Gift Tax - Global Tax Blog

1/14/2013

The American Taxpayer Relief Act of 2012 and charitable giving

January 7, 2013

Nonprofit Organizations Alert

An admittedly unscientific survey reveals that 2012 finished with a flurry of charitable giving, particularly to donor advised funds, out of concern of what Congress would or would not do. There is something to like for everyone in promoting charitable giving—wealth redistribution to those most in need through a wide base of programs for liberals, and the ability of individual donors to self-direct charitable support without the interference of the government for conservatives. Yet the effect of these multiple, seemingly unrelated changes in the tax law will have an as yet unknown effect on this well-functioning social support system.

Rate impact

The saying goes that tax policy does not initiate charitable giving; tax incentives never fully make up for the cost of the donor parting with contributed assets. Every development officer knows that some level of innate generosity (preferably of the “detached and disinterested” type) prompts gifting. Yet an increase in tax rates on certain donors may affect the amount of a contribution based on myriad personal factors. A simple conclusion that higher income tax and capital gains rates will lead to more charitable giving proves too much, especially when Congress has left any number of traps for the unwary.

ATRA continued the Bush-era income tax rates, but imposed a new, higher 39.6% rate for those taxpayers with taxable income above $400,000 ($425,000 for heads of households, $450,000 for married filing jointly). The same taxable income threshold applies to the increased capital gains rate, moving from 15% to 20%. Remember, too, the 3.8% additional tax on net investment income for those with income above $200,000 ($125,000 for married filing separately, $250,000 for married filing jointly) under the Patient Protection and Affordable Care Act in 2013.

The reaction of donors to these increases is difficult to judge. Often the response is relative to the current state of affairs; tax rates on many major donors just went up. And the impact is not the same for everyone. For single taxpayers, the 35% tax rate has almost entirely been replaced by the higher rate. Yet, the new 39.6% rate is the same percentage that applied during the Clinton era, which certainly had its share of charitable giving. There is a good deal more capital invested today in limited liabilities companies taxed as pass-through entities, so the higher individual rate relative to the corporate tax rate of 35% may have some effect. In summary, development officers need to be aware of the higher rates and how they work, but there is no clear path to stimulate charitable giving here.

The Pease limitation

We are familiar with the percentage limitations which prevent a donor from taking a full deduction for gifts made in a particular year based on the donor’s adjusted gross income (or AGI), the nature of the gifted assets, and the form of recipient charity. We are familiar with the charitable reduction from fair market value for certain gifts of ordinary income property. But the effect of a dormant cap on itemized deductions generally could have the most deleterious effect on the value of current charitable gifts.

In order to recognize the benefit of a large income tax deduction, a taxpayer will itemize deductions on his or her tax return. The so-called Pease limitation reduced the amount of itemized deductions claimed depending on the taxpayer’s AGI. The underlying basis for the concept, apparently shared by the President, is that high net worth individuals can radically diminish their tax bill by the aggressive use of legitimate deductions. In the case of charitable giving, that means avoiding tax on income by giving it away for the benefit of others without an expectation of any return . . . hardly an inventive tax-avoidance scheme. That limitation was repealed from 2010 through 2012, but now is back.

ATRA shields income from the Pease limitation at or below $250,000 (individual filers), $275,000 (heads of households) and $300,000 (married filing jointly) for taxable years beginning after December 31, 2012. Itemized deductions in excess of these amounts will be reduced by 3%. The higher the AGI, the greater the effect of the limitation growing to a possible reduction of the value of deductions by up to 80%.

The net effect? Charitable solicitors are rarely invited into the details of how a charitable gift will be reflected on a tax return beyond the terms of the gift itself. There is a value in being unobtrusive. Donors will now need to look more deeply at their personal tax situation to assure that the expected level of tax benefit is available and is not the victim of the Pease limitation.

