Among those lawyers who are active in trusts and estates and other wealth planning, 2012 has been described as the Year of Certainty, and future years as the opposite. For that reason, the last four months of 2012 should see an increase in planning activity, beyond the higher levels that have already occurred this year.
What Caused This Situation?
In the tax law that was enacted in 2001, at the beginning of the George W. Bush administration, the exemption from federal estate tax, which was then at a level of $675,000, was increased over a period of years to $3.5 million. As the law was written, the estate tax was to disappear for 2010. Then, in 2011, the tax was to return and the exemption was to fall back to $1 million. Meanwhile, the estate tax rate structure was gradually changed from a graduated structure of rates to a flat rate of 45 percent, with a return to the graduated rates in 2011. Few believed that the tax structure as enacted would remain in effect, but it did. Congress then renewed the federal estate tax law in 2010, as part of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010. For those who died in 2010, their representatives could make a choice: either pay zero estate tax and get no step-up in basis on the assets in the estate (and therefore subject any increase in the value of the assets to capital gains tax) or be subject to estate tax at a flat rate of 35 percent with an exemption of $5 million and receive the step-up in the basis of assets (and pay no tax on the capital gains up to the date of death).
For deaths in 2011 and 2012, the federal estate tax exemption was fixed at $5 million and the rate was 35 percent. In addition, when the estate tax law was amended, two other changes were made. First, the federal gift tax exemption, to the surprise of many, was increased from $1 million to $5 million. During the years when the federal estate tax exemption was increasing to $3.5 million, the federal gift tax exemption had remained at $1 million. The enhanced federal gift tax exemption meant that far larger gifts could be made without incurring gift tax.
Second, the federal estate tax exemption was made portable between spouses. In simple terms, this means that if one spouse died and did not use the entire $5 million federal estate tax exemption, the balance was added to the exemption of the surviving spouse. Of course, federal tax law is never that simple. There are complex rules relating to successive marriages that make the portability rules a subject for extensive research before taking advantage of them. If they are a permanent part of the federal estate tax law, the portability rules could substitute for the necessity of transferring assets between husbands and wives to obtain the maximum benefit from the federal estate tax exemption.
However, the changes made in 2010 are not permanent; they expire at the end of 2012. At that point, the federal estate tax and federal gift tax exemptions will return to $1 million and the tax rates will return to a graduated system extending as high as 55 percent (just as was to happen in 2011 before the Tax Relief Act was enacted). Unless Congress passes a revision of that law and the president signs it, those changes will automatically take effect on January 1, 2013. It appears that neither political party favors this result, but, as with many other subjects, they cannot seem to agree on how to change it. President Obama favors a return to the $3 million exemption and a tax rate of 45 percent. The Republicans want to extend the life of the current rules permanently, but are also committed to eventual repeal of the estate and gift tax laws.
These factors create the confusion that is facing planners next year:
• A temporary provision of the law that is to expire unless extended.
• Proposals for changes in the law that are tied to control of the presidency and each house of Congress.
• The ongoing uncertainty that what the parties propose in an election year might not come into effect in any recognizable form next year.
Why Certainty Makes 2012 The Year For Planning
The factors described above demonstrate that planning next year looks very uncertain at this time and is likely to remain uncertain long after 2013 has begun. The possibility exists that planning opportunities will expand next year, and the possibility also exists that they will shrink. More so than almost any other year we can think of, the chasm between the certainty of 2012 and the uncertainty of 2013 is huge. This is an important reason for taking action this year: We can say with certainty what will be the tax consequences of planning in 2012. After December 31, we cannot, at least with the information we have now. The chances for certainty would be enhanced if one party controlled the White House and both houses of Congress next year, but predicting the future will still be very difficult.
Transfers of wealth this year have other advantages. First, despite the modest economic recovery we have experienced, the values of all sorts of assets are still much lower than they were five years ago. This is an advantage, because it allows property owners to make transfers and use less of their federal gift tax exemption than would be possible if asset values were higher.
In addition, the transfer of closely held property, like ownership in a family business, can benefit from valuation methods that offer discounts in value because the property transferred is not marketable on public stock exchanges and represents a minority interest, carrying with it no ability to control the business. These types of discounted gifts must always be supported by detailed reports by valuation experts, and carefully prepared and supported valuations should be accepted by the Internal Revenue Service. But various tax proposals being floated in Washington include the elimination of these types of discounts for business interest transfers. That might not happen, although it is often the case that tax law changes are discussed for a while before being enacted. But we know that discounted gifts are safe for this year.
A further factor affecting gifts is the very low interest rates we are now experiencing, and the low “hurdle rates” set by the IRS each month with respect to transfer techniques. Lower interest rates result in lower valuations for business and property interests, and lower IRS rates produce more favorable gift tax results for planning grantor retained annuity trusts and other interest-sensitive planning. And speaking of GRATs, tax proposals have been offered to cut back the planning opportunities with that technique, but not this year.
Finally, we know that capital gains rates are at a low point this year. These reduced rates will also expire at the end of the year and return to higher levels that were in effect previously.
What To Do Now
These next four months constitute a perfect storm: a coming together of all of the valuable planning techniques and favorable conditions that might not occur again. It is very important that clients who are considering wealth planning or are considering selling their businesses know in the next few weeks of the opportunities and the certainty that exist now and that may disappear in the new year. Planning is still possible this year, but it takes time to complete it. This is especially the case when there is a desire to transfer closely held business interests. For those clients who want to sell their businesses, the process could take several months, so the window for that activity will soon close.
The key to this opportunity is to help clients understand the several factors that have combined to make this the year of planning; to advise them how they might take advantage of the opportunities available to obtain and document their decisions about planning, even if they do not choose to do anything this year; and to complete the planning techniques well before year-end. Then if the uncertainty is ever resolved, it will be important to review the new or reduced opportunities available with whatever tax system we finally have next year.
Robert H. Louis is a partner and co-chairman of the personal wealth, estates and trusts department at Saul Ewing. His practice includes estate, tax and retirement planning for individuals and closely held businesses. He is a fellow of the American College of Tax Counsel and a graduate of the Wharton School and Harvard Law School. Louis can be reached at firstname.lastname@example.org and 215-972-7155.