Four Ways to Use Your $5.12 million in Transfer Tax Credits before They Fall Off the Fiscal Cliff on 12/31/12

In just over a month, the amount of wealth that can be transferred tax free is set to drop from $5.12 million to just $1 million.  And the tax rate that applies to amounts transferred beyond this “lifetime exemption” is rising from 35% to a highest rate of 55%.  In light of the election results and the few days remaining before Congress adjourns for the year, it is becoming increasingly unlikely this change will be postponed.  Those waiting until the last minute to “see what happens” should recognize this is it, and it’s time to at least understand how much you stand to lose before you miss the boat.


Here are a few moves you can make before year end (besides dying) to take advantage of millions of dollars in tax credits before they disappear.  Notwithstanding all the legal mumbo jumbo that makes it actually work, the basic idea is that by “giving” away some of your assets now, they won’t be taxed as part of your estate later.  You can keep some strings attached (that’s where the legal mumbo jumbo comes in), but the economic benefit of the transferred asset must be ultimately and permanently given up.


1. Outright gift of liquid assets.

This is the simplest and fastest way to take advantage of the expiring exemption.  No lawyers necessary.  Just report the transfer and apply your credit.  There are however a few disadvantages.  Once the transfer is complete, the assets become exposed to anyone who sues the recipient, as well as in the case of death or divorce.  Moreover, the recipient is free to make whatever good or bad decisions regarding investing the assets.  Any amount the recipient still has when they die will be subject to their estate tax.  If keeping it simple is more important than incurring these risks, this strategy should be executed in addition to and not in lieu of other gifting techniques that can be done tax free without even using the lifetime exemption.


2. Gift of company interest.

For those with family or closely held businesses, including real estate holding companies, gifting stock in these companies can allow the transfer of more value tax free.  For example, the tax law will recognize that 10% of a company worth $1,000,000 is in reality worth less than $100,000 due to the fact that a 10% owner can’t control the company and might not even have the right to sell the stock.  A carefully drafted partnership agreement is necessary to get the maximum discount on the value of the gift for tax purposes and has the added benefit of providing for a business succession plan while you still control the company.


3. Gift to Irrevocable Family Trust

This is essentially giving your heirs an advance on their inheritance, but with restrictions on how and when they can actually spend it.  While the assets remain in the trust, all the appreciation accrues outside your taxable estate and theirs. Therefore, the value of the assets is “frozen” as of the date you transferred them to the trust and there is no estate or gift tax on their appreciation.  With the proper legal structure and execution, a gift of a company interest to an Irrevocable Family Trust can be made using technique #2 for the combined benefit of greater control and maximum leverage of the lifetime exemption.


4. Gift to Irrevocable Dynasty Trust

A Dynasty Trust is intended to continue beyond the lives of your children so as to benefit your descendants for generations to come.  The problem with transfers that “skip” a generation is that they are subject to an additional Generation Skipping Transfer Tax, resulting in an effective tax rate of up to 80% starting next year.  Therefore, even greater tax savings can be achieved by using the expiring lifetime exemption for generation skipping transfers.


There are an infinite variety of ways to draft the trusts described in techniques 3 and 4 above, depending on the level and type of control you want to retain, income tax considerations, asset protection, and how you want things to be handled during your lifetime, upon your death, your spouse’s death, and beyond.  For example, you can reserve the right to dictate how the trust  invests its assets, including having the trust continue to participate in your business or real estate deals.  If drafted properly, these irrevocable trusts can also provide asset protection benefits for you and your family.


Anyone with a net worth over $1 million (including life insurance) should consult an experienced tax attorney to take advantage of this unique opportunity before it expires.  Beside drafting the the appropriate legal transfer documents and creating a personalized trust, your attorney should work closely with your financial adviser and accountant to help you determine which assets to transfer for maximum income tax advantage and investment return.  In order to secure the desired tax treatment, extreme care must be taken in how the company and trust agreements are drafted, as well as how the transfers are documented,  executed and reported.  Getting it done right can take time, so those wishing to make these maneuvers must start now.