New Paradigms for Wealth Transfers

Most professional estate planners and their clients breathed a big sigh of relief when Congress enacted “permanent” relief from estate taxes for smaller estates in the final days of 2010. Following the somewhat bizarre phase-in of larger Federal exemptions between 2002 and 2009, and a one year “holiday” in 2010, the Federal law was set to revert to its pre-2002 structure in 2011. Instead, the expected $600,000 Federal exemption was increased to $5 million, and the highest estate and gift tax rate decreased to (then) 35% from 55%. What was not to like?

Since that time, the Federal exemption has increased (to $5.45 million) with inflation, but some subtle and not-so-subtle changes have crept into the individual income tax structure. While these changes should not end the celebration of the reduction in estate and gift taxes, they do prompt us to re-examine many traditional estate planning strategies, particularly for clients whose net worth is below the Federal exemption amount.

Before the dramatic increase in the estate and gift tax exemption, estate planners usually started by identifying assets that might be moved out of taxpayers’ estates using a variety of devices. The tools of the trade included Family Partnerships, GRATs, QPRTs, and other acronym-inspiring structures that provide the legal and logical foundations for valuation discounts. Not only do these techniques support transferring today’s values at a discount, they also remove any further growth in value from the estate.

For example, assume Stanley paid $100,000 to buy an oceanfront cottage in 1980. He was too busy to use it, so he offered it for rent to vacationers for many years. On his accountant’s advice, in 1995, he obtained a real estate appraiser’s opinion that his oceanfront rental property was worth $700,000. He then transferred it to an LLC owned by his four children. Because it was income-producing property, he retained a business appraiser to express an opinion on the value of a one-fourth interest in the LLC. The appraiser valued each quarter interest at $113,750, taking a 35% discount from the expected $175,000 (25% of $700,000). If we assume that Stanley lives another twenty years, and dies in 2015 when the property is worth $1,150,000 (value assumed to increase at an average rate of 2.5% for 20 years), he will have removed $ 1.15 million from his estate but used no more than $455,000 ($113,750 x 4) of his estate and gift tax exemption. Assuming a transfer tax rate of 40%, the strategy would have saved his children about $280,000 in estate taxes in 2015.

Now let’s assume that the children have no interest in the property, so they sell it in 2015 for $1,150,000. Because of the increased exemptions, they discover that there would have been no estate tax on the property, so…while it seemed like (and was) a terrific strategy at the time, the LLC and the resulting appraisals and discounts did not reduce the family’s overall tax burden at all. In fact, because the property was not included in Stanley’s taxable estate, it will have cost the family about $340,000 in income taxes. The tax occurs because the basis (cost) of the property is based on what Stanley paid for it (a so-called “carryover basis”). Having paid $100,000 and then rented (and depreciated) the property for many years, for discussion purposes we might assume that the basis is essentially zero. If Stanley had owned the property when he died instead of giving it away, the basis of the property would have been fair market value of that property included in his estate (a so-called “stepped-up basis”). In this simple example, the difference in the amount of taxable gain is the entire date-of-death value of the property, or $1.15 million. Furthermore, while the tax on a sale might have been calculated prior to 2012 at the rates then in effect (about 23%), in 2015, the effective rate on the gain will likely be about 29%.

Naturally, the actual outcomes in this example depend on many other variables, like the presence or absence of other assets in the estate, both Stanley’s and his children’s income from other sources, and their susceptibility to the Alternative Minimum Tax. The example also illustrates the lasting impact of estate planning decisions. Who would have anticipated in 1995 that Stanley would ultimately be able to pass the entire property to his children with NO transfer tax? As a practical matter, the estate planning process has become a lot more complicated in the present environment. We will explore some of the planning techniques being discussed under the new paradigms in future editions of this newsletter.

If you would like to discuss further, please contact your BNN advisor at 1.800.244.7444.

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.

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