With the lifetime Gift Tax exemption at the highest it has ever been ($5,120,000 in 2012)1 and Gift Tax rates (capped at 35% in 2012) and Applicable Federal Rates being historically low, 2012 is a perfect storm of gifting opportunity for anyone who is in a position to transfer assets to loved ones. If Congress fails to act by January 1, 2013, at that time, the exemption will decrease to $1 million and the top Gift Tax rate will increase to 55%. Given this limited window of opportunity, those who wish to take advantage of this favorable gifting environment must begin planning immediately.
This newsletter will discuss some of the details of the lifetime Gift Tax exemption and the individuals who should consider taking advantage of this significant gifting opportunity.
Gift Tax Exemptions
The Gift Tax is a tax that is levied on the individual making the gift (the “giftor”) for transfers exceeding the annual exclusion amount in any given year ($13,000 in 2012). Gifts of tuition and medical care in any amount are exempt from Gift Tax, but must adhere to specific requirements.2
In addition to the $13,000 annual exclusion, individuals may use their lifetime Gift Tax exemption to make larger gifts. Essentially, since the Estate and Gift Tax exemptions were re-unified, this amounts to using an individual’s Estate Tax exemption during life rather than at death, because any use of the lifetime exemption reduces the giftor’s available Estate Tax exemption. Non-exempt gifts that exceed the annual exclusion must be reported on a Gift Tax return and the individual must either pay Gift Tax on the excess or use his or her lifetime exemption.
Gifting Strategies
There are many ways to transfer wealth to the next generation or generations by leveraging the annual exclusion and lifetime exemption. However, based on the giftor’s family and financial situation and the types of assets being transferred, one method may be more suitable for the giftor than others.
Outright Gift– An outright gift to one or more individuals is the easiest way to transfer wealth. The giftor can simply write a check or transfer assets and report the gift to the IRS. However, the flaw in this method is that the giftor has no control over how or when the gift may be used. Additionally, this method does not offer any protection from the recipient’s creditors or divorce.
Gift Trust– As opposed to an outright gift, a Gift Trust allows the giftor to instruct the trustee how or when a beneficiary may use the gift. In order to comply with IRS requirements, such instructions must be provided in an irrevocable instrument at the time the trust is established. The trust agreement may also permit the trustee to delay rights of withdrawal to the beneficiary if he or she has creditor issues or a pending divorce.
Grantor Retained Annuity Trust (“GRAT”)– A GRAT allows the giftor to make a gift in trust while retaining an annuity interest in the assets. As long as (a) the assets appreciate at a higher rate than the Applicable Federal Rate (1.2% in July 2012) and (b) the giftor survives the chosen term of the GRAT, the giftor will be able to successfully transfer the excess appreciation to the beneficiaries free of Estate and Gift Tax.
Qualified Personal Residence Trust (“QPRT”)– If the giftor intends to transfer ownership of his or her residence, then a QPRT is likely the best method. Similar to a GRAT, a QPRT makes a delayed gift to the beneficiary. The giftor retains the right to live in the residence during the term of the QPRT. After the term ends, the residence is transferred to the beneficiary. At that time, if the giftor chooses to remain in the residence, he or she may rent the residence from the beneficiary, allowing for the additional transfer of assets out of the giftor’s taxable estate.
The Risks
Clawback– There is the possibility that Congress will implement a “clawback” provision for large gifts made during an individual’s life. Essentially, this would apply the Gift Tax exemption applicable during the year of the giftor’s death rather than the exemption applicable during the year of the gift. The clawback is based on the interpretation of an existing provision rather than new legislation, and though it may be unlikely, it is a risk that must be considered.
Survival Requirement – If the grantor does not survive the term of a GRAT or QPRT, the gifted assets will revert back to the giftor’s taxable estate. Therefore, the term of the trust must be chosen carefully and the risk of the giftor not surviving must be balanced against the benefits of a longer term.
IRS Challenge– There is always a risk that the IRS will challenge the terms of a gift trust. However, by having the trust prepared by an experienced estate planning attorney, this risk can be minimized.
Who Should Consider Gifting?
Of course, the one essential aspect of utilizing lifetime gifting strategies is that the giftor must be prepared to surrender control of the asset. Individuals who are in a position to do so should strongly consider making such gifts to utilize this opportunity prior to its expiration on December 31, 2012.
Since preparation and implementation of trusts that comply with the IRS gifting requirements can take three to six months, it is important for individuals who can benefit from such planning to speak to an experienced estate planning attorney as soon as possible.
- Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.
- For a detailed discussion of tax exempt gifts, please see the August 2011 Newsletter, Gifts of Tuition and Medical Care.