Post-Election Tax Planning for 2012

We write this blog post on the eve of President Obama’s re-election and the potential continuing gridlock between the House of Representatives and the Senate.

This makes for a very interesting playing field from the point of view of taxpayers who want to know what the situation is or will be with respect to their income and estate tax planning.

On the income tax side, the significant increases in rates already programmed into the law for January 1st may actually occur. This could be a significant burden upon single individuals who earn more than $200,000 per year and married couples who earn more than $250,000 per year.

The scheduled income tax increases include a highest bracket of 39.6% instead of the present 35%, and a 3.8% tax on interest, dividend, net rent, and other passive income to the extent that the taxpayer has total earnings exceeding the $200,000 and $250,000 thresholds.

In the estate tax arena the chips are even higher, as the present $5,120,000 gifting and estate tax exemptions would drop to $1,000,000 on January 1!  This is why so many clients have been working with us to make gifts exceeding $1,000,000 in value to make use of all or part of the $5,120,000 temporary gifting allowance, an opportunity which may never exist again during our lifetimes.  In addition to this, the estate tax rate, which is now only 35%, would go up to 55%!

Many clients do have a concern that if they gift too much away they could run out of assets.  Popular solutions to this have been (1) have a spouse as a beneficiary of the trust and assume that as long as the spouse is alive the donor can derive indirect benefit by being supported by the spouse while the spouse is being supported by the trust, and (2) forming the trust in an asset protection jurisdiction, since the IRS has ruled in at least one case that the contributor can be a discretionary beneficiary and actually receive the benefit of trust assets if and when ever needed.

Hopefully, there will be a political compromise with respect to both income and estate taxes between now and year-end. But most experts who have significant political/legal observation histories feel that this will probably not be sorted out until 2013, with the compromise to be retroactive to January 1, 2013.

Last week Professor Jerry Hesch, who is a well respected tax professor, author, and the Chairman of the annual Notre Dame Tax & Estate Planning Institute, hosted a webinar for tax lawyers and CPAs for Bloomberg BNA Tax & Accounting.

Professor Hesch suggested that every affluent person should consider putting an irrevocable trust into place that can hold assets that would not be subject to federal estate tax, but would be considered as owned by the grantor for income tax purposes.

This is because two very important estate and gift tax provisions that presently exist for these trusts would be eliminated if President Obama’s February 2012 budget suggestions are adopted, which are as follows:

1.       Presently the grantor can pay the tax on dividends, interest and other income earned by such a trust, so that the trust can grow faster to increase the assets that would pass free of estate tax.

Under President Obama’s proposal, this type of trust would be subject to estate tax on the death of the grantor.  Professor Hesch observed that trusts of this type existing before the end of this year probably would be grandfathered.  The effect of being able to pay the income tax on behalf of this type of trust, and be able to sell assets or discounted family interests to this type of trust in exchange for a low interest note has an incredible mathematical value.

2.       Presently this type of trust can be used to avoid estate tax not only at the grantor’s level, but also at the level of generations of descendants going for as long as 360 years if the trust is formed in Florida.

President Obama’s proposal would limit this “generation skipping dynasty” trust effect to 90 years.

In addition, many clients are making sure that they make their sales of family company interests to these types of trusts before year-end because we can presently value non-voting or minority interests in family entities using discounts.  President Obama’s 2012 budget proposal would eliminate discounts.

The Republican House of Representatives may be able to resist having some of these new restrictive estate tax provisions enacted, but what will the trade-off be for raising the estate tax exemption above $1,000,000 per taxpayer?  President Obama’s February 2012 budget called for a $3,500,000 per taxpayer estate tax exclusion and did not make mention of what the gifting exclusion would be.   Since the majority of super wealthy individuals have probably used their $5,120,000 gifting exemption in 2011 and 2012, we may not see significant resistance to allowing the gift tax exemption to go down to $1,000,000.

It is a stressful time for individuals who have a net worth of well over $1,000,000 and may find themselves wondering whether living until after December 31, 2012 will cause significant additional estate tax.  The situation that we have been fearing since December 2010 is now almost upon us.

So what are people to do between now and December 31, 2012?

If you fail to plan then you are planning to fail.

If In Doubt Gift It Out! – Many clients with net worth’s in the $2,000,000 to $4,000,000 range have stopped annual gifting in the hopes that the $5,120,000 exemption will continue.

Since that now seems highly unlikely, it may be a good idea to complete normal 2012 year end gifting to make maximum use of the $13,000 per person annual exclusion.

Also, do not forget that the Obama budget proposals would largely curtail grantor retained annuity trust planning by requiring a minimum 10 year term and a positive remainder interest.

Please contact us as quickly as possible if you have any questions or if we can be of assistance to you between now and year end.