Estate taxes

The federal estate tax (together with the gift tax) has been the subject of much debate. Labeled the “death” tax by those perceptive enough to recognize that the levy is indeed made only after someone dies, the tax now is imposed at a rate of 40%, with an inflation-adjusted $5 million exclusion for the estates of those who die after December 31, 2012. ATRA continues the portability feature allowing the estate of a spouse to transfer the unused exclusion to the surviving spouse. Once again, the estate tax is unified with the gift tax.

Predicting the effect of this change in the estate tax is even more daunting than for the income tax. Given that those contemplating a bequest are less concerned with timing advantages and were probably only confused by the dizzying array of changes over the past few years, some certainty in this area will be a welcome change for estate planners and their clients. Charities will continue to promote their wills programs as in the past with some assurance that tax policy will not evince the gyrations of years past.

Alternative Minimum Tax

The AMT is the phantom tax system intended to make up for apparent unintended disparities of the regular tax system in favor of the highly compensated. Should that second tax regime compromise the effectiveness of any charitable giving program, it poses a threat to giving. The oft-asked question was whether the charitable deduction would be a “preference” ignored under the AMT.

The Act fashions a permanent “patch” for the AMT, retroactive for 2012, indexing the AMT exclusion for inflation. That is not to say that the system goes away, but only that it is more predictable. Importantly, charitable giving was not disadvantaged by the patch.

Extenders

Congress sees fit to extend certain charitable deductions instead of incorporating them “permanently” into the law. Of course, not even “permanent” provisions are really permanent anymore, with the effect being that members of Congress regularly put these extended deductible contributions into play, subject to frenetic lobbying when they are about to expire. (For example, the enhanced deductions for corporate gifts of book and computer inventory was allowed to sunset.)

ACTA’s extenders include those: preserving the 50% contribution limit for contributions of capital gain realty for conservation purposes; allowing businesses to claim an enhanced deduction for the contribution of food inventory; allowing S corporation shareholders to take into account their pro rata share of charitable deductions, even where such deductions exceed the shareholder’s adjusted basis (available from December 31, 2011 to January 1, 2014); and continuing the popular Tax-Free Charitable Distribution from Individual Retirement Plans after it expired at the end of 2011. As in the past, the Charitable IRA Distribution includes transition rules: a taxpayer can make a distribution during January, 2013 and have it count for the prior year; while those who took a distribution in December of 2012 will be able to contribute that amount to a charity before February 1 and count it as an eligible charitable distribution.

Research tax credit

While not a charitable giving device as such, the reinstatement of the research tax credit will benefit payments to universities and exempt research institutes. The credit applies to increased qualified research expenditures averaged over the preceding four years.

Conclusion

The effect of ACTA on charitable giving is as yet unclear. The messaging from charities to donors will offer no new tax incentives or giving methods, though the relative certainty of the estate tax regime and the availability of the IRA rollover for a very limited time will require some communication. What is especially clear is that our lawmakers lack a basic appreciation of tax policy, especially as it comes to charitable giving. For example, what distinguishes charitable giving from the other deductions affected by the Pease limitation? Well, paying state and local taxes, mortgage interest, and other deductible expenses are certainly less discretionary than charitable giving. And isn’t one of the core purposes of tax policy (versus unbridled tax collection) the provision of incentives to individual taxpayers to engage in behaviors we all wish to promote . . . behaviors which benefit all of us with little if any benefit to the taxpayer, all while relieving the increasingly heavy burdens of government? Despite the urgings of the sector, lawmakers continue to ignore the benefits of a uniquely American concept forged in the tax law from its inception. Let’s hope for better in 2013.

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Posted at 1:32 PM by makeenan@nixonpeabody.com | Category: Gift Tax | Permalink | Email this Post | Comments (0)

5/17/2012

Estate, gift, and GST tax opportunities: Going, going, gone?

Estate, gift, and GST tax opportunities: Going, going, gone?
The current federal estate, gift, and generation-skipping transfer (GST) tax law presents a unique planning opportunity for high net worth taxpayers that may not be around for much longer. For the remainder of calendar year 2012, you can make lifetime gifts of up to $5,120,000 without the imposition of gift or GST tax. Depending upon your particular circumstances, there may be one or more gift planning options available to you to take full advantage of this situation.

