2010 year-end estate planning: Navigating the uncertainty

Estate planning in 2010 has proven to be quite complicated due to the uncertainties surrounding the estate, gift and generation-skipping transfer tax laws. The midterm elections have changed the Congressional landscape, but there is still no certainty as to what (if anything) the lame-duck or the new Congress can (or will) do. While many of the usual planning techniques remain viable, the current state of the transfer tax laws provides for additional opportunities, but makes 2010 year-end planning a bigger challenge than in past years.

Status of Estate, GST and Gift Taxes

The estate and generation-skipping transfer taxes do not apply in 2010, although Congressional action to reinstate them is possible (with discussions still indicating that such legislation may be made retroactive to January 1, 2010). Without Congressional action, as of January 1, 2011, the federal estate tax will again be effective with a $1 million exemption and a 55 percent top marginal rate. Likewise, the generation-skipping transfer tax will be effective with a $1.36 million inflation-adjusted exemption and a 55 percent rate. While both of these taxes have been repealed for 2010, the gift tax has not. The gift tax rate this year stands at 35 percent, but will rise to a 55 percent top marginal rate in 2011. In this complex environment, where planning is all the more important, the following techniques are worth considering:

• Annual Exclusion Gifts

• Tuition and Medical Gifts

• Lifetime Gift Exemption

• Taxable Gifts

• Generation-Skipping Transfer Tax Planning

• Making Use of the Economy

• Roth IRA Conversions

Annual Exclusion Gifts

Making use of your annual exclusion gifts remains one of the most powerful—and simplest—estate planning techniques. For 2010, individuals can make an unlimited number of gifts of up to $13,000 per recipient, per year. Over a period of time, this approach can result in substantial transfer tax savings, as both the gift itself and its income and growth are removed from the donor’s estate. It also allows you to avoid paying gift tax or using any lifetime gift exemption (discussed below). However, if annual exclusion gifts are not made by the end of the year, that year’s exclusions are lost.

Tuition and Medical Gifts

You can still make unlimited gifts by paying tuition costs directly to the school or medical expenses directly to the health care provider (including the payment of health insurance premiums).

Lifetime Gift Exemption

The lifetime gift exemption, which remains because the gift tax still applies, allows gifts of $1 million in excess of the annual exclusion, tuition and medical gifts without the current imposition of gift taxes.

Taxable Gifts

Although no one likes paying a tax, taxable gifts in 2010 may prove to be very beneficial. For example, those who believe they will be in a taxable situation no matter what action Congress takes will be taxed at a 35 percent rate for any gifts they make this year. If they make the same gifts (or die with the assets) in 2011, a 55 percent tax may be imposed. Thus, there is a 20 percent benefit for those who make gifts by the end of this year. (Additional benefits are also obtained if wealth is transferred by lifetime taxable gifts, rather than at death, based on the differing manner in which the gift and estate taxes are computed and paid).

Generation-Skipping Transfer Tax Planning

In order to ensure a death tax at each successive generational level, the generation-skipping transfer tax is imposed on transfers to grandchildren or more remote descendants. However, a 2010 hiatus from the generation-skipping transfer tax provides for additional planning opportunities.

While the break on the gift tax is a boon to children of wealthy parents, 2010 offers a rare opportunity for those who want to transfer wealth to grandchildren or more remote descendants. Gifts to grandchildren or more remote descendants can be made this year without the imposition of the additional generation-skipping transfer tax that, under current law, would incur a 55 percent tax in 2011. However, due to uncertainties as to how the generation-skipping transfer tax will be applied in future years, outright gifts, rather than gifts in trust, are advisable.

For existing trusts with grandchildren or more remote descendants as beneficiaries, consideration should be given to making distributions before year-end, even to the extent of terminating the trust. A distribution in 2010 carries no transfer tax, while a distribution next year may incur a 55 percent tax.

Making Use of the Economy

The current market volatility, depressed asset values and historically low interest rates continue to create an environment ripe for estate planning and transferring wealth to descendants on a tax-advantaged basis. Assets with values that are temporarily depressed due to current economic conditions but are expected to recover would be good targets for a giving program. Based on the current applicable laws, the increase in value when the economy recovers and the appreciation thereon would pass to the donees free of gift tax. The lower current applicable federal interest rates also make gifting through a grantor retained annuity trust (GRAT), a charitable lead annuity trust (CLAT), intra-family loans, and the “sale to grantor trust” techniques even more beneficial. (For a more detailed discussion of these estate planning techniques, please see “Record Low Interest Rates Mean Good Times for Estate Planning.”)

As the economy moves in cycles, it is likely that asset values and interest rates will eventually increase again. When they do, the opportunity to reduce—or even eliminate—your transfer taxes on such favorable terms may be gone. But prompt action to implement these techniques may be prudent for two reasons: (1) market conditions may change, making such planning less attractive, and (2) Congressional action may negatively affect such planning. Legislation was introduced in 2010 that, if enacted, would place substantial limitations on the use of valuation discounts in connection with family-controlled entities. That same legislation would also restrict the use of the highly recommended short-term zero-gift GRAT by requiring GRATs to have a 10-year minimum term (increasing mortality risk) and a taxable gift upon formation (although the amount of the required taxable gift was not specified).

Roth IRA Conversions

Beginning in 2010, anyone (regardless of income) is allowed to convert a regular IRA to a Roth IRA. Upon conversion, the entire converted amount is subject to income taxation at your current tax bracket. If you complete the conversion in 2010, the rollover can either be reported in 2010, or spread out ratably in 2011 and 2012.

There are certain unique features of Roth IRAs that make them particularly attractive. Distributions, for example, are generally income tax-free. In addition, the required minimum distribution rules do not apply to Roth IRAs during your lifetime. You can also pass a Roth IRA to a younger generation, thus allowing it to continue growing income tax-free (although your beneficiaries will be required to take minimum distributions). Ultimately, converting a regular IRA to a Roth IRA will shrink the size of your taxable estate and the estate taxes that may be due thereon, and with careful estate planning, can foster decades of tax-free growth for these assets.

If you already converted a traditional IRA to a Roth IRA in 2010, you should review the current value of these assets. If your Roth IRA has decreased in value, you may be able to save taxes by reversing the conversion (and reconverting at a later time), thus only having to pay income tax on the smaller amount. Although a recharacterization can be done at any time up to the due date (including extensions) for filing your income tax returns, if the reversal is completed this year, the reconversion can be made in 2011. Otherwise it cannot be done until 2012. ■