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EXPERT VIEW: Hemenway & Barnes On Making The Most Of Year-End Tax Planning
Michael Puzo and Nancy Dempze
11 October 2013
The authors of this
article, Michael Puzo, of East Coast law firm Hemenway & Barnes, and Nancy Dempze, addresse
the issue of getting the best possible results from year-end planning. Puzo –
who has been interviewed by Family Wealth Report here - concentrates on trust
and estate matters, serving as a trustee of private trusts and charitable
foundations. Puzo chairs the private client
group at Hemenway & Barnes and was formerly its managing partner. He is
also a managing director and treasurer of Hemenway Trust Company, a New Hampshire-based
private fiduciary firm. Dempze is a partner at the firm. In recent years, uncertainty around taxes and fiscal policy
set the tone for estate planning: “hurry up and wait” was the order of the day,
followed by a year-end scramble to minimize damage from anticipated changes.
2013 brings a reprieve of sorts, with much to do, but a well-marked landscape
in which to do it. From 2001-2012 the federal estate tax exemption was more
volatile than the stock market – ranging from $1 million in 2001 to unlimited
in 2010 to $5.12 million in 2012. The federal gift tax exemption also changed
dramatically, increasing from $1 million in 2001 to $5.12 million in 2012. The
increased estate and gift exemptions were set to expire after 2010, but were
made permanent beginning in 2013. Hardly an ideal environment for estate
planning. Fortunately, the new estate tax law provides a firm foundation
for planning, with its four key elements. First, it keeps the amount exempt
from federal transfer taxes high. In 2013, each person has a $5.25 million
exemption that he or she can apply to lifetime gifts. Any exemption that is not
used for gifts can be applied at the person’s death. There is also a $5.25
million exemption from generation-skipping transfer taxes which apply to
transfers to grandchildren. Second, the new law provides for automatic
increases each year to reflect federal cost of living adjustments. Those
adjustments are significant – resulting in an increase of $125,000 last year.
Third, the tax rate for estate, gift and generation-skipping transfers over the
exemption is a flat 40 per cent. Fourth, a surviving spouse can now elect to
use a deceased spouse’s unused federal estate tax exemption. Given the dramatic increases in the transfer tax exemptions
over the past decade, it is important to do a checkup on existing wills and
trusts. Estate planning documents often include formulas that allocate assets
to trusts for spouses and descendants based on the desired tax results. That
can result in too much being set aside for grandchildren, for example, and not
enough for children or the surviving spouse. Also, under the old estate tax laws, it was usually better
for a married couple to shelter the maximum amount from estate tax at the first
death. Now that unused estate tax exemption can be transferred to the surviving
spouse, it may be better to include more in the surviving spouse’s estate to
get a higher income tax basis in family assets when the spouse dies. The bottom
line? There is no one size fits all approach – each plan should be reviewed and
revised as needed. The increased estate and gift exemptions mean that the 40
per cent tax on gifts and estate transfers is a concern primarily reserved for
the most affluent of US citizens. It “leaves very few people who will be
subject to the tax,” Reuters noted in
a 2013 wrap-up of the changes. “For married couples, the estate tax is usually
deferred, even for large estates, because of the unlimited marital deduction.
Just 3,800 estates are expected to owe any federal estate tax in 2013,
according to estimates from the Tax
Policy Center.” To some extent, estate and gift tax relief serves as a
counterbalance against income tax increases that will hit the highest brackets.
“Taxpayers in the top tax bracket will pay higher rates on income, dividends
and long-term capital gains,” writes Kiplinger. “But the law also provides relief for upper-income taxpayers
concerned about protecting their estates…In the future, less than 1 per cent of
taxpayers will have to worry about federal estate taxes.” In addition to income tax increases, the new 3.8 per cent
Medicare tax also impacts high earners. From a planning perspective, higher tax
rates make vehicles with tax favored status attractive, including 529 plans,
Roth IRAs, Roth 401k Plans, and charitable remainder trusts. The higher income
tax brackets also make charitable gifts more attractive because they can be
used to offset higher income tax rates. Finally, trusts for future generations
can be set up as “grantor trusts,” so that the income taxes are paid by the
donor, rather than the trust. The donor’s payment of income taxes on the trust’s
income is not an additional gift to the trust beneficiaries; taking on this tax
liability will allow a generous donor to maximize what he or she can pass on to
younger generations over time. Wealthy taxpayers who are willing to plan ahead, fund trusts
early on, and leverage the gift tax exemption have opportunities to
significantly reduce their estate tax down the line. While some strategies are
part of the program every year, here are several of the most appealing ways to
ease the tax burden for 2013: Be strategic about charitable giving Charitable giving serves the dual purpose of advancing
philanthropic goals and reducing the taxable estate. For charitable gifts made
in cash by year end, up to 50 per cent of a taxpayer’s “contribution base”
can be deducted – a tremendous benefit,
especially for families experiencing a major income event. This may explain why donors nearing retirement register as
the most philanthropic demographic. A recent study showed that “not only are Boomers
the largest group numerically, with 51 million individuals
comprising 34 per cent of the donor base, they are also the largest
contributors, giving an estimated total of $61.9 billion per year .” Donors can also be creative about how they give. Deductible
charitable gifts can be made by transferring value by any method and in any
form to a charity. This includes gifts of cash or
gifts of property . Given the increase in the capital gains rate from 15 per
cent to 20 per cent for the highest tax bracket, 2013 is an ideal year to
donate appreciated stock. Taxpayers get a charitable deduction for the full
fair market value deduction of the stock given, including the untaxed
appreciation. Typically, the charity then sells the stock and, being tax
exempt, can do so tax free. Remember, the process of donating stock takes time.
