SEIZE THE DAY – A WINDOW OF OPPORTUNITY FOR TAX PLANNING

If your experience over the past six months is anything like that of most Americans, you may be shell-shocked by the decline in your net worth. Given recent developments in the financial markets, estate tax planning may be the furthest thing from your mind. However, those very market conditions, combined with historically low interest rates and the prospect of adverse changes in the transfer tax laws, create an especially favorable opportunity for high net worth individuals to save estate and gift taxes through effective tax planning. The tax planning environment may not be nearly as attractive even a year from now.

Estate and Gift Tax Law Is in Flux

The estate and gift tax law remains unsettled at present, but the future of that law is becoming somewhat more predictable. For decedents dying in 2009, the maximum estate tax exemption amount is $3.5 million. Under current law, the estate tax will be completely inapplicable to estates of decedents dying in 2010, but in 2011 the exemption level will drop back down to $1 million and the maximum estate tax rate will jump back up from its current 45% to 55%.

The Obama administration has expressed a desire to see the $3.5 million exemption amount made “permanent” and the current 45% flat rate retained. [1] Most observers believe that such a change, or something similar, will be enacted by Congress either this year or early next year. Few observers hold out any hope that the estate tax will be repealed or that the exemption amount will be increased substantially over its current level. Few believe that the estate tax rate will increase; however, few observers hold out much hope that the estate tax rate will decline much, if at all.

Under current law, the lifetime exemption from gift tax is relatively small, covering only $1 million in total taxable lifetime gifts. It is not at all clear whether the current $1 million lifetime gift tax exemption amount will be increased to coincide with the estate tax exemption amount. [2] Therefore, any planning you undertake should be structured in a manner that minimizes or completely eliminates all taxable gifts.

The Present Tax Planning Environment Is Uniquely Favorable

For anyone whose taxable estate is likely to exceed his or her available estate tax exemption, the current tax planning environment presents unique opportunities. Several factors contribute to this favorable environment:

  1.    Temporarily Depressed Asset Values. As you know, our depressed economy has caused asset values to decline precipitously. While values may decline even further in 2009, most people believe that the declines that have occurred thus far have resulted in a significant undervaluation of many assets and that values will rebound substantially as we work our way out of this recession.

  2.    Interest Rates Are At Historic Lows. Many tax planning techniques produce the best economic results when they are initiated at a time when interest rates are low. During the past 50 years or so since the Government began requiring the use of their published rates to value retained interests and taxable gifts, interest rates have never been as low as they are right now. The federal rate that is required to be used for valuing life estates and remainder interests for tax planning purposes (the so-called “7520 rate”) is now just 2.6%! The minimum allowed interest rate on long-term promissory notes (the so-called “1274 rate”) [3] is currently 3.64%, and the minimum rate on mid-term obligations is just 2.14%. [4]

  3.    Proposed Changes in Tax Law May “Shut the Window” on Availability of Certain Planning Techniques. Congress will be considering significant changes to the estate and gift tax law this year. A bill already introduced in the House of Representatives would include the following changes:

These new rules, if enacted, will have the practical effect of eliminating valuation discounts for transfers of interests in family entities. The effective date of that law, if it is passed, would be its date of enactment rather than the date of its introduction, so there is still a brief window period during which we can use such entities in our tax planning and secure valuation discounts for gift and estate tax purposes.

For Planning With Entity Interests, the Time Is Now

For many years, people have achieved substantial estate and gift tax savings by forming closely-held entities, such as family limited partnerships (FLPs) and limited liability companies (LLCs), to hold investment assets and by transferring non-controlling interests in such entities to family members. Non-controlling interests in such entities have routinely been eligible for valuation discounts of 35-40% off of the net asset value of the assets owned by the entity. Use of FLPs and LLCs has enabled many people to make tax-efficient transfers to the next generation without sacrifice of management control.

The proposed tax law changes mentioned above would severely limit future opportunities for tax planning with FLPs and LLCs, and those law changes may become effective sometime before the end of this calendar year. You may already have formed one or more of such entities in the past. If so, and if you have not already transferred all of the interests that you ultimately wish to transfer, you should consider making additional transfers at this time. If you do not now own interests in any FLPs or LLCs but wish to take advantage of their tax-saving potential, you should look into forming such an entity without delay. Transfers of entity interests at discounted values will more likely survive IRS scrutiny if the entity has been formed and funded at least a few months prior to transfers of entity interests to others. The use of entity interests to implement other tax planning techniques - such as grantor-retained annuity trusts and sales to grantor trusts - can greatly enhance the tax-saving benefit of those techniques.

Don't Let the Window of Opportunity Shut

If you think that tax planning at this favorable moment in time may benefit you and your family, please get in touch with us. We stand ready to help you take advantage of this opportunity.

[1] In January, HR 436 was introduced in the House of Representatives. That bill would freeze the estate tax exemption amount at $3.5 million and retain the 45% estate tax rate on all taxable amounts over the exemption amount.

[2] Many observers believe that the new law will not re-unify the estate and gift tax exemption amounts.

[3] The 1274 rate is the minimum rate that one must charge on loans between related taxpayers in order to avoid imposition of imputed interest by the IRS.

[4] Long-term obligations are those with a term in excess of nine years, and mid-term obligations are those with a term of between three and nine years.

Trust and Estates Law Alert is a publication of the Trust and Estates Practice of Downey Brand LLP, a full-service law firm with over 100 attorneys.