Gift Tax Structure
Under current law, you, as an individual, may make “annual exclusion gifts” without gift tax consequences. The annual exclusion amount has been $12,000 for several years, but has increased to $13,000 for 2009. In addition, during your lifetime, you can give away an additional $1 million free of federal gift tax (which reduces dollar for dollar the amount that can pass free of federal estate tax upon your death). However, for many years, most North Carolina residents could not make such gifts without incurring state gift tax, as the only exclusion to the state tax was a relatively small $100,000 lifetime exclusion for gifts made to certain individuals. Effective as of January 1, 2009, however, the North Carolina gift tax was repealed, so there is no longer a local disincentive for North Carolinians to move wealth to the younger generations.
Gifting Depreciated Assets
Giving cash appears to be the most common form of lifetime gifting to family members. However, a simple way to leverage your gift tax exclusions discussed above is to transfer to your family members non-cash assets that have values which are believed to be temporarily depressed, such as real property, stocks, and ownership interests in your family businesses. When the values of the transferred assets rebound, the appreciation will pass to your family members without incurring any gift or estate tax.
Installment Sales to a “Defective” Grantor Trust
If you have income-producing property expected to appreciate significantly in value, your sale of that property to an income tax “defective” grantor trust on an installment basis can be an attractive estate planning technique. Such a trust is deemed “defective” for income tax purposes because you, as grantor, are considered to be the owner of the trust. The result is that you and the trust are deemed to be the same “person” with respect to income tax issues so that your sale of the property to the trust does not result in any taxable capital gain to you. In addition, such a trust can be designed so that the property in the trust is not includable in your taxable estate for estate tax purposes.
Typically, your transaction will take the form of an installment sale of the property by you to the trust with the trust making payments to you over an extended period of time. The trust’s payment obligation to you would be evidenced by a promissory note from the trust to you. Current low interest rates will cause the note payments to be less. Therefore, more value will accumulate inside the trust, which ultimately will pass to whomever you desire free of estate tax.
Grantor Retained Annuity Trust
In a Grantor Retained Annuity Trust (“GRAT”), you, as grantor, retain the right to an annuity payment from the trust for a period of years. At the end of the annuity period, the trust terminates, and any remaining trust assets are distributed to the beneficiaries you have chosen. As a result, the remaining assets are removed from your taxable estate and the potential estate tax burden on your estate is decreased.
Typically, when you make a gift, the transfer will trigger gift tax liability based on the total value of the assets you are transferring. In the case of a GRAT, however, only the value of the remainder interest which will be left to your chosen beneficiaries is considered a gift because you have retained the right to an annual annuity payment. Since there is no precise way to assess the value of your chosen beneficiaries’ remainder interest at the beginning of the trust term, the present value of the remainder interest is calculated based on the interest rate in effect at the time of your transfer of the property to the GRAT. If the increase in the value of the trust assets outperforms the applicable interest rate over the term of the GRAT, there will be a windfall to your beneficiaries.
As a result, today’s economic climate and near-historic low interest rates make the GRAT a particularly attractive option. Assuming the markets rebound strongly, the growth in the value of the assets in your GRAT easily should exceed the applicable interest rate.
Charitable Lead Trust
A Charitable Lead Trust (“CLT”) is an excellent estate planning technique that can provide you both income tax and estate tax savings. A CLT must provide that annual income payments will go to charity. You would provide that the balance of the trust assets after the income interest has expired (typically, in a set number of years) go to beneficiaries you name, usually younger members of your family. If the trust is established during your lifetime, you will receive a charitable deduction for income tax purposes for the actuarial value of the income interest. The actuarial value of what will be left for your family’s younger generation will be a gift.
With low interest rates, the actuarial formula assumes your CLT will not grow to cover its annual payments to charity and, thus, a portion of the principal must be used to pay the annual payments to charity. This reduces the actuarial value of the remainder interest in the trust assets, causing the value of the gift for gift tax purposes to be less. If the annual return on your CLT assets is higher than the interest rate mandated by the IRS, principal accumulates inside the CLT, which ultimately will pass to your family’s younger generation without gift and estate tax consequences.
The Estate Tax is Here to Stay
Just a few years ago, the estate tax appeared to be headed for extinction. With the increasing federal budget deficit and the new political environment, it seems possible that the federal estate tax exemption amount (currently $3.5 million) could decrease to $1 million as scheduled in 2011, or possibly even earlier. With proper planning, the current environment is ripe to take advantage of the current depressed markets and low interest rates.
For further information regarding the issues described above, please contact Gregory T. Peacock.
