Cummings & Lockwood

2013 Private Clients Group Annual Client Update

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December 2013

DECEMBER 2013

Dear Clients and Friends:

The year 2013 has been, relatively speaking, a quiet one on the federal estate, gift and generation-skipping transfer (“GST”) tax front.  Unlike the transfer tax regime which expired on December 31, 2012, the 2013 regime is “permanent” in the sense that it is not set to expire on any given date.  There are inflation adjustments in the annual exclusion from gift taxes and the exemptions from estate and gift taxes and GST tax, but aside from these, the 2013 regime will be with us in 2014.  We remain mindful that future negotiations on spending cuts, the debt ceiling and other fiscal initiatives create the possibility of further changes in rates or exemptions, or the curtailment of certain popular gifting techniques.  This letter summarizes the current tax regime and some important gifting techniques used by our clients.  Should you have questions or desire a more detailed explanation of any of the provisions of the transfer tax system or this letter, you should consult with your Cummings & Lockwood attorney.

ESTATE, GIFT AND GST TAX RATES AND EXEMPTIONS IN 2013 AND BEYOND

The amount exempt from the estate and gift taxes is $5,000,000 indexed for inflation (set at $5,250,000 for 2013 and expected to increase to $5,340,000 for 2014) and the taxes are now unified so that the entire exemption can be used during lifetime or, if unused during lifetime, at death.  Prior to 2011, only $1,000,000 of the total exemption was available for lifetime use.  The GST tax exemption is also now $5,000,000 indexed for inflation.  The maximum estate, gift and GST tax rates are now 40%, more than the 2011 and 2012 rates of 35% but still a significant decrease from the 2001 rate of 55%. 

The increased exemptions offer an opportunity to make additional gifts tax free and to shelter gifts from the GST tax as well.  For those clients who have previously used their entire lifetime gift exemptions, the inflation index will make additional tax-free gifts possible without incurring a federal gift tax.

When making gifting decisions, remember that if you live in a state that has a separate gift tax system, such as Connecticut, it is important to take state taxes into account as well. 

EXEMPTION PORTABILITY

Married clients should bear in mind that each spouse has his or her own federal estate tax exemption, thus allowing a married couple with a proper estate plan to pass on double the exemption amount tax-free to their beneficiaries.  Until recently, the benefit of the exemption of the first spouse to die would be wasted if the assets of the deceased spouse were left entirely to the survivor or did not equal at least the exemption amount.  In 2011, the federal tax laws provided for the first time that under most circumstances any unused exemption of a deceased spouse could be transferred to the surviving spouse and saved for later use to reduce estate taxes in the surviving spouse’s estate or to shelter lifetime gifts by the surviving spouse.  In 2013 this “portability” feature of the estate tax exemption was made permanent.  A portability election requires the timely filing of a federal estate tax return after the death of the first spouse.

There are some limitations to relying on portability, including the fact that currently most states do not allow portability of state estate tax exemptions, meaning that state exemptions may be wasted and state estate taxes increased by relying on portability.  In addition, the GST exemption is not portable and in most cases the best way to use GST exemption is to combine it with the estate tax exemption when the first spouse dies.  Also, under the traditional system of leaving the exemption to a trust at the death of the first spouse, the exempt amount plus all of the appreciation on that amount between the death of the first spouse and the death of the surviving spouse escapes estate tax, whereas portability only protects from estate tax the unused exempt amount of the first spouse to die without any inflation adjustment.  Perhaps most importantly, the first spouse to die will have no opportunity to direct the passage of assets to specific beneficiaries if portability is used.

CHANGES TO ANNUAL EXCLUSION AMOUNTS

Because of inflation indexing, some annual exclusion amounts have increased as of January 1, 2013.  The annual exclusion from gift tax, i.e., the amount that you can give to any number of people each calendar year without using lifetime gift exemption or incurring a gift tax, is $14,000 per donee in 2013 and will remain at that amount in 2014. The amount an individual can give to his or her non-US citizen spouse per calendar year is $143,000 in 2013 and is expected to increase to $145,000 in 2014.

GIFTS TO ESTATE REDUCTION TRUSTS FOR SPOUSE AND/OR OTHER FAMILY MEMBERS

An Estate Reduction Trust is an irrevocable trust created by you for the benefit of your spouse and/or other family members to remove assets and their appreciation from your taxable estate.  For married couples, a gift to such a trust can be particularly attractive because your spouse can be the primary beneficiary of the trust, allowing the assets to remain available to your spouse.  In addition, if you choose to allocate GST exemption to the gifts to an Estate Reduction Trust, the trust assets and their appreciation can also be removed from the GST tax system for as long as the trust exists, meaning that eventual transfers from the trust to grandchildren and more remote descendants can be made without any tax.  These trusts also can be designed to maximize ongoing creditor and divorce protection for children and grandchildren.