The clock is ticking. When the calendar turns over on January 1, 2013, the law is scheduled to revert to a federal gift and estate tax exemption of only $1,000,000.

5/16/2012

Open PDF: Estate, gift, and GST tax opportunities: Going, going, gone?

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “2010 Act”) made some significant changes to the estate, gift, and generation-skipping transfer (“GST”) tax laws. One of the most impactful changes was the increase in the federal estate, gift, and GST exemption amount, which, for 2012, is $5,120,000 per taxpayer. This exemption amount, however, applies only until December 31, 2012.

As of January 1, 2013, the law is scheduled to revert to the way it was in 2001, which means a federal estate and gift exemption amount of only $1,000,000 per taxpayer.

The current federal estate, gift, and GST exemption, coupled with the scheduled impending reversion to the much lower exemption levels, provides unique and time-sensitive estate planning opportunities for taxpayers with significant wealth who wish to shift a portion of their assets to their children and more remote issue (as well as to other family members) in a tax efficient manner.

The following chart highlights some of the key changes to the federal estate, gift, and GST tax laws that we can expect based on the current state of the law.

	2012	2013 and after
Top estate tax rate	35%	55%
Estate tax exemption	$5,120,000	$1,000,000
Portability of unused estate tax exemption between spouses*	Yes	No
Top gift tax rate	35%	55%
Gift tax exemption	$5,120,000	$1,000,000
Gift tax annual exclusion	$13,000	$13,000**
Annual exclusion for gifts to non-citizen spouse	$139,000	$139,000**
GST tax rate	35%	55%
GST tax exemption	$5,120,000	$1,390,000**

* The concept of “portability” was also introduced as part of the 2010 Act and provides generally that the surviving spouse can take advantage of the unused estate tax exemption of the deceased spouse who has died in 2011 or 2012 without utilizing his/her exemption.
** Subject to inflation adjustment that is not yet available

Estate planning strategies for you to consider in 2012
For high net worth individuals, the current state of the gift tax law provides you with the ability to make lifetime gifts of up to $5,120,000 in 2012 without the imposition of gift or GST tax. As noted above, however, this opportunity may only be available for the remainder of 2012. Fortunately, there are many options available to you to take advantage of this unique situation. Depending on your particular circumstances, one or more of these options may be appropriate for you.

Long-term (or “dynasty”) trusts
The tax savings aspect of your estate planning is only one component of your overall plan and when contemplating a large gift other factors need to be considered as well. By using a long-term trust, also sometimes referred to as a “Dynasty Trust,” you have the ability to direct the timing and manner of enjoyment of your gift for many years in the future. In addition, by using a trust you can protect your beneficiaries from the claims of their creditors (which includes divorcing spouses) as well as from their own potential spendthrift habits. Dynasty Trusts can hold all types of assets, from cash and securities, to real estate to carried interests in venture funds or private equity funds.

Cash and property gifts
The most simplistic way to utilize the gift tax exemption is to make gifts of cash or property, such as marketable securities, to one or more beneficiaries, either outright or in trust. While outright gifts are appealing for their simplicity, they offer none of creditor and asset protection benefits associated with a trust and should only be considered in appropriate circumstances. In addition, with respect to any gift of cash or marketable securities, although such a gift provides you with the benefit of shifting future appreciation on the transferred assets to the recipient, there are potentially more efficient strategies to consider, as noted below.

Leveraged gifts
Depending upon the nature of the asset to be transferred as well as the structure in which that asset is currently held, some gifts may be able to be discounted for lack of marketability and/or lack of control, which enables you to transfer more value for each gift tax dollar. You might also consider making gifts of assets with depreciated values, which are likely to increase in value dramatically.

