Attorney | Ward & Smith, P.A.
In an effort to help provide clarity for wealth Clients on a timely tax planning issue, we asked Gregory Peacock, an attorney with North Carolina-based Ward and Smith, P. A., to share his insight on the uncertainty surrounding the estate and gift tax exemption.
All individual taxpayers have a window of opportunity for passing their assets to family members or other individuals with less gift tax than ever under current tax law. But this window is more than “half-way shut.” Immediate action is necessary to take advantage of this opportunity.
The Current Status of the Gift and Estate Tax Exemption
In late 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Act”) was enacted. One of the provisions of the Act increased the federal gift and estate tax exemption to $5,000,000 for 2011 and 2012. Unless Congress acts, the exemption will decrease to $1,000,000 on January 1, 2013. Of course, it is possible that Congress will enact new tax law before then, but most commentators are not optimistic that the current $5,000,000 exemption will remain. (Note: The $5,000,000 and $1,000,000 exemptions referred to in this article will be indexed for inflation.)
The current $5,000,000 exemption can be used during lifetime or at death — or some portion during lifetime and the rest at death. Any portion of the exemption used during lifetime decreases the amount available upon death. Since most of us are not planning to die before the end of 2012, most of us will not be able to use any portion of this exemption for transfers at death. But, wealthy individuals who want to ensure that they will be able to use the current $5,000,000 exemption and are comfortable making significant gifts at the present time should consider using the exemption during their lifetime. And, because the $5,000,000 exemption may not be available after 2012, it may be a “use it or lose it” proposition.
The Opportunity for Lifetime Gifts
There are many techniques available to those who wish to use the increased exemption during lifetime. The simplest approach is to make a direct gift to the desired recipient. This is as simple as writing a check, transferring securities, or deeding real property to the desired recipient. The fair market value of the gifted asset is used to determine the tax effect of the gift. If the value of the gift plus the value of all prior taxable gifts made to all recipients does not exceed the current $5,000,000 exemption, then the remaining exemption is reduced by the value of the gift. If, however, the value of the gifted asset plus the value of all prior taxable gifts exceeds the current $5,000,000 exemption, gift tax would be owed on the value that exceeds the exemption.
A simple gift as described above provides several benefits. First, the value of the gift is determined by using the valuation at the time of the gift. If the value of the gifted asset increases between the date of the gift and the donor’s date of death, the appreciation is not subject to estate tax upon the donor’s death because the asset is not owned by the donor at the donor’s death. This is commonly known as an “estate freeze.” Second, any income earned on the gifted asset will accrue in the name of the donee. This prevents the income from accumulating in the donor’s name, thus preventing the donor’s estate from growing by the amount of income accumulated. Finally, the value of the gifted asset should not be subject to estate tax on the donor’s death if the $5,000,000 exemption is not exceeded.
However, the third benefit discussed has created much debate over the past year. There is a question as to whether gift or estate tax could be owed on the value of the previously gifted asset if the exemption returns to $1,000,000 in 2013 or future legislation results in a gift and estate tax exemption in an amount less than $5,000,000. This is referred to as the potential for “claw back.”
What is “Claw Back”?
The potential for “claw back” exists because of the manner in which the estate tax is calculated upon death. Specifically, the estate tax is calculated by adding the value of the assets owned at death and the value of the assets gifted during lifetime to which the gift and estate tax exemption has been applied. If the total is more than the value of the gift and estate tax exemption at the time of death, then estate tax would be calculated on the amount that the total exceeds the exemption at that time.
For example, assume an individual dies in 2013; has $2,000,000 in assets at the time of death; and the gift and estate tax exemption has returned to $1,000,000. During 2012, the individual gifted $3,000,000 to which the gift and estate tax exemption was applied. In order to determine the value of the estate for estate tax purposes, the $2,000,000 owned by the individual at death is added to the $3,000,000 of prior gifts, creating a taxable estate of $5,000,000. If “claw back” occurs, estate tax will be calculated on $4,000,000, which is the value of the taxable estate reduced by the gift and estate tax exemption at the time of death. Therefore, the gifted assets actually are subjected to estate tax at death. Most commentators believe that the potential for “claw back” is an unintended glitch in the legislation and expect a technical correction to eliminate the potential. But there is no way to predict the actions of Congress.
Tax Advantages Even if Claw Back Exists
Despite the uncertainty as to whether “claw back” will become a reality, consideration still should be given to making gifts in 2012 to use the $5,000,000 gift and estate tax exemption. Even if the value of the gifts ultimately becomes subject to gift or estate tax, several objectives would still be accomplished. First, the value of the gift would be “frozen” at its value in 2012. Therefore, any increase in the value of the gifted asset after the date of the gift would not be subject to estate tax. If, however, the gift had not been made and the value of the asset increases, the increased value at the time of death would be the amount taxed. Second, any income earned on the asset would accrue in the name of the donee and estate taxation in the donor’s estate would be avoided. Further, the donee’s income tax bracket often is less than the donor’s income tax bracket, so there could be some income tax savings as well.
Structure and Reporting of Gifts
There are many gifting techniques available to use the current $5,000,000 gift and estate tax exemption depending on the nature of the assets and the family dynamics. Often, some type of trust or limited liability company (“LLC”) structure is utilized. A discussion of these options is beyond the scope of this article. Any individual considering a gift of this nature should seek legal counsel to discuss the alternatives. If the gift and estate tax exemption is used during lifetime, a gift tax return must be filed even if no tax is due. The only exception is if the value of the gift is less than the annual exclusion from gift tax ($13,000 for 2012) or qualifies for the exclusion for medical or educational expenses.
Often, individuals tend to not concentrate on gifting strategies until the end of the year; however, waiting in 2012 may eliminate the ability to structure gifting in the most advantageous manner. That said, those interested in making gifts should begin to formulate a gifting plan sooner than later in 2012.
About the Author:
Gregory Peacock’s practice experience encompasses estate planning, estate administration, and elder law. He is certified by the North Carolina State Bar both as a Board Certified Specialist in Estate Planning and Probate Law and as a Board Certified Specialist in Elder Law. Mr. Peacock also is certified by the National Elder Law Foundation as a Certified Elder Law Attorney (CELA) and frequently lectures to civic and community groups and at continuing legal education seminars on various topics relating to estate planning and administration and Medicaid planning.
© 2012, Ward and Smith, P.A. For further information regarding the issues described above, please contact Gregory T. Peacock.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.