Over the Horizon, Some Estate-Gift Tax Issues Loom
by Joseph Growney
Recent changes to the federal estate and gift tax laws provide significant planning opportunities for high-net-worth individuals and owners of closely held businesses.
Some of the more favorable provisions of these laws may be cut in 2013, which means that now is the time to take advantage of an ideal planning environment.
In December, President Obama signed into law the Tax Relief, Unemployment Insurance Authorization, and Job Creation Act of 2010, which includes provisions related to the federal estate, gift, and generation-skipping transfer taxes. Under that act, the exemption for estate, gift, and generation-skipping transfers is $5 million and the top rate of tax for transfers exceeding that amount is 35 percent.
Absent further legislation, the act will expire at the end of 2012 and the law will return to the pre-2001 exemption amounts and rates—a $1 million exemption, with a top rate of tax of 55 percent.
New legislation enacted effective for 2013 could also scale back the beneficial exemption amounts and rates. The Obama administration’s recently released 2012 budget proposal calls for a $3.5 million estate tax exemption (not indexed for inflation) and a top tax rate of 45 percent, effective January 2013.
The administration’s proposal would also affect the use of some longer-term planning options currently available to high-net-worth individuals and closely-held business owners, including the use of grantor retained annuity trusts, or GRATS, and valuation discounts for estate and gift tax purposes.
Under current law, an individual may establish a GRAT for a term of years (usually two or more), in which such individual holds the right to receive an annuity each year of the term, and upon conclusion the remaining assets pass to one or more family members. The advantage of using a GRAT is that the appreciation in the value of property may be transferred to family members at a reduced transfer tax cost. The gift of the remainder of the interest is valued at the time the GRAT is created. If structured properly, the value of the gift may be $0 (a “zeroed-out GRAT”), but the GRAT may result in a significant transfer of wealth if the property appreciates at a higher rate than the required interest rate. The risk is that if the individual fails to survive the GRAT term, all or a significant portion of the property held in the GRAT is included in the individual’s taxable estate.
The Obama budget proposal would require a minimum GRAT term of 10 years (thereby eliminating the use of shorter-term GRATS and increasing the mortality risk), and would require that the initial value of the remainder interest be greater than zero (barring the use of zeroed-out GRATs and imposing a gift tax cost).
Valuation discounts are used when an individual makes a gift or sale of closely held business interests, and the fair-market value is discounted to reflect the inherent lack of marketability or lack of control (if a minority interest is transferred). The discounts may greatly reduce the impact of transfer taxes and allow a greater value to be transferred to family members. The administration proposal would limit the use of valuation discounts in family-controlled entities, by disregarding certain transfer restrictions for valuing interests for estate or gift tax purposes.
In light of the uncertainty on the horizon in 2013, the next two years provide a prime opportunity for high-net-worth individuals and closely held business owners to capitalize on the favorable estate and gift tax laws. The following are a few planning options these individuals should consider:
• Make gifts of appreciating assets, such as closely held business interests, to utilize the increased $5 million gift tax exemption (and use valuation discounts as appropriate).
• In larger estates, make gifts in excess of the exemption amount, and pay tax at the reduced 35 percent rate.
• Form a zeroed-out GRAT, with a shorter term to reduce the mortality risk; and/or
• Sell closely held interests to an Irrevocable Trust in exchange for an installment promissory note, to take advantage of valuation discounts.
Each of these options could allow for a significant transfer of wealth at a reduced transfer tax cost. In two years, the landscape could change dramatically, so high-net-worth individuals and business owners interested in succession planning would be wise to make any desired transfers now instead of waiting for the unknown. Waiting, in this case, could cause unnecessary transfer tax consequences. 
Joseph Growney is a lawyer with Lathrop & Gage in Kansas City.
P | 816.460.5417
E | jgrowney@lathropgage.com