An enormous opportunity for families to reduce their estate taxes – and in some cases, save millions of dollars – will end on December 31, 2012. If there’s a chance you can take advantage of these savings, it’s wise to act immediately, because unless Congress changes the law, the window of opportunity will close permanently when the ball drops on New Year’s Eve.
Between now and the end of the year, the lifetime exemption from the federal gift tax is $5.12 million. But on January 1, 2013, this exemption is scheduled to be reduced drastically, to just $1 million.
The gift tax applies anytime you make a gift to someone other than a spouse or a charity. In general, you can give any person (or a trust) up to $13,000 a year without there being a gift tax. But if you give someone more than $13,000 in a calendar year, then the tax applies to the excess.
However, you also have a “lifetime exemption.” Over the course of your lifetime, you can make gifts over the $13,000 annual threshold up to the amount of this exemption without paying tax.
(The lifetime exemption isn’t a complete “freebie.” Any amount you use of your lifetime exemption is subtracted from your estate tax exemption, such that when you die, your estate taxes might be higher. But in general, the tax benefits of using the lifetime exemption far outweigh the disadvantages.)
A chance to transfer large assets tax-free is slated to disappear next year.
Since the lifetime exemption is $5.12 million for the rest of the year, you can make gifts of up to $5.12 million this year without paying gift tax. Even if you already used up your lifetime exemption in the past, when the amount was smaller, you can now make very large additional gifts.
But this is true only if you make these gifts before the end of 2012.
Many people can benefit from this situation by putting significant assets into a trust that will pay income to their children, and ultimately benefit their grandchildren.
Here are some of the benefits of such a trust:
- Suppose you transfer an asset worth $1.5 million to a trust today, and by the time you die, that asset has increased in value to $2 million. The entire increase – $500,000 – will go to your heirs without being subject to estate tax.
- Suppose the asset also generates annual income. For instance, over the course of the rest of your life, it might generate $300,000 in income. That entire $300,000 will also go to your heirs without being subject to estate tax.
- Suppose you set up the trust so that your children receive the income, and when they die, the trust assets go to your grandchildren. The entire trust, regardless of how much it has increased in value, will go to your grandchildren without any estate tax being due when your children pass away.
- You will also have protected your grandchildren, because assets left in a trust for them generally can’t be taken away if your children incur debts, are sued in a lawsuit, get divorced, etc.
What assets should you consider putting into a trust? Obviously, ones you don’t need to keep for your current or future support. Beyond that, it’s a great idea to contribute assets that are temporarily reduced in value and that have the potential for significant appreciation. In the current environment, real estate might be a good example.
Another possibility, if you own a business, is to give a minority interest in the business to the trust. You might be able to discount the value of the minority interest due to a lack of marketability and control – after all, a 49% share of a business is typically worth a lot less than a 51% share. This could allow you to give away more assets tax-free, or limit the eventual reduction in your family’s estate tax exemption.
In some states, it’s possible to create a “dynasty” trust, which continues to exist and benefit future generations such as great-grandchildren.
Remember, too, that the $5.12 million gift tax exemption is per-person. So a married couple could contribute as much as $10.24 million.
If you’re in a committed relationship with someone but you aren’t married to them, there may be other tax benefits in using the $5.12 million exemption this year in order to share assets with the other person. (Remember that transfers between spouses aren’t subject to the gift tax, but transfers between an unmarried couple are.)
There are some possible downsides that should be considered. One is that we don’t know what Congress will do after 2012, and there is a theoretical possibility that it will impose a retroactive tax on lifetime gifts over $1 million. There are also state tax issues to think about. And of course, you don’t want to make gifts of assets that you will need to live on in retirement.
But in general, the benefits of taking advantage of this tax break before the end of the year are very significant, and should definitely be considered by anyone in a position to do so.