For high-net-worth clients, there are less than four months left to avoid the effects of potentially severe tax changes. Many advisors have undoubtedly been beseeching wealthy clients to take advantage of existing gift, estate and generation-skipping tax exemptions of $5.12 million and other wealth-transfer planning opportunities while they can. The zero hour is assumed to be Dec. 31, but could potentially be sooner if President Obama is reelected and pushes legislation through the lame duck session of Congress.
Of course, it is also possible that the current rules could be extended, but there is no assurance that many great tax planning techniques will not disappear eventually. Among the vulnerable techniques are grantor trusts, generation-skipping transfer tax allocations and dynastic trust planning, certain valuation discounts, grantor- retained annuity trusts and more.
What can your procrastinating clients do before the clock runs out?
GIFTS TO TRUSTS
The simplest answer is: Create a trust. Outright gifts are rarely the best choice, and trusts last for a long time. Trusts can protect recipients of largesse in 2012 from their own imprudence, divorce and lawsuits. If you can allocate a generation-skipping transfer tax exemption to a long-term trust, assets in the trust can stay out of the tax system forever, capturing a benefit that is on President Obama's hit list.
For income-tax purposes, trusts should almost always be grantor trusts. This means the client pays income tax on earnings inside the trust. This is a great way to keep reducing a client's estate and enable trust assets to grow faster.
Trusts should often be directed trusts. This means an investment trustee is named and can designate you to continue the money management. Presumably, you don't want to plan yourself out of a good client if you don't have to.
Making this kind of gift cannot be accomplished instantaneously, however. "We've already handled as many trusts in the first half of 2012 as we did in all of last year, which was itself a record," notes Brandon Cintula, senior vice president and senior trust officer of the Alaska Trust Co. in Anchorage. "While we'll bend over backward to help clients get 2012 trusts done, planners should realize that there are a host of steps involved in every plan, each of which takes time."
Near the end of the year, when it might be impossible to complete a new irrevocable trust, gifts may of necessity be made to existing trusts. Old trusts may have more flexibility than some people realize. A trustee might be able, for example, to divide assets into separate trusts or subtrusts. This might permit allocating the generation-skipping transfer tax exemption to the new gift regardless of the status of the old trust. It may be feasible to have a fiduciary relinquish or modify a general power of appointment granted to the children that included the trust assets in their estates. If the trustee has authority to make that into a limited power of appointment, the trustee might then make a late allocation of generation-skipping transfer tax exemption and make a new 2012 gift to the trust. In 2013, the client's CPA would prepare a gift-tax return reporting the 2012 gift and allocating some of the $5.12 million exemption to protect the gifts, and perhaps the value of prior gifts so that a generation-skipping transfer tax will never apply.
Another possible approach might be to transfer assets into an existing family limited partnership or limited liability company and then gift equity interests in that partnership to the children. This can take advantage of the big 2012 exemption, but also provide some measure of protection for the recipient.
Caution is in order, however. There may be estate-tax inclusion issues if the donor is the one who controls certain decisions with respect to the partnership, like the power to control distributions. Partnership interests can provide significant protection from lawsuits faced by the child. The legal structure of the partnership can also prevent the child from having unfettered control over the assets. For example, if limited partnership interests are given to the child, he or she will not have the right to vote or manage the family limited partnership.
Importantly, the partnership agreement can be amended in future years to better tailor the planning. Unlike a trust, a family limited partnership agreement is not irrevocable. There are some complications and traps, however. For example, valuation discounts may be jeopardized if the transfer of assets to the partnership is followed too quickly by gifts of its interests.
The transfer of ownership interests in a closely held family limited partnership or a family S corporation is relatively simple and quick. In general, all that is required is an assignment of the equity interests, new certificates (perhaps) and a revised governing document.
While prudent planning would mandate a qualified appraisal, this may not be feasible in order to get a transfer made before Dec. 31 to capitalize on the $5.12million gift exemption. Transferring non-controlling interests in a business entity might be a lot better than missing out on the supersize gift exemption, and also better than merely gifting cash or marketable securities outright to an heir, losing any control over the gift property.
For an elderly or infirm client, consideration should be given to the possibility that the client will lose the ability to consummate future transfers. One approach could be to fund all of a client's assets that are appropriate (not IRAs or pension plan interests) into a revocable living trust and grant an independent person the right to revoke the client's rights, in whole or part, to the trust. That revocation arguably consummates instantaneously a completed gift of those interests.
