Special Guest Author Kevin J. Zezula: Taking Advantage of the 2012 Gift Tax Exemption

Tax provisions enacted in 2010 increased the 2012 lifetime gift tax exemption to $5.12 million and lowered the top gift tax rate to 35%.  Beginning in 2013, absent any new legislation, the estate and lifetime gift tax exemptions are scheduled to return to $1 million and the top gift and estate tax rates are scheduled to increase to 55%. The higher 2012 exemption provides investors with an unprecedented opportunity to transfer wealth to future generations gift and estate tax free, provided they act quickly.

Although the higher exemption is scheduled to remain in effect through 2012, investors are well-advised not to wait until near year-end to prepare to gift assets. As noted below, most investors will want to place amounts gifted to children or grandchildren in an irrevocable trust, rather than give it to them outright. Using a trust allows the donor to retain control over the assets, preventing the recipients from squandering the gift prematurely. Determining appropriate trust terms—such as when and in what circumstances assets will later be distributed to heirs—requires careful consideration, and preparation of the associated legal documents requires time. If the assets to be transferred are privately held, additional time may be needed to obtain an asset valuation, secure the permission of partners, institute a new capital structure, and draft necessary legal documents. And, the sooner a gift is made, the greater the opportunity for the assets to appreciate outside of the donor’s taxable estate.

Wealth transfer attorneys already are noting a significant up-tick in demand for their services. By year-end, that demand is likely to become a deluge. Thus, investors should initiate discussions with qualified professionals now to determine (i) whether a gift makes sense, (ii) which assets should be transferred, (iii) whether conditions must be met to effectuate a transfer of those assets, (iv) whether a trust will be used to hold the gifted assets, and (v) the terms of that trust.

The fate of the gift and estate tax exemptions and rates likely will be tied up with Congressional action (or lack of action) on the Bush tax cuts—the lower tax rates in effect for the past decade that are scheduled to expire at the end of 2012. With Congress likely deadlocked until Election Day, the fate of the Bush cuts will be decided by a “lame duck” Congress convening between Thanksgiving and Christmas in 2012. The Congress that returns for that session will be the existing Congress—a Republican-led House and Democratic-led Senate—regardless of the election results. President Obama, too, will still be in office at the end of 2012: either he will have been re-elected—feeling newly-empowered to enact his policies—or he will be a lame-duck president who can do what he believes is right without concern for the consequences.

As noted above, an individual may give away up to $5.12 million before year-end 2012 without imposition of gift tax. A married couple may give away up to $10.24 million. Someone who used his $1 million lifetime exemption before 2012 may give away an additional $4.12 million. These lifetime exemptions are in addition to the annual gift tax exclusion that permits an investor to give away $13,000 each year to as many recipients as he or she wishes.

If an investor uses his $5.12 million lifetime gift tax exemption, he is not permitted to give away an additional $5.12 million estate tax free at his death. Essentially, by making the gift, he is accelerating his estate tax exemption and using it during his life. Doing so can make sense for at least two reasons. First, as noted above, the $5.12 million estate tax exemption is scheduled to expire at the end of 2012. Although Congress might decide to extend the exemption further, there is no assurance it will do so. Thus, an investor who dies after 2012 has no assurance he will be permitted to pass on $5.12 million estate tax free at his death. He might be well-advised to use the exemption now while it is available.

Second, by giving away $5.12 million now, the gift can appreciate during the remainder of the donor’s life. By the time it is finally distributed to heirs, the gift may have increased substantially in value, yet the full amount distributed will be entirely free of estate tax.

In addition to providing for a $5.12 million lifetime gift tax exemption, the 2010 tax compromise provides for a $5.12 million lifetime generation skipping transfer (GST) tax exemption in 2012. The GST tax is an additional tax levied on gifts that “skip” generations (for instance, a gift from a grandparent to a grandchild). By combining these exemptions, an investor can give up to $5.12 million to grandchildren entirely free of estate, gift, and GST taxes. Such a gifting arrangement would permit the $5.12 million to grow not only during the investor’s lifetime, but during his children’s lifetimes as well.

Typically an investor wishing to make a large gift to children or grandchildren will put the gifted amount in an irrevocable trust, rather than giving it to heirs outright. Use of a trust gives the investor control over the later distribution of the assets, keeping them away from heirs who, due to youth or inexperience, might squander them.

An irrevocable trust usually has two classes of beneficiaries: income beneficiaries, who may receive the earnings on the assets placed in trust for a specified number of years or for life, and remainder beneficiaries, who receive the trust assets at the end of the specified years or upon the income beneficiary’s death. Typically, a donor names a spouse as the income beneficiary and children as remainder beneficiaries, or names children as income beneficiaries and grandchildren as remainder beneficiaries, although any individuals may be named for these purposes.

The fact that the trust is “irrevocable” means the donor cannot later reclaim the assets or make significant changes to their disposition. Thus, a donor must be comfortable with the arrangement at the time assets are placed in the trust. For this reason (and others), it is critical to consult with a qualified estate planning attorney when establishing a trust, gifting assets, or considering any of the techniques described in this paper. Individuals establishing trusts also should retain a qualified professional fiduciary to assist in managing and administering the trust and directing the investment of trust assets.

By adopting an effective gifting strategy in preparation for the expiration of the higher gift tax exemption at year-end, individuals can take timely action to reduce their future estate taxes and leave their inheritances intact. Choosing which assets to gift and how to invest gifted assets can enhance this objective.

To assure and maximize tax savings, investors should initiate discussions now with a qualified professional. This lead time is necessary to make sure terms are fleshed out, necessary legal documents are prepared, any required asset valuations are obtained and gifts are completed before the current tax exemptions are scheduled to expire.   To review more information from Merrill Lynch regarding this important topic, please click here. 

Kevin J. Zezula, Financial Advisor at Merrill Lynch, assists individuals and businesses to define and achieve their financial goals utilizing a Risk Management philosophy.  Kevin is a graduate of Michigan State University where he studied Business Administration and Finance. He lives in Royal Oak, MI with his wife, Katie, and 3 children (Nadia, Quinn and Wilhelmina) where he is actively serving on St. Mary’s Catholic School Board & Athletic Board, Medical Main Street Ambassador Committee, and the Board of Director’s for Gilda’s Club of Detroit. Kevin can be reached at [email protected] or 248-645-7262.