Finally, A new estate tax law

But more like a good news, bad news joke

On December 17, 2010, the President signed the 2010 Tax Relief Act (New Law), after cutting a deal with Congress.

In a nutshell, here’s what the New Law does: extends for two years (a) the Bush-era income tax cuts (highest rate for all of 35%); (b) retains the favorable tax rates (15%) for long-term capital gains and qualified dividends; (c) significant estate and gift tax changes and; (d) a ton of other provisions beyond the scope of this article.

We are going to zero in on the most significant changes in the estate and gift tax area.

The Good News

Bottom line: The New Law applies to lifetime gifts and transfers of death for only 2011 and 2012 offering an exemption (pay no tax) on the first $5 million of your wealth per person. That’s a delightful $10 million – tax-free – if you are married. Any excess, over the $5 million ($10 million, if married), will be taxed at a 35% flat rate.

NOTE: 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 Makes The Good News A Joke

The New Law has a sunset provision. After December 31, 2012, the old law will be reincarnated: a measly $1 million exemption ($2 million, if married) and a stratospheric tax rate of 55%.

Outrageous!

And dumb. The 2010 lame-duck Congress replaced the uncertainty we suffered with for 10 years under the old law, with a two-year period of uncertainty under the New Law. Want to be safe? … Better die in 2010 or 2011. Married?… To get the full $10 million benefits, you both must die during those two years. Crazy.

The new joke – if the kids come to visit, better lock the bedroom door.

But Wait There Is Some Really Good News… Not a Joke

Let’s talk about the pleasant surprise – the two-year window you have to make a $5 million ($10 million if married) gift. Sorry, the window will close on December 31, 2012. Too bad. But what about gifts that you (and your spouse, if married) make during 2011 and 2012?… The gifts are good FOREVER. The IRS can’t take ‘em back or tax you. Unquestionably, Congress made an unintended mistake.

You Own A Closely Held Business

Here’s an example. Joe and Mary (married and affluent) make $10 million in gifts of various assets to their kids during 2011 and 2012. That $10 million, plus future income earned by the $10 million of assets, plus any appreciation of the assets will never be taxed to Joe and Mary… for as long as they live or when they die.

NOTE: In addition, Joe and Mary each can make annual gifts (including 2011 and 2012) of $13,000 ($26,000 total) to every one of their kids… really a continuation of the old law.

So, the real question becomes how can we maximize the tax benefits of this two-year gift tax window? First, I should tell you the challenge my typical worried-about-the-estate tax client throws at me: “Irv, how do I get the most significant assets I own out of my estate, yet keep control of those assets?” Well, we (my network of advisors and me) have been meeting this challenge for years. But Hallelujah!… the New Law, concerning gifts you can make in 2011 and 2012, gives us an easy way to keep huge amounts of your wealth in the family, instead of losing it to the IRS.

My network (other experienced estate planning experts I work with regularly) called a meeting to discuss the New Law. We all recognized that completed gifts made in 2011 and 2012 are a made-in-heaven-tax opportunity. We spent a fun afternoon exchanging ideas and came up with 14 ways to take advantage of the gift provisions in the New Law. We have come up with more since.

Following are three examples (that occur often in practice and for many of the readers of this column) and will enrich your family, instead of losing tax dollars to the IRS.

Business Succession

Joe (married to Mary) owns 100% of Success Co., which is run by his son Sam. Success Co. is profitable, growing in sales, net profit and value (now worth about $12 million). Joe wants to transfer Success Co. to Sam.

Here’s the simple plan: Step #1. Recapitalize Success Co. so Joe now has nonvoting stock (say 10,000 shares) and voting stock (say 100 shares)… a tax-free transaction.

Step #2. Joe gifts the nonvoting shares to an “intentionally defective trust” (IDT) with Sam as the beneficiary.

NOTE: For tax purposes, Success Co., because of discounts (typically, about 40%) allowed by current law, is only worth about $7.2 million (the actual gift tax amount) for tax purposes.

A few significant bonuses for Joe: Not only is Success Co. out of Joe’s estate, but the future substantial income will not be added to his estate. Nor is the company’s future appreciated value a continuing problem. Also, the IDT acts as a perfect asset protection device: protecting Joe as well as Sam (including keeping the trust assets away from Sam’s wife should he get divorced). And maybe best of all, Joe still controls Success Co. (because he still owns all the voting stock).

Finally, because Joe intends to keep working for Success Co., he can continue to take a salary and his usual fringe benefits. Also, we would put in a wage continuation plan, so Joe can keep getting a salary to the day he dies (in case he stops working and still needs income).

You Own Investment-Type Assets

We are talking about real estate (whether income producing or not, but excluding any residence), stocks, bonds, CDs, cash and similar assets. For example, Jake owns many of the assets just listed. Here’s the strategy: Step #1. When real estate is involved, we start by putting the real estate in one or more limited liability companies (LLC) as an asset protection device.  Step #2. Then we transfer the real estate LLC interest and the other assets to a family limited partnership (FLIP). Jake (married to Sue) transfers $11 million of such assets to his FLIP. The discounts (about 30%) under current law make the assets transferred worth only about $7.7 million for tax purposes. Step #3. Jake and Sue  give the limited partnership units (cannot vote), which own 99% of the FLIP to their kids. Jake and Sue retain all the voting units (1%) of the FLIP and keep absolute control of the assets transferred.

What if Jake needs or wants the use of funds inside the FLIP?… Easy enough… the FLIP loans the funds to Jake. He may pay back the loan, or die owing it, which would reduce his taxable estate dollar for dollar.

NOTE: Instead of transferring the assets to a FLIP, an IDT or other irrevocable trust might be used, depending on the exact facts and circumstances.

You Want To Create Additional Wealth Without Risk

This strategy actually has a number of variations… all legally taking advantage of the tax law and the favorable economic possibilities if you (or your spouse or both) are insurable for life insurance.

For example, (the following facts apply to many Americans, from the little guy to the affluent) Jim and his wife Jane (both 70 years old) have a large portfolio of conservative cash-like assets (stocks, bonds, municipals, CDs and the like) that they will never need to maintain their lifestyle. The portfolio grows every year… nice! But Jim is furious when he knows the IRS will get 35% (or more) in estate taxes when he and Jane 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 (value about $4.2 million for tax purposes). Result: The $6 million is out of their estate. When Jim and Jane go to heaven, the kids will get $21 million. Tax-free (no income tax, no estate tax)… and oh, yes, NO market risk.

Strategy #2. Same facts as above, except 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 (where they met).

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 (and principal, if necessary) to buy $8 million of life insurance in an irrevocable life insurance trust.

Result: Charity (the foundation) gets $21 million… tax-free. The family keeps $8 million (or more)… $6 million, tax-free. Thank you, Congress, for your New Law.

In Conclusion

All of the above gives you a great opportunity. But the clock is ticking… By the time you read this, you will have only 22 months or less to take advantage of the New Law.

One caution: No attempt is made to cover every strategy available using of the New Law… Nor is every exception and possible tax trap considered. It is essential that you only work with advisors who are knowledgeable with the old law as well as the New Law. Also, it is critical that you revisit your existing estate plan in light of the New Law.

And be smart… always get a second opinion. Got a question, problem or concern involving the New Law?.. .Call me (Irv) at 847-674-5295.

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