Ho Ho Ho – Congress delivers an estate-planning present to business owners

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Print this page John Dedon

When the president signed into law a two-year extension of the Bush Tax cuts, most Americans were focused on the income tax ramifications. U.S. taxpayers will benefit from a two-year extension of a maximum 35 percent income tax rate and 15 percent capital gain rate. Business owners, who were rushing to sell their companies prior to increased capital gain rates, now have a two-year period to shop their companies and hope for a better market. 

Yes, these income tax provisions are beneficial and significant. Yet, the estate and gift tax benefits are even greater for business owners seeking to transfer wealth to their children.

As late as Thanksgiving, experts believed Congress was considering a 45 percent or 55 percent estate-tax rate for assets exceeding $3.5 million or $1 million. Indeed, once the Times Square Ball dropped, the law automatically would have taxed all assets exceeding $1 million at 55 percent.  But with only two weeks left in the year, Congress and the president delivered business owners a huge transfer-tax present. 

Highlights of the changes

Among the primary estate and gift tax changes applicable in 2011 and 2012 are the following:

—A $5 million exemption amount, meaning a single person can pass $5 million upon death without any federal estate tax.  A married couple with proper planning can protect $10 million.

—Just as significant, the amount a person can gift during lifetime is $5 million. This is a radical departure from the current $1 million gift amount. The significance is that, in 2011, substantial wealth can be transferred without incurring any gift tax. For the very wealthy, assets in excess of $5 million can be transferred with only a 35 percent gift tax. Also, with a $5 million gift exemption amount ($10 million for a married couple), advanced gifting techniques, such as transfers involving a gift and sale of assets to intentionally defective trusts, are even more useful.  (See example below.)   

—The Generation Skipping Tax Exemption is also $5 million. Again, using advanced planning tools, there is an opportunity to provide significant estate tax savings for future generations.

An example

The example below illustrates how the $5 million gift exemption amount turbo charges the wealth transfer opportunities for business owners.  The example uses a transfer of assets to an irrevocable trust to remove assets from the taxpayer’s estate.  The trust is created as a “grantor trust,” meaning that, although the assets are not in the taxpayer’s estate for estate tax purposes, the income inside the trust is taxed to the taxpayer (a so-called “intentionally defective trust”).  Thus, there is no capital gain tax when the taxpayer sells assets to the trust.  Finally, the trust is created to avoid tax not only when the taxpayer and his spouse die, but for all future generations (i.e., a “dynasty trust”). 

The example illustrates how a $35 million company can be removed from the taxpayer’s estate.  The stock, an appreciating asset, is protected from estate tax, so when the stock is sold for a higher value or when the taxpayer dies the value is not in the taxpayer’s estate. The company or the wealth it generated is protected for future generations free of any estate tax.  Inside the estate is a note, which “freezes” the taxpayer’s estate at the lower relative value. The note will be repaid when the company is sold; can be paid upon death from insurance proceeds; or can be donated all or in part to charity upon the taxpayer’s death.

Sale of stock (or llc interests) by business owner to an intentionally defective grantor trust (“IDGT”)
Total transfer:  $35 million

STEP 1 – Gift of seed money or stock
Gift: $5 million of stock
Gifts should be at least 10 percent of the value of the total sale.

STEP 2 – Sale to IDGT (intentionally defective grantor trust)
Sale: $30 million of stock

Promissory note:
Principal amount $30 million
Interest rate:  1.53 percent (December 2010 mid-term AFR rate)
Interest-only with annual interest payments
9-year term with balloon payment

Interest and Principal Payments

The $35 million of transferred stock will earn dividends, which will pay the annual interest payments. The balance, if any, may be accumulated and reinvested by the IDGT, used to pay down principal, or disbursed to the IDGT beneficiaries.

Assume the trust earns 7 percent income each year:
$35 million trust assets x 7 percent income = $2.45 million annual income

Annual interest payments:
$30 million principal x 1.53 percent AFR interest rate = $459,000 annual interest

For married business owners who have estates of $10 million or less, outright gifts are effective for transfer tax planning.  Thus, substantial wealth can be transferred in a simplified fashion.

New Law and 2010 decendents

The law also addressed the uncertainty pertaining to taxpayers who die in 2010.  The decedent’s estate may elect the $5 million exemption amount, or benefit from no estate tax but also no step-up in basis for assets exceeding $1.3 million (and an additional $3 million increase in basis to property that goes to the decedent’s spouse). Generally, estates under $5 million will benefit from the $5 million exemption amount, and estates such as that of former Yankees owner George Steinbrenner will benefit from no estate tax. 

Some planning decisions are immediately obvious and others will emerge as the new law is studied. Despite the abundance of good news, there is remaining uncertainty: the law only applies for two years.  But two years provides ample time to take advantage of the planning opportunities. 

Santa — I mean the President and Congress — was very generous this Holiday Season.

John P. Dedon is a principal in the firm with the Trust, Estate & Tax Planning practice group of Odin, Feldman & Pittleman. Dedon blogs about estate planning issues for Virginians and U.S. citizens at http://www.dedononestateplanning.typepad.com.

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