In a nutshell, the Tax Relief Act (TRA) extends for two years the Bush-era income tax cuts (highest rate is 35 percent); retains the favorable tax rates (15 percent) for long-term capital gains and qualified dividends; and changes estate and gift taxes significantly.
Here’s the good news: The TRA, which applies to lifetime gifts and transfers at death for only 2011 and 2012, offers an exemption on the first $5 million of your wealth per person. Any excess over the $5 million ($10 million if married) will be taxed at a 35-percent flat rate.
The gift tax and estate tax are unified into one tax. You can use part or all of the $5 million/$10 million during 2011 and 2012 as a gift. Any unused gift amount is tax-free for estate tax purposes.
The bad news is that the TRA has a sunset provision. After Dec. 31, 2012, the old law will be reincarnated. This means there will be $1 million exemption and a tax rate of 55 percent.
A pleasant surprise concerns the two-year window during which you can make a $5 million ($10 million if married) gift. The window will close on Dec. 31, 2012, but the gifts that you make during 2011 and 2012 are good forever.
For example, Joe and Mary make $10 million in gifts of various assets to their kids during 2011 and 2012. They won’t be taxed on that initial $10 million, any increase in the assets’ value from appreciation, or income earned from the assets in the future.
In addition, they each can make annual gifts (including 2011 and 2012) of $13,000 ($26,000 total) to every one of their kids.
So, how can we maximize the tax benefits of this two-year gift tax window? Here are three examples of ways to take advantage of the gift provisions of the TRA.
Business Succession
Joe owns 100 percent of Success Co. and wants to transfer it to Sam. Here’s the simple plan:
Step #1. Recapitalize Success Co. so Joe now has non-voting stock (say 10,000 shares) and voting stock (say 100 shares). This is a tax-free transaction.
Step #2. Joe gifts the non-voting shares to an intentionally defective trust (IDT) with Sam as the beneficiary. Note that under the current law, Success Co. is worth only about $7.2 million (the actual gift tax amount) because of tax-purpose discounts.
By doing this, Success Co. is out of Joe’s estate, and future substantial income will not be added. The company’s future appreciated value isn’t a continuing problem, either. Joe can continue to take a salary and his usual fringe benefits as he continues to work for Success Co. Also, a wage continuation plan enables Joe to keep his salary to the day he dies.
Investment-Type Assets
Real estate (excluding residence), stocks, bonds, CDs, cash and similar assets are areas in which you can take advantage of the TRA’s gift provisions.
Step #1. Put real estate in a limited liability company (LLC) as an asset protection device.
Step #2. Transfer the real estate LLC interest and the other assets to a family limited partnership (FLIP). For example: Jake (married to Sue) transfers $11 million of such assets to his FLIP. The discounts under current law make the transferred assets worth $7.7 million for tax purposes.
Step #3. Jake and Sue give the non-voting limited partnership units, which own 99 percent of the FLIP, to their kids. Jake and Sue retain all the voting units (1 percent) of the FLIP and keep absolute control of the assets transferred.
The FLIP can lend the funds to Jake. He can either pay back the loan or die owing it, which would reduce his taxable estate dollar for dollar.
Additional, Risk-Free Wealth
If you are insurable for life insurance, there are multiple strategies for taking advantage of the tax law.
For example, Jim and his wife Jane have a large portfolio of conservative cash-like assets in stocks, bonds, municipals, CDs and the like that they will never need in order to maintain their lifestyle. The portfolio grows every year, but the IRS will get 35 percent in estate taxes when they die.
Strategy #1. Jim and Jane gift $6 million to a FLIP, which purchases $21 million of second-to- die life insurance on Jim and Jane. The FLIP limited partnership interests are gifted to their kids ($4.2 million for tax purposes). This results in taking $6 million out of their estate. When Jim and Jane go to heaven, the kids will get $21 million tax-free.
Strategy #2. This time the $6 million gift goes to the family foundation created by Jim and Jane. The foundation purchases the $21 million in life insurance, which Jim and Jane want to go to their alma mater.
Jim and Jane will save about $2.1 million (Federal and State) in income taxes because of the $6 million contribution to their foundation. They will use the income from the $2.1 million to buy $8 million of life insurance in an irrevocable life insurance trust. The result is that $21 million goes to charity (the foundation) tax-free. The family keeps $8 million (or more) with $6 million of which is tax-free. Thank you, Congress, for your TRA.
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