GIFTS TO DYNASTY TRUSTS

A Dynasty Trust is designed to benefit multiple generations by permitting property not needed by your children to assist with their cash needs to remain in trust for multiple generations without the imposition of estate tax or GST tax.  The increased gift and GST tax exemptions present an excellent opportunity to preserve the full value of family assets for grandchildren, great-grandchildren and more remote descendants.  Estate Reduction Trusts discussed above can be designed as Dynasty Trusts.

FRACTIONAL INTEREST GIFTS

The federal gift tax is imposed on the fair market value of the gifted asset at the time of the gift.  The value of a fractional interest in property or a minority interest in an entity may be discounted in determining the asset’s fair market value.  This is because a fractional or minority interest often is not freely marketable and the underlying asset is not one that can be controlled by the donee.  A professional valuation will normally be required to determine the appropriate discount.

QUALIFIED PERSONAL RESIDENCE TRUSTS

A Qualified Personal Residence Trust (“QPRT”) is a tax-efficient means of transferring a personal residence to your intended beneficiaries.  The concept of a QPRT is relatively simple:  You transfer your personal residence to a trust but retain the right to live rent-free in the residence for a specified number of years.  At the end of that period, ownership of the residence is transferred to the beneficiaries (or a trust for their benefit) and is removed from your estate.  At that time, you may rent the property from the beneficiaries.

The tax advantage of the QPRT results from the way in which the taxable gift is calculated.  The value of the taxable gift does not equal the full value of the residence on the date of the gift, but rather the value of the residence, reduced by your right to reside in the residence for a specific number of years and the right of your estate to get back the residence if you do not survive that term of years.  With the increased gift exemption, QPRTs may be an appropriate vehicle for people who otherwise would not consider such a gift because they did not have enough gift exemption remaining or did not want to use a large portion of the more limited exemption.

It is very important to administer a QPRT according to its special rules so that the tax savings achieved by this device are preserved. The Internal Revenue Service routinely audits the administration of QPRTs when the grantor dies.

GRANTOR RETAINED ANNUITY TRUSTS

The objective of a Grantor Retained Annuity Trust or “GRAT” is to transfer appreciation in value to your beneficiaries free of any gift or estate tax.  A GRAT is a trust to which you transfer an asset and from which you receive a fixed amount annually (an “annuity”) for a specified number of years.  The annuity is calculated using the IRS interest rate in effect at the time of the gift.  If you survive the period of years, the trust beneficiaries will receive the assets remaining in the GRAT free of gift and estate tax.  The tax advantage of this technique is derived principally from the way in which the value of the gift to the GRAT is calculated.  The value of the gift for gift tax purposes is not the value of the assets transferred, but rather is the value of the right of the remainder beneficiaries to receive the assets after the annuity payments have been made to you and the period of years has expired.  The GRAT is typically structured so that the combination of the duration of the GRAT and the annuity amount retained reduces the value of the gift on creation to essentially zero.  If the assets in the GRAT appreciate at a rate higher than the IRS interest rate used to calculate the annuity paid to you, then on termination there will be assets remaining in the GRAT that will pass tax-free to your beneficiaries.  The IRS interest rate for December is two percent.  Like QPRTS, the administration of GRATs is important to preserving the tax savings.  GRATs require the use of minimal gift tax exemption and are not effective vehicles for GST transfers.

As discussed below, there has been much discussion in Congress about eliminating some of the most attractive and effective provisions of the GRAT laws in future years so that these trusts may no longer be available or you may not be able to structure them to achieve the maximum chance of success available now.

GRANTOR TRUSTS

To further enhance the potential for appreciation of gifted property outside of the donor’s taxable estate, many of the trusts described in this letter can be designed as “grantor trusts” thereby making the grantor personally taxable on the taxable income generated by the trust assets.  This relieves the trust from any liability for income taxes during the grantor’s lifetime, allowing the trust to grow tax free and reducing the grantor’s estate without any gift tax consequences to the grantor.  

