Not since enactment of the first federal gift tax in 1924 had there been such a strong incentive as there was in 2012 to give property to one's heirs during one's lifetime, and to do it right away. Part of the so-called "fiscal cliff" was the prospect that the lifetime exemption for passing property tax-free to one's children and grandchildren would go from $5.12 million per person in 2012 to $1 million per person in 2013. The automatic expiration built into the Bush-era tax reductions would have returned the lifetime exemption to that amount, and President Obama's position was that the exemption applicable to decedents' estates could be larger, but that $1 million should be reinstated as the limit on tax-free gifts during a lifetime.
By kickoff time at the Rose Bowl, however, the fiscal cliff looked more like a speed bump. Except for a hike in the federal gift and estate tax rate, to 40 percent, most favorable aspects of 2012 law remained unchanged. The New Year's Day tax bill included none of a list of gift tax loophole plugs previously proposed by the Treasury Department.
What's more, the lifetime gift tax exemption had risen, from $5.12 million per person to $5.25 million, thanks to an inflation adjustment. Even people who maxed out their $5.12 million lifetime exemptions the day before now had some ongoing gifting ability. Those who had not gone to the limit, or who had somehow missed the party, still had the ability to make tax-free lifetime gifts on a scale not seen for almost a century until the past few years. The trick now is to get the biggest bang out of every buck of exemption remaining.
The way to do that is to use leverage systematically. That includes leverage in the traditional sense: using as much debt as possible in a transaction financing structure, so that whatever equity is present has a lower value but greater potential return. But it also means leveraging gifts that count toward the $5.25 million lifetime limit with gift-like elements that do not count toward the limit.
Of course, leverage generally creates additional risk. But three elements of the gift-tax legal structure as it has developed radically reduce the risk from leverage. Not coincidentally, two of these have been targeted for legislative change by the IRS and Treasury Department. Taxpayers' ability to use them could expire as soon as the next significant tax bill is passed.
First, loans between family members receive very favorable tax treatment in the current climate. In theory, family lenders are supposed to charge a market rate of interest, but the Internal Revenue Code requires taxpayers and the IRS to measure "market" interest by reference to Treasury bonds, not actual interest rates that would apply in an arm's-length transaction between private parties. The "applicable federal rate" under Code §§1274 and 7872 for obligations due within three years is currently 0.21 percent, and 1.01 percent for those due in three to nine years. (It goes all the way up to 2.52 percent for longer-term instruments.) The rate used to value annuities for gift-tax purposes under §7520 is 1.2 percent.
Family members and family-owned companies can make loans to one another on a basis that would be impossible for a bank. Federal tax law authorities will respect the form of such loans, as long as the parties give the loans the basic structure of actual debt. No Federal Reserve regulations apply to intrafamily loans; no one worries about the Basel Accords, capital reserves or stress tests.
Second, appraisers regularly apply discounts of 30 percent or higher to the value of underlying assets when they are valuing an illiquid, non-controlling interest in a business or investment fund. Valuation discounts go a long way toward assuring that a leveraged gift will be successful. Success for a leveraged gift means that the rate of return on the underlying productive assets must exceed the interest rate on the debt. Valuation discounts make it far more likely that will happen.
If the underlying asset is in fact sold, and all equity owners participate, the initial valuation discount will increase the yield of any equity owners who acquired their interest at the discount. A 25 percent interest in a business valued at $1 million may be appraised for gift-tax purposes at $175,000, and if it is subject to an additional $150,000 of debt, it may represent a gift of only $25,000. If the business is later sold for its current value, without appreciation, the net value of the gifted interest will be $100,000, a 300 percent return. If the business is sold for $1.5 million, the return will be about 900 percent.
Even if the property declines in value between the appraisal and a sale, the valuation discount provides a cushion. The million-dollar business could be sold for $750,000, and the 25 percent leveraged gift would still be worth $12,500 more than its gift-tax value. And if the underlying asset is not sold, but it performs more or less as was expected when the valuation was made, the valuation discount will significantly increase the return on equity.