Donors should plan for a full month to complete the transaction, especially at
year-end when brokers are inundated with similar requests. Finally, unless the law is extended, 2013 is the final year
in which donors over 72 can donate up to $100,000 directly from an IRA to a
charity. The donation counts towards the donor’s required minimum distribution,
but unlike normal IRA distributions, the amount passing directly to charity is
not included in the donor’s taxable income. This giving strategy is especially
helpful in states that do not provide a charitable deduction . It is worth noting that charitable giving is not only part
of tax strategy, it is an important part of cultural advancement. Donors are
able to channel resources to a mission, whether to fund the arts, the
environment, support medical and other health and welfare needs, or – all too
often in the past several years – respond to natural disasters or acts of
violence. Even when spurred on by timely events, giving should be part
of a long term plan that supports the estate plan and the long term charitable
philosophy. As community members respond to an event by donating, they may lose
sight of the effect on their plan and on other charities. A donation to a
specific community need may come at the expense of other philanthropic efforts.
Year-end is an ideal time to reflect on the charitable giving philosophy and
make decisions about where to direct donations. Give smart: use the right vehicles While families try to plan as far ahead as possible and stay
true to a strategy, sometimes year-end comes faster than expected. When time is
an issue or donors are uncertain about their philanthropic strategy, they can
transfer assets to a family foundation. If they do not have a family
foundation, they can establish a Donor Advised Fund. A foundation or DAF allows
donors to allocate funds to charity without immediately specifying a recipient.
They can make a general donation, receive a tax deduction in the year the
assets are allocated, and distribute the funds over time to various causes.
DAFs have quickly become a popular vehicle because of their flexibility and
tax-friendly status. The charitable lead trust is another option, especially for
the wealthy donor who wishes to fund a certain level of charitable giving each
year and also leverage the amount being left to children. With a charitable
lead annuity trust, for example, the donor agrees to pay a certain percentage
of the trust’s initial assets to one or more charities each year for a term of
years. At the end of the term, any assets remaining in the trust will pass to
the donor’s children. The value of the gift to the children at the time that
the trust is established is based on the IRS interest rate in effect at the
time of the gift. The IRS rates are currently very low and if the trust appreciates in excess of 2 per cent per year, that
excess growth passes to the donor’s children free of gift tax. Maximize family gifts, but be careful gifting low basis
assets In addition to charitable donations, gifts to children and
other relatives move money out of the taxable estate. With the gift tax
exclusion now set in stone , families can make
significant annual gifts that reduce tax exposure. In fact, a cost of living
adjustment provides for an additional amount each year that can be gifted
tax-free; even those who gave gifts to the maximum lifetime allotment of $5.125
million by the end of 2012 can give another $125,000 in 2013. The annual gift
tax exclusion – the amount up to which taxpayers can give to any individual
each year without reporting it – has also increased to $14,000, the first such
jump since 2009. In addition, there is an unlimited annual exclusion for the
direct payment of tuition and medical expenses. A major advantage of gift giving strategies is that they not
only allow for the straightforward tax-free transfer of an asset, they also
protect all future appreciation and income earned by the assets after the gift.