STATE TAX CONSIDERATIONS

When making gifting decisions, remember to consider state tax implications, some of which include: 

Connecticut has a separate state gift tax with an exemption of only $2,000,000.  This means that if a Connecticut resident makes a $5,250,000 gift to take full advantage of the federal gift exemption available in 2013, a Connecticut gift tax of $251,700 will be due on the $3,250,000 difference between the federal and Connecticut exemptions.  Note, however, that this tax can be avoided if the gifted property is real property or tangible personal property not located in Connecticut.

New York has no gift tax but has an estate tax with an exemption of only $1,000,000.  This means a New York client can gift $5,250,000 during 2013 and pay no New York tax, while the same transfer at death would incur at least $420,800 in New York estate tax.  New York is considering reinstating its gift tax.

Florida has no state gift or estate tax.

REASONS TO ACT NOW

We remain mindful that even “permanent” provisions to the tax code are “permanent” only until Congress changes them.  In light of the upcoming negotiations on spending cuts and the debt ceiling, it is possible that tax laws could change.  Even if the current exemption amounts and rates remain intact, there have been various legislative proposals in recent years, including President Obama’s budget proposals, which would limit certain gifting techniques entirely or significantly curb their effectiveness.  These provisions may become a part of any debt ceiling or budget compromise.  These include:

  1. Restricting fractional interest discounts for many transfers of non-business assets made to family members.

  2. Requiring Grantor Retained Annuity Trusts (“GRATs”) to have a minimum term of 10 years and a remainder greater than zero.

  3. Imposing a 90 year limit on the protection from GST tax for trusts to which GST exemption is allocated.

  4. Severely limiting the use of “grantor trusts” that permit donors to pay the income tax on the taxable income generated by assets owned by the trust without such tax payments being treated as additional taxable gifts and without the trust assets being included in the donor’s taxable estate.

     

AN IMPORTANT CONSIDERATION EVEN IF YOU ARE NOT INCLINED TO MAKE GIFTS OR OTHER CHANGES TO YOUR ESTATE PLAN NOW:  TAX FORMULA CLAUSES UNDER WILLS AND TRUSTS

If your current Will or Trust divides your estate so that (i) the share exempt from estate tax passes to a beneficiary other than a trust for the benefit of your spouse, or (ii) the share exempt from GST Tax passes in a way that bypasses your children, you should contact your Cummings & Lockwood attorney as soon as possible to consider whether the increase in the exemptions from these taxes reduces the property passing to or in trust for your spouse or children to less than you would want.

2013 INCOME TAX CHANGES

We thought you would like to be aware of some of the following changes in the income tax laws for 2013 which may result in higher income taxes for many clients:

  1. Taxpayers with Modified Adjusted Gross Income greater than $200,000 ($250,000 for married couples) may be impacted by a new 3.8% Medicare surtax on net investment income.

  2. Taxpayers with earned income above $200,000 ($250,000 for married couples) will also pay an additional .9% Medicare payroll tax.

  3. Taxpayers with an Adjusted Gross Income (AGI) above $250,000 ($300,000 for married couples) may have their personal exemptions reduced or eliminated and their itemized deductions reduced by 3% of their AGI to a maximum reduction of 80% in value.

  4. Taxpayers will pay a higher income tax rate (up to 20%) on their qualified dividends and long-term capital gains.

  5. Taxpayers with taxable income greater than $400,000 ($450,000 for married couples) will face a new 39.6% top marginal rate.

TAX-FREE DISTRIBUTIONS FROM INDIVIDUAL RETIREMENT PLANS FOR CHARITABLE PURPOSES

In 2013, clients may again make tax-free distributions (not to exceed $100,000 in the aggregate) from an Individual Retirement Account (“IRA”) to qualified charities.  Currently, this rule applies only to distributions made before December 31, 2013 directly to the qualified charities.

CONCLUSION

We will, as always, keep you posted of any major developments in future updates.

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Copyright 2013, Cummings & Lockwood LLC.  All rights reserved.

 

In this Update, we have deliberately simplified technical aspects of the law in the interest of clear communication. Under no circumstances should you or your advisors rely solely on the contents of this Update for legal advice, nor should you reach any decisions with respect to your personal tax or estate planning without further discussion and consultation with your advisors.

In accordance with IRS Circular 230, we are required to disclose that:  (i) this Update is not intended or written by us to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer; (ii) this Update was written to support the promotion or marketing of the transaction(s) or matter(s) addressed by such materials; and (iii) each taxpayer should seek advice on his or her particular circumstances from an independent tax advisor.