A Once-in-a-Generation Opportunity: The Current Perfect Storm of Estate Planning

To almost everyone’s surprise, new legislation for estate and gift tax laws went into effect in 2011 that increased an individual’s exemption to $5 million ($10 million for a married couple) for both estate tax and gift tax purposes and reduced the estate and gift tax rate to 35%. Unfortunately, these new laws are only effective for tax years 2011 and 2012. In 2013, the exemptions for estate and gift tax purposes are scheduled to be reduced to $1 million with a maximum estate and gift tax rate of 55%. This presents a window of opportunity for estate planning that may not be in existence after 2012.

Over the last three years of economic crisis and unfunded legislative spending, extraordinary deficits have been created and will continue for years to come. Congress and the Administration are now examining all available means for raising new tax revenue. New gift and estate tax revenue is in the crosshairs of this search. The Administration’s revenue raising proposals for the 2010 and 2011 budgets, set forth in the “Green Book” included: (1) limiting grantor retained annuity trusts to a minimum 10-year term; and (2) disregarding valuation discounts applicable to certain restrictions on transfer of interests in family-controlled entities. The balance of this article focuses on the current opportunities presented by the “perfect storm” of estate planning and the likely “sea change” that will bring it to an end soon.

Why is this the perfect time to do significant wealth transfer planning? It results from the coincidence of three economic factors: (1) historically low interest rates; (2) depressed values in many asset classes; and (3) increased valuation discounts based on market volatility. In addition to the economic factors, each person can gift up to $5 million without incurring gift tax. Many traditional estate planning techniques employ these factors to facilitate the transfer of wealth to heirs with little or no gift or estate tax consequences.

GRATs. Consider a Grantor Retained Annuity Trust (“GRAT”), for example. The Internal Revenue Code expressly allows a person to transfer assets to a trust in exchange for payment from the trust of an annuity (a yearly amount), that includes an interest factor set by the IRS, called the Section 7520 rate (which is 1.4% for October, 2011). The annuity payment can be set so that the grantor receives total payments during the term of the GRAT (two years or more, under current law) equal to the value of assets contributed to the trust. If so, there is no gift at inception (called a “zeroed-out GRAT”). If the value of GRAT assets increases more than 1.4% per year, the entire excess passes to or in continuing trust for the grantor’s children.

This has been a favorite wealth transfer technique of the rich and famous, including the Gates, Buffet and Walton families, and numerous Google millionaires. For example, pre-IPO Google shareholders held stock worth a fraction of its IPO price and a much smaller fraction of its post-IPO run up in value. Many such shareholders contributed shares to zeroed-out GRATs shortly before the IPO, received an annuity measured by the pre-IPO value, and terminated the GRATs after two years with a transfer of 10 times the pre-IPO value in trust for their children.

GRATs work for many different asset types including marketable securities, family businesses, real estate and family investment partnerships. The value of many of these assets is at 5 to 10-year lows today. The IRS implied interest rate of 1.4% is among the lowest rates ever. In addition, if the assets are held in an entity such as a partnership, LLC or corporation, traditionally accepted valuation principles permit an interest in the entity holding the assets to be discounted in determining its fair market value for estate and gift tax purposes. These discounts (for lack of marketability and minority interest), determined by appraisers and confirmed in numerous decisions of the Tax Court and Federal appellate courts, often range from 30% to 40% or more.

Current revenue raising proposals would also severely limit discounts applicable in valuing the transferred assets. The Green Book proposal is to disregard restrictions on transfer that are more restrictive than those to be described by the Treasury Department in future regulations. The Green Book acknowledges that these restrictions “would normally justify discounts” in transactions not involving family members. [Green Book, p. 121.] This will result in great uncertainty in planning for family businesses as final regulations often take several years to be issued. In 2009, H.R. 436 was introduced, which if enacted would have eliminated discounts for gift and estate tax purposes, except in the case of an active trade or business. Fortunately, the bill did not pass, but it is clear that the Administration and Congress will consider these changes again in the future.

The proposed restrictions on GRATs will likely favor a related technique referred to as a sale to an intentionally defective grantor trust (“sale to a DGT”). The benefits of a sale to a DGT are effective immediately – the grantor does not have to survive any certain time. The beneficiaries of the DGT also can include grandchildren, as well as children, unlike a GRAT. There are many nuances applicable in considering these and other planning techniques that should be reviewed with a qualified estate planning professional.

Finally, the grand revenue raiser – rates and exemptions. No one would have predicted that 2010 would be the year with no estate tax and that we would actually see an increase in exemptions to $5 million for both estate and gift tax with a maximum estate and gift tax rate of 35% in 2011 and 2012. Now, the specter of a 2013 estate tax resurrection looms – with a $1 million exemption and a 55% marginal tax rate. The additional revenue from these changes would be substantial. This two year window of opportunity combined with favorable economic factors makes this the time to act to transfer wealth to children and grandchildren.

The “perfect storm” of estate planning is a once-in-a-generation opportunity. Advisors and clients should take advantage of this situation before the inevitable sea change occurs.

Scott A. Harshman Jeffer Mangels Butler & Mitchell LLP 3 Park Plaza, Suite 1100 Irvine, CA 92614 T: 949-623-7224 E: SHarshman@jmbm.com

Gordon A. Schaller Jeffer Mangels Butler & Mitchell LLP 3 Park Plaza, Suite 1100 Irvine, CA 92614 T: 949-623-7222 E: GSchaller@jmbm.com