If there is no time to make a gift to an entity (for example, a gift of securities to a family limited partnership) and the client is concerned about the imprudence of the heir, there is another option: Make an outright gift of a non-controlling interest in real estate. If the client has a new deed giving the child, say, a one-third share of a vacation home, the child will not have the authority to sell the house, and a 2012 gift of value may be consummated in time. But keep in mind that, as a co-owner, the child might be able to commence a "partition" action, resulting in the sale of the property.
Even if there is inadequate time to get a certified appraisal, it might be feasible to have a local real estate agent provide a comparative market analysis so that you have an idea of how large the taxable gift might be. You can then follow up with a formal appraisal after consummating the gift. After Dec. 31, an agreement between the co-owners of the property can be created. The property could even be transferred to a limited liability company or limited partnership next year.
If it is impossible to value an asset before the end of the year, a client might be willing to have an estimate completed quickly and make a gift transfer subject to a "valuation adjustment clause." Under this tax-planning strategy, the documents transferring ownership of the asset can include formulaic language that effectively caps the value of the assets being transferred.
If a client intends to transfer an interest in a family limited partnership worth no more than $2 million, the gift documents might state that. If the value of the partnership interests is later determined in an IRS audit to be higher, then the percentage transferred will be limited to the percentage that does not exceed $2 million.
If the client obtains a preliminary appraisal or comparative market analysis to set the value for the formula and follows up with a formal certified appraisal, this approach may provide some protection from inadvertently triggering a large gift tax.
For a client who is reluctant to make a large gift out of the limited resources he has in hand, why not gift something that's not in his hands? "For surviving spouses who are beneficiaries of the typical marital [Qualified Terminable Interest Property] trust, they should consider giving away all of their income interest in that trust," recommends Robert Keebler, a CPA in Green Bay, Wis. All this should require is for the surviving spouse to sign an appropriate disclaimer and deliver it to the trustee.
If your client has made intrafamily loans, consider suggesting he or she forgive the loan. That can constitute a quick means of completing a valuable gift without requiring further transfers or new accounts. The client might simply write "Forgiven" or "Canceled" across the face of the note and execute a notarized formal termination or cancellation agreement.
Some wealthy clients waiting until the last minute may be advanced in age or facing health challenges that might make their competency questionable. In order to make a gift transfer, the client will probably need to have contractual capacity - sufficient competency to enable the client to execute a contract under state law. This is a higher degree of competency than that required to execute a will, which is called testamentary capacity. The determination of competency is a decision for lawyers to make.
Consider the example of an elderly client in the early stages of Alzheimer's disease. Her daughter is her caregiver and has been a source of help for decades. Her son is a ne'er-do-well who limits his contact to calls on her birthday and the holidays.
The client wants to make a large gift to her daughter and a smaller gift to her son. If the Alzheimer's has progressed to the point where she could not consummate a gift transfer, the IRS would have a strong position to unravel the gift and include the assets in her estate in a future year, when the laws may be less favorable. If there is an issue of competency, the son may well challenge the gift as invalid so he might inherit under a will that bequeathed assets equally. If the son loses that argument, he may argue undue influence by his sister. If the gift is planned and coordinated by a financial planner without the involvement of counsel, it may trigger tax, family and malpractice issues.
For some clients, year-end gifts will have to be made under durable powers of attorney if the client doesn't have sufficient competency. This will require a careful review. Keep in mind that some states, such as New York, have strict rules relating to gift giving by an attorney-in-fact. The only recourse might be to appoint a guardian of the property and have the court approve an estate plan. But that may take more time than is available.
In some cases, a property owner's revocable trust will permit the trustee to make gifts of the trust assets. Estate planner Jonathan Blattmachr, a principal of Eagle River Advisors in Chicago and New York, recommends that clients take action now. Such action includes revising their revocable trust or executing a power-of-attorney with broad gift- giving powers, including the power to create trusts so that year-end estate planning steps can be implemented later this year.
Contrary to what many might think, it may actually be a relatively quick task to create a sophisticated new trust. This may require no more time then revising the operating documents of a family business or family limited partnership used in a gift or modifying an existing irrevocable trust.
"Several drafting programs permit the creation of basic dynasty trusts in short order - and many of these trusts can contain their own revision provisions, which can be used at a later time to modify the irrevocable trust when there is more time to determine what approaches are preferred," Blattmachr suggests.
Martin M. Shenkman, CPA, PFS, J.D., is a Financial Planning contributing writer and an estate planner in Paramus, N.J. He runs laweasy.com, a free legal website.