Most of our clients are aware that Congress dramatically increased the individual gift tax exemption from $1,000,000 to $5,120,000 in 2012, and that the exemption is scheduled to revert to $1,000,000 on January 1, 2013 unless Congress takes some action. If this reduction in the gift tax exemption occurs, clients may lose an opportunity to remove a substantial amount of assets from their estates, and, with it, the opportunity to reduce estate taxes payable by their children.

Many clients have taken advantage of this opportunity to transfer property to a trust that is designed to continue for multiple generations (often referred to as a “Dynasty Trust”), but other clients have been reluctant to make a large gift because of uncertainty whether they may need these assets during their lifetimes. For example, a married couple with three children and a total estate of $20,000,000 should not transfer $10,000,000 to a trust for their children and grandchildren unless they are 100% certain they will never need any of those funds. While trust assets can be used for certain expenses of the children (such as college and graduate school education, automobiles, and the purchase of a home), the client will not be able to directly or indirectly benefit from the trust. In this alert, we have suggested some alternative transactions under which a gift is made to a trust that includes one of the spouses as a beneficiary, while the appreciation and growth of the trust should be excluded from their estates on death.

Wealth Management Trust

Some clients have asked a parent to create a trust with a relatively small amount of money (typically $5,000) that names the client as trustee and primary beneficiary; the client’s children are often included as secondary beneficiaries. The client can then loan cash to the trust to be used for investment opportunities or sell assets with substantial appreciation potential to the trust for current fair market value. The client is treated as the “owner” of the trust for income tax purposes, so the client pays all taxes on income and gains out of the client’s own funds, and the trust retains the gross amount of income and gains. We generally recommend taking a very conservative approach to valuation of assets that are sold by the client to the trust to avoid a possible gift by the client to the trust, which would result in some or all of the trust being included in the client’s estate on death (defeating one of the primary purposes of the trust). Thus, this is generally a long-term opportunity, but it does have the potential for transferring significant wealth to children and grandchildren without estate or gift tax (based on appreciation and retained income), while allowing the client access to the trust for living and medical expenses. We refer to these trusts as “wealth management trusts,” also known as “beneficiary grantor trusts” or “inheritance trusts.”

Marital Trust

Other clients have chosen to transfer considerable assets to trusts for their spouses, naming the spouse as primary beneficiary and trustee, with children and grandchildren as secondary beneficiaries. The trust is similar to an irrevocable life insurance trust (“ILIT”), and usually gives the spouse a power to direct how the remaining trust assets will be distributed at the spouse’s death. Assets transferred to such a trust often include closely-held business interests or fractional interests in real estate. This allows the client to apply a portion of his or her gift tax exemption to the trust in 2012, but, at least indirectly, retain some access to the funds in the trust. The trust cannot provide for any distributions to the client or for the client’s benefit, but payment of the spouse’s expenses (such as purchase of an automobile, payment of the spouse’s education expenses, or purchase of a recreational home) can provide indirect benefits. Then, at the spouse’s death, the trust can continue for descendants with no estate tax. If such a trust is formed with $3,000,000 and has grown to $10,000,000 when the client dies, $7,000,000 will pass to the next generation without any gift or estate tax.

If you are interested in discussing how you can use your gift tax exemption to implement an effective gift program, please contact one of the attorneys listed below. 

To ensure compliance with requirements imposed by U.S. Treasury Regulations, Haynes and Boone, LLP informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. 

*Board Certified – Estate Planning and Probate Law and Tax Law by the Texas Board of Legal Specialization.