Nearly every time I go into an estate planning meeting the first question my client asks is, “What’s going to happen with the estate tax next year.” Unfortunately, I cannot provide my clients with an answer I would be willing to bet on. For those of you who do not understand what prompts the initial question, I will enlighten you. Today, you could gift (or die with) up to $5.12 million and not owe a penny in estate taxes, but on January 1, 2013, this number drops to a mere $1 million unless Congress passes new estate tax laws. Worse yet, any money above that $1 million threshold will be subject to tax at a 55% rate.
One thing that is nearly certain is that Congress will not pass any new estate tax laws until after the elections, and I would be surprised if we see them do anything before mid-December. Even then, I do not expect to see Congress make any groundbreaking moves. In other words, they will not abolish the estate tax, and I do not think Congress will let it fall back to a $1 million exemption, as that would hit far too many of their constituents throughout major metropolitan areas such as northern Virginia. Even so, I have many clients who want to take advantage of the increased exemption now in case the exemption amount is lower in the future.
So, the next question is: How can I gift millions of dollars and yet retain control of the money? Technically, the answer is that you cannot because such a gift would constitute a retained interest in violation of Internal Revenue Code §2036; however, there are some ways to work within the bounds of the law and minimize the effect on your budget. Please note these are complex strategies that you should implement only with the counsel of an experienced estate planning attorney, as there are many traps for the unwary.
The goal is to set up a trust that utilizes nearly all of the donor’s estate tax exemption today so he will have transferred more money free of estate taxes if he dies at a time when the exemption is lower. If the exemption is higher when he dies, then the donor will have more money to give away tax-free. If the donor can set this up so he receives the income from a trust established by his wife and she receives the income from a similar trust established by her husband, it would be a win-win situation for the donor; but as we all know, the IRS does not like to lose. Ultimately, the IRS would declare these trusts to be in violation of the reciprocal trust doctrine. In layman’s terms, the IRS looks at the two trusts together, and if both spouses are in the same relative position before and after the creation of the trusts, then the IRS will take the position that nothing of substance happened. Based on existing precedent, the IRS will prevail in their argument, but there are ways to adjust to trusts to accomplish similar objectives with a lower risk of losing an IRS challenge.
If you are like the vast majority of Americans and cannot afford to give up $10 million this year, there are still options available. You can take advantage of annual exclusion gifts of $13,000 per beneficiary, per year, and a married couple can employ gift splitting to increase this to $26,000. Further, you can pay certain medical and educational expenses in unlimited amounts if the payment is made directly to the educational institution or health care provider. If that is not enough inducement to pay for your grandchild’s educational expenses, you could also take advantage of the 5-year election for contributions to §529 educational savings accounts. This means a married couple can contribute up to $65,000 each ($130,000 total) to a §529 plan in any one year, and that contribution is treated (for tax purposes) as having been made pro rata over a 5-year period. The election is not automatic, and you must file Form 709 to elect the 5-year option, but this is a wonderful option for grandparents to provide funds that will grow tax-free until they are used to pay educational expenses.
