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Saturday, October 9, 2010

In a Giving Mood?

Why now is an excellent time to give away assets to loved ones

A smart gifting strategy is always an important piece of an estate plan. But thanks to a confluence of four factors — depressed asset values, an increase of the gift tax exclusion, very low interest rates and proposed legislative changes — it’s never been more advantageous to give gifts to family members than right now.

Doing so can help loved ones through tough times while you benefit by removing assets from your taxable estate. And with the estate tax repeal scheduled for 2010 likely to itself be repealed, reducing the size of your taxable estate is as important as ever.

Asset Values Low, Opportunities High

Because of the economic downturn, many assets have lost a lot of their value. It’s particularly attractive to make lifetime gifts of assets whose values are depressed, but likely to appreciate significantly when the economy recovers. Those assets may include real estate, stocks and interests in a closely held business.

The benefit of gifting when asset values are low is twofold: 1) you can transfer a greater number of shares or greater percentage of the asset without giving away more value for gift tax purposes, and 2) you can remove all future appreciation on the asset from your taxable estate. What’s more, the simplest strategy for removing assets from your estate — making annual exclusion gifts — is more powerful because the exclusion increased in 2009 by $1,000 ($2,000 for married couples splitting gifts or gifting community property). The exclusion allows you to give up to $13,000 ($26,000 if splitting gifts or gifting community property with your spouse) to an unlimited number of recipients gift-tax free and without tapping any of your (or your spouse’s) $1 million lifetime gift tax exemption. Combined with low asset values, this may allow you to transfer substantial wealth tax free.

Before making gifts, it’s important to consider income taxes. If your heirs inherit assets when you die, the tax basis of the assets is generally “stepped up” to their current fair market value, minimizing, or even eliminating, capital gains taxes in the event of a sale.

But the basis of assets that you gift to family members isn’t stepped up. So your loved one may be exposed to significant income tax if the assets appreciated in value while you held them and your loved one subsequently sells the assets. In the case of an asset that is expected to be held for future generations, the income tax issue is effectively a nonissue.

Interest Rates Low, Trusts More Powerful

Trusts are commonly used tools in estate planning. And now, thanks to very low interest rates, certain trusts — such as a grantor retained annuity trust (GRAT) or a charitable lead annuity trust (CLAT) — are even more attractive.

In this instance, the interest rate to pay attention to is the Section 7520 rate. It’s an assumed rate of return the IRS employs to value certain interests for gift tax purposes. The good news is that in February 2009 the rate dropped to a record low of 2%. The rate has increased to 2.4% in May 2009, but that’s still near the record low.

The Sec. 7520 rate comes into play when using a GRAT or a CLAT because the remainder beneficiary receives what’s left in the trust at the end of the trust’s term after all of the annuity payments have been made. (In a GRAT, you receive the annuity payments; in a CLAT, one or more charities receive the payments.)

For gift tax purposes, the remainder interest is calculated assuming that the trust assets will grow at the Sec. 7520 rate. For a GRAT, you use the Sec. 7520 rate in effect the month that you fund the trust, but for a CLAT you may use the Sec. 7520 rate for that month or either of the two preceding months.

If the trust’s earnings outperform the Sec. 7520 rate (which is likely when interest rates are low, assuming a 5- to 10-year trust term), those excess earnings will be transferred to the remainder beneficiaries tax free.

Keep in mind that there are additional factors that could affect the tax consequences and other financial considerations as well. So consult your tax and estate planning advisors to determine whether a GRAT or CLAT is appropriate for your situation.

FLPs and FLLCs Still Beneficial but Require Caution

Gifting interests in family limited partnerships (FLPs) and family limited liability companies (FLLCs) can be advantageous for a variety of reasons, but for tax purposes, it may be especially beneficial now. First, low asset values mean you can transfer more FLP or FLLC interests at a lower tax cost. Second, proposed legislation that could eliminate valuation discounts on gifts of FLP and FLLC interests means you may want to make such gifts as soon as possible, to help ensure they qualify for discounts.

To use an FLP in your gift planning, form a limited partnership to own your business or other assets. (In the case of an FLLC, you form a limited liability company and contribute your interest in the business or other assets.) Next, transfer limited partnership interests (or non-managing FLLC interests) to your loved ones. You can retain the right to manage the business or other assets by maintaining a small ownership interest and acting as general partner (or a managing member).

Transfers of FLP or FLLC interests are subject to gift tax, but they can qualify for the annual gift tax exclusion. So when asset values are lower, you can transfer more interest tax free or at least at a lower tax cost.

You can further leverage gifts of FLP or FLLC interests by taking advantage of valuation discounts. Currently, if an FLP or FLLC is properly structured and managed, discounts for lack of control and lack of marketability can be applied to the value of transferred interests for gift tax purposes. For example, the total value for gift tax purposes of an FLP divided among six family members might be substantially less than the value of the FLP’s underlying assets.

But the ability of families to claim valuation discounts may be in jeopardy. Lawmakers have been proposing eliminating or limiting the tax-saving advantages of FLPs and FLLCs for several years. Thus far, nothing has come to fruition. However, because of budget concerns, Congress may now be more motivated to pass such legislation.

As of this writing, a bill has been introduced (H.R. 436) that would eliminate gift tax valuation discounts for transfers of minority interests in FLPs, FLLCs and other “non-actively-traded” interests if the transferee and certain family members control the entity. It also wouldn’t allow valuation discounts to the extent such entities own non-business assets, such as marketable securities.

If this bill is signed into law, the changes would be effective prospectively. In other words, they wouldn’t affect transfer to FLPs or FLLCs made before the bill is enacted. So you may want to set up an FLP or FLLC — or make transfers of interests in an existing FLP or FLLC — now, while you still can take advantage of discounts.

As with any other gifting strategy, there are many other factors to consider before forming an FLP or FLLC. Additionally, careful planning and execution are critical to ensure an FLP or FLLC will survive IRS and Tax Court scrutiny. So consult your tax and estate planning advisors for assistance.

Uncertainty Reigns, Planning Critical

These are uncertain times — for the economy as well as for the federal estate tax. The gifting strategies discussed will remain effective after the economy recovers, but they may never be as powerful as they are at this time.

And be sure to keep an eye on the actions of Congress. H.R. 436 likely won’t be the last bill introduced this year with the potential to affect estate planning. The 2010 estate tax repeal is almost certainly to be addressed. Current proposals suggest that the 2009 estate tax regime, with an estate tax exemption of $3.5 million and top estate tax rate of 45%, will be retained. Be sure to contact your tax and estate planning advisors for the latest information. They can discuss how economic factors and any new estate tax laws may affect your estate plan.


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