overall tax bill. In the pages that follow, we provide further illustrations of how these work. Sometimes clients shy away from these strategies thinking they are hard to understand or unduly complicated or unnecessary. Yet we employ these strategies for one purpose and one purpose only: to use the tax rules to reduce taxes and preserve assets you want to keep in the family.
If you’re like most people, when you realize how much of your estate can be lost to taxes, you’d rather part with some portion of your assets now, to loved ones or charities, than give it away to Uncle same. After all, you’ve already paid income taxes on the funds used to acquire these assets. With the dual advantage of the increased exemption and low gift tax rate, truly the best advice we can offer is to ACT NOW to maximize your use of the exemption in a tax advantaged way.
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