The bad news is that your net worth is almost certainly less (and likely significantly less) than it was just six months ago. The good news is that these changed economic conditions combined with the increased estate tax exemptions have reduced (or maybe, for the time being, eliminated) your estate tax exposure. Additionally, if you are still exposed to estate, gift and generation skipping transfer taxes (Wealth Transfer Taxes), the current lower market values and interest rates have created unprecedented opportunities to shift some of your wealth.
"Mr. Extax" provides an example of how these changed conditions can temporarily eliminate estate tax exposure. Only one year ago he had a net worth of approximately $5 million (all in the market). At that time he had approximately $1.35 million of estate tax exposure ($5 million minus $2 million estate tax exemption, multiplied by the 45 percent estate tax rate). If he died today, Mr. Extax would likely have no estate tax. Why? Because: (1) his net worth has likely decreased to $3.5 million, or less; and (2) the estate tax exemption increased to $3.5 million in 2009.
Of course, Mr. Extax still has two significant Wealth Transfer Tax concerns (remember, we did say his estate tax exposure was "temporarily" eliminated). First, a market rebound puts him back above the current $3.5 million exemption. Second, although new legislation will likely lock in the estate tax exemption at $3.5 million for the immediate future (see 'What's Next For Estate (And Gift And GST) Taxes?'), the exemption could eventually decrease (as it would without new legislation by returning to the $1 million exemption presently set to become effective in 2011).
If you remain, or like Mr. Extax, could again become exposed to Wealth Transfer Taxes, and you want to efficiently transfer some of your wealth to non-charitable beneficiaries, you should take advantage of the unprecedented current opportunities to avoid Wealth Transfer Taxes. Several current opportunities are directly tied to market values and interest rates. Therefore, you’ll want to act soon before market and property values bounce back and interest rates increase.
Some of the current opportunities are very basic and simple to implement. For example:
Simple gifting of depreciated assets: Transferring stock or other assets while values are depressed allows all future value appreciation to escape Wealth Transfer Taxes. For example, an annual exclusion gift of stock that was at $40 a share last year and is now at $10 a share allows you to double the size of your exempt gift if the stock value returns to $20 a share and quadruple the value of your exempt gift if it returns to its prior $40 a share value. The "carry-over basis" rules that apply to gifts can provide additional income tax benefits when you select the best stock for the gift.
Making loans at the decreased imputed rates: Multiple negative tax consequences (both income and Wealth Transfer Tax) apply when related parties make interest-free loans. To avoid those consequences, related-party loans must be made at minimum (safe harbor) interest rates. These safe harbors (known as applicable federal rates) vary based upon the duration of the loan and the timing of the required loan payments. Most of these rates hit historic low levels in February. For example, short term loans of three years or less requiring annual payments (which could be interest only with a balloon payment at maturity) can now be made at 0.83 percent interest. That’s actually up from 0.60 percent in February. These rates are low enough that your children or other intended gift recipients can purchase low-risk, income-based investments such as insured CDs, T-Bills, top-rated bonds, etc., through loans from you. The spread between the interest they receive and the interest they pay you passes without any gift taxes or the use of any gift tax exemption. Making these loans to children in lower income tax brackets (who are not subject to the kiddie tax) can also reduce overall family income taxes. Take, for example, a $1 million loan used to buy multiple fully insured CDs averaging 2.8 percent interest. Those CDs would generate $28,000 a year in interest for your child, reduced only by the $8,300 interest paid back to you (at the 0.83 percent safe harbor rate). That transfers $19,700 without Wealth Transfer Tax and could allow $19,700 of the $28,000 total income to be taxed at lower income tax rates applicable to your child.
Those are two simple techniques that require very little advanced planning and documentation. There are many other more complicated techniques that are also likely to perform very well in the current environment. For example:
- Grantor Retained Annuity Trusts (GRATs): These are structured with required fixed payments being made to the grantor over a fixed period (the annuity payments). The balance remaining after the annuity payments, if any, passes to the named beneficiary. The annuity payments and their value are based upon a current interest rate. That rate was at an all-time low in February and it has modestly increased to 2.6 percent for April (the "7520 Rate"). This generally means that the combination of all income generated from and appreciation of the assets placed in a GRAT, which together exceed the 7520 Rate, passes without gift taxation.
- Several other wealth transfer techniques, such as sales to Intentionally Defective Irrevocable Trusts (IDITs), Private Annuity transactions and the use of Self Canceling Installment Notes (SCINs), have similar enhanced performance probabilities in the current environment of depressed values and low interest rates. Other wealth transfer techniques, such as the use of Qualified Personal Residence Trusts (QPRTs), partially perform better (by funding them with residences likely to appreciate) and partially perform worse (by valuing the use portion at the current lower rates) under the current environment. Additionally, there are certain charitable giving techniques that generally perform better (e.g., Charitable Lead Annuity Trusts) and some that generally perform worse (e.g., Charitable Remainder Annuity Trusts) in low interest rate environments.
The above illustrates a few wealth transfer opportunities that are enhanced by the current decreased market values and interest rates. For more details check with your Warner Norcross & Judd Trusts & Estates attorney and act soon before these enhanced opportunities decline.