If individuals do not need certain assets to support their current or future
needs, their family can enjoy significant financial benefits of their gifts
well into the future. A word of caution, though: with the federal exemption so
high, the temptation to make sizable gifts can lead to higher capital gains
taxes when the family later sells an asset that has been given to them. Years
ago, with estate tax exemptions low and rates high, it was almost always better
to make lifetime gifts than to pay estate tax, even if it meant higher capital
gains tax when an asset was sold. That is no longer the case for families with
assets below the federal estate tax threshold. If the federal estate tax does
not apply, then the only estate tax may be at the state level. State estate tax
rates tend to be significantly lower than the current federal capital gains tax
rate of 20 per cent. Also, for sales of tangible objects such as art or fine
furnishings, the federal capital gains tax rate is 28 per cent. A vacation home handed over to children, for example, will
have an income tax basis equal to the donor’s tax basis. If instead, the
vacation home were left to the children at death, it would receive a step up in
tax basis equal to date of death value. The home could then be sold without
triggering large capital gains taxes. One of the best ways to shift assets to the next generation
is to fund a generation-skipping trust that is a grantor trust for income tax
purposes. That way the donor will pay the tax bill on the trust during the
donor’s lifetime and the trust assets can grow free of the annual income tax
hit. A generation-skipping trust shelters assets from estate tax for so long as
the assets remain in trust. The generation-skipping trust can be established in
states such as New Hampshire,
that allow the trusts to go on indefinitely. Generation-skipping trusts also
offer important benefits in terms of creditor protection for beneficiaries.
That helps protect the assets in the event of a beneficiary’s divorce. While it
sounds counter-intuitive, the generation-skipping trust can also benefit the
children. The trust can be drafted so that the trustees have discretion to make
distributions to them as needed. Once the generation-skipping trust is funded, it can be used
to purchase assets from the donor if it is set up as a grantor trust for income
tax purposes. The purchase allows the trust to lock in the value of the assets
now before they appreciate further. The sale can be structured as an
installment sale, so that the trust can pay back the donor over time, with
interest set at the minimum federal rate, which is much lower than commercial
rates. Because of uncertainty about how these transactions may be taxed if the
donor dies while the loan is outstanding, the sale should be structured to pay
off the loan well within the donor’s life expectancy. Grantor retained annuity trusts or “GRATs” continue to be a
great way to transfer assets to children without using up gift exemption. With
a GRAT, the donor transfers assets to a trust and receives an annual annuity
that is designed to zero out the value of the gift passing to children based on
the IRS valuation rules. The federal interest rate used to value a GRAT is very
low right now – 2 per cent in September – so GRATs provide an ideal way to
transfer appreciation in excess of the assumed federal rate to the children
free of gift tax. For example, if a donor transfers $5 million to a GRAT with a
2-year term and the assets appreciate at an annual rate of 7 per cent vs 2 per
cent, the remainder passing to children after two years gift tax free would be
almost $400,000. Doing the simple things Finally, don’t forget to do the simple things well each
year. Each individual can transfer up to $14,000 per person per year as an
“annual exclusion gift.” You can make the gifts outright or to a trust that
qualifies for the annual gift exclusion called a “Crummey Trust.” You can give
cash or marketable securities, which are easy to value, or interests in any
other type of asset. If you give an interest in a family limited liability
company or partnership or closely held stock, real estate or tangible objects,
such as art, you will need to obtain an appraisal. A bit of effort in making
full use of annual exclusion gifts will be well rewarded. The $14,000 annual
exclusion adds up fast – if grandparents give to a grandchild’s trust every
year for 21 years and the assets grow at a modest rate, the trust will have
over $1 million in assets by the time the grandchild is 21. There is also an unlimited gift tax exemption for direct payment
of tuition and medical expenses. The expenses must be paid directly to the
provider – the donor cannot reimburse the child or grandchild for an expense
that has already been paid. Tuition for any age student enrolled in an academic
program, even some preschool programs, qualifies for the gift exemption. Given
the high cost of private education at all grade levels, and the high cost of
both public and private colleges, the unlimited exemption for direct payment of
tuition enables families to transfer millions of dollars gift tax free to
younger generations. Many of us are surprised at how much we spend on medical
expenses, including health insurance payments and co-pays, prescription
medicines and treatments and eye care and dental care. Parents or grandparents
can help by paying those expenses directly on behalf of their children or
grandchildren. Avoid the year-end scramble Whichever strategy is employed to move assets out of the
estate, thoughtful planning allows individuals to make the most out of their
current environment. With a more certain tax landscape in 2013, there are
opportunities to make informed decisions that will benefit families for the
next several years and for generations to come. To make the most of opportunities to reduce taxable estates
this year, taxpayers should be sure to check into: • Charitable donations of appreciated stock • Charitable donations of up to $100,000 from IRAs • Funding a charitable lead annuity trust to support annual
charitable giving and provide for children in the future • Funding the family foundation or donor advised fund • Making annual gifts to family members of up to $14,000 per
individual • Directly paying tuition and medical expenses • Giving an additional $125,000 this year if you maxed out
your lifetime gifts in 2012 • Funding a GRAT • Funding or adding to a generation-skipping trust.