30th Apr 2013

On January 2, 2013, President Obama signed the American Taxpayer Relief Act of 2012 (the “ATRA”) into law.  Failure to pass the new law would have resulted in a significant decrease in the estate and lifetime gift tax exemptions and a significant increase in the maximum estate and gift tax rates.  Instead, the ATRA set the estate and lifetime gift tax exemptions at the highest in history ($5 million per individual, indexed for inflation) and fixed the maximum federal estate and gift tax rates at 40 percent.  More importantly for planning purposes, the ATRA finally provided “permanent” exemption and tax rate solutions…or so we thought.

The relief from uncertainty lasted just over three months when, on April 10th, President Obama proposed his budget and again raised the estate tax issue.  The proposal calls for fixed $3.5 million estate and generation-skipping transfer tax exemptions, without indexing them for inflation, and only a $1 million lifetime gift tax exemption.  The proposed changes would also increase the maximum estate and gift tax rates to 45 percent.  Additionally, the proposal once again brings “estate tax loopholes,” such as short-term Grantor Retained Annuity Trusts (“GRATs”), to the negotiation table.

Under the proposal, these changes would not take place until 2018, which would allow individuals and couples to plan using the higher exemption and lower rates through 2017, similar to the surge in planning that occurred at the end of 2012.  For a detailed discussion of the ATRA, please see “Estate and Gift Tax Aspects of the American Taxpayer Relief Act of 2012” in the February 2013 Newsletter.

Planning for Uncertainty

As we knew even before the latest budget proposal, tax laws are rarely permanent and should never be relied upon as a planning tool.  Unfortunately, it is the estate tax exemption in the year of death—not in the year of document preparation—that is applied to the decedent’s estate, so it is uncertain to begin with, but even more so with drastic changes in the law.

The key to having a proper, effective estate plan that can weather changes in the tax laws is to work with an estate planning specialist who will (a) prepare documents that provide for flexibility and maximize available exemptions and (b) recognize changes in the laws that will affect you and your family and alert you to such changes.  Of course, there is a lot more to estate planning than tax benefits, but for those individuals and couples who may incur a tax liability, working with an expert will likely result in a significant estate tax savings.

Effect on Illinois Law

Historically, the Illinois estate tax has been equal to or lower than the federal estate tax exemption.  Currently, the Illinois estate tax exemption is $4 million per individual for decedents dying in 2013.  If the federal exemption is lowered to the proposed levels, Illinois would likely lower its exemption to $3.5 million or less as well.

Again, the key to utilizing the available exemptions is to work with an estate planning specialist who is aware of how federal and state laws work together.  Illinois law provides sophisticated planning techniques that allow a decedent’s estate to defer state estate tax liability until the death of the surviving spouse by utilizing an Illinois Qualified Terminable Interest Property (“QTIP”) trust.  This is a complex planning technique that can provide significant flexibility and tax savings to the family, but must be done correctly in order to comply with state requirements.

Planning for 2018

As was the case at the end of 2012, the end of 2017 may present the expiration of significant gifting opportunities.  If the proposed decrease in the estate and lifetime gift tax exemptions and increase in estate and gift tax rates become law, those individuals and couples with taxable estates will have to decide whether to make significant gifts using one or more of the following strategies.

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.  In Irrevocable Life Insurance Trust (“ILIT”) is a type of Gift Trust that is designed specifically to hold life insurance on the life of the grantor.

Grantor Retained Annuity Trust – 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 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 taxes.  As mentioned above, President Obama has been a proponent of imposing a minimum 10-year term on GRATs, which would significantly diminish their value as a planning tool.

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 continue to reside in the home, 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 earlier that gifting strategies are implemented, the better.  Along with the lifetime gift tax exemption, the annual gift tax exclusion allows individuals to gift up to $14,000 per year to as many individuals as he or she pleases without any gift tax consequences.  However, this annual exclusion is lost at the end of each calendar year.  By starting to work with your estate planning attorney now, you can be prepared for significant changes in the estate and gift tax laws and provide for your family as efficiently as possible.

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