Unique Planning Opportunity Scheduled to Expire this Year

September 2012

Under provisions of the current federal gift and estate tax laws, an individual can transfer a total of $5,120,000 of wealth free of federal gift and/or estate tax, either during life or upon death. Additionally, such transfer can be made to a trust that will ultimately pass the assets to grandchildren and more remote descendants, free of the generation-skipping transfer tax.

However, unless new legislation is enacted, these favorable provisions will expire on December 31, 2012, and the exemptions will be reduced from $5,120,000 to $1,000,000 per individual. Furthermore, the maximum tax rate for the estate, gift and generation-skipping taxes will be increased from 35% to 55%. Given the uncertainty of the fate of the current provisions, individuals should consider using some or all of the current exemptions before the end of the year. This can be accomplished by making one or more lifetime gifts.

For example, sizeable gifts can be made to a trust for the benefit of a child. By making a gift of assets to a trust for the child's benefit rather than outright to the child, the individual utilizes his or her current exemptions, and the value of the assets — including all appreciation — will not be included in the taxable estate of the individual or the child upon their deaths. The wealth in the trust can be used by the child during his or her lifetime, and the remaining balance in the trust on the child's death can pass on for the benefit of grandchildren and more remote descendants without additional gift, estate or generation-skipping taxes.

To provide additional tax benefits, a trust may be structured as a "grantor trust," which allows the individual who creates the trust to pay the trust's income tax liability from his or her personal wealth, thereby further reducing his or her taxable estate. By paying the trust's income tax liability, the individual is, in essence, making a tax-free "gift" to the trust each taxable year. In addition, because the value of the trust is not reduced by the payment of income tax, the assets are essentially growing free of income tax inside the trust.

For individuals reluctant to part with a significant amount of wealth, a spouse may use all or a portion of his or her exemption to set up a trust for the benefit of the other spouse and their descendants. It also may be possible for the other spouse to use his or her exemption to set up a trust for the first spouse, thereby protecting a total of $10,240,000 ($5,120,000 x 2) from transfer taxes. However, to avoid tax-related complications, the beneficial interests provided to one spouse under one trust must be distinctly different from the beneficial interest provided to the other spouse under the second trust.

Even if new legislation is introduced to extend the exemptions, additional legislation has been proposed that would significantly diminish the tax benefits provided by certain planning techniques, including grantor trusts. Therefore, individuals interested in taking advantage of the current wealth transfer laws should act quickly to develop a plan for doing so.

For more information on this or other trusts and estate matters, please contact:

Paul Herman at (212) 592-1408 or [email protected].

© 2012 Herrick, Feinstein LLP. Tax Alert is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.