Family Limited Partnerships (“FLPs”) and Family Limited Liability Companies (“FLLCs”)
FLPs and FLLCs can be used in appropriate circumstances to create value by pooling resources in a single entity and transferring that value to younger generations without ceding complete control over the assets. Caveat: although Congress did not act to curtail the use of such vehicles (by limiting the fractional interest discounts that are typically applied to the transfer of ownership interests in such entities), FLPs and FLLCs are still on the IRS radar screen. Careful and thoughtful planning is a must, and respect for the underlying structure is imperative for success.

Irrevocable Life Insurance Trusts (“ILITs”)
Life insurance is another type of leveraged gift that may be an ideal strategy for “dynasty planning” by using your GST exemption. A properly drafted and funded ILIT (which might own insurance on one or more individuals) will exclude the proceeds of that insurance from the estates of both a husband and a wife. Traditionally, most ILITs make use of the $13,000 annual gift tax exclusion to pay the premiums on the insurance. Unfortunately, if your goal is to avoid making taxable gifts each year, this strategy limits the amount of insurance that can be purchased and depends upon the number of beneficiaries of the ILIT who can have so-called “Crummey withdrawal rights.” With the increased gift tax exemption amount, new strategies can be employed to purchase larger policies.

The ILIT strategy can also be useful if you already have an existing ILIT. For example, if you are currently using your annual exclusion to make gifts to the ILIT, you might want to pre-fund your ILIT with a large gift in 2012 so that no future gifts will be required to the ILIT to cover the remaining premium payments. This very simple cash gift relieves some of the administrative burden associated with the ILIT, and also “frees up” your annual exclusion gifts so they can be used in other ways (perhaps as outright gifts to your children who are now young adults).

Qualified Personal Residence Trusts (“QPRTs”)
This statutory technique involves the gift of a personal residence to a trust for the benefit of your children while retaining use of the residence for a specified period of time. Your retained interest in the house reduces the value of the gift, enabling you to transfer a valuable asset for something less than its full fair market value. In addition, a husband and wife (or any set of co-owners) may be able to take advantage of fractional interest discounts by each establishing his or her own QPRT. This strategy can be especially useful if your wealth is “tied up” in a personal residence (which can be a vacation property) and where you wouldn’t otherwise feel comfortable making cash gifts. Although the current low-interest rate environment reduces some of the effectiveness of this strategy, it is a tried and true statutorily permitted technique that is easily quantifiable.

Sales to intentionally defective grantor trusts
This strategy is used to “freeze” the value of an asset in your estate while transferring most of the appreciation to the beneficiaries of a trust. This strategy works by establishing an irrevocable trust that will purchase an asset from the taxpayer in exchange for a promissory note. To the extent that the asset increases in value (or generates income in excess of the required debt-service on the promissory note), such value will accrue for the benefit of the trust beneficiaries free of transfer tax. The key to this strategy, however, is having a funded irrevocable trust, and the gift tax exemption in 2012 offers the perfect opportunity for that funding. Even if you cannot currently identify an asset that might be sold to such a trust, by funding the trust today you set yourself up to be able to utilize this strategy in subsequent years with an adequately capitalized trust. Ideal assets for this technique include stock in S corporations, income producing real estate, or other closely held businesses with a predictable cash flow. Unlike GRATs (which are discussed below), this technique is also ideal for dynasty planning.

Grantor Retained Annuity Trusts (“GRATs”)
Another “freeze” technique, a GRAT, works by having you make a gift to a trust while retaining the right to an annuity from the trust over a fixed term of years. Because the value of the retained annuity is almost exactly equal to the value of the gift made to the trust, you have made only a very small taxable gift when setting up the GRAT. The upside to a GRAT occurs when the asset in the trust increases in value at a rate that exceeds the IRS’s deemed rate of return (which is currently very low). In order for the assets to be removed from your estate, you must outlive the trust term. In light of this constraint, many taxpayers utilize short term GRATs, which can be as short as two years. Despite the fact that this planning strategy actually utilizes very little of your gift tax exemption (and is therefore not designed to take advantage of your 2012 gift tax exemption), GRATs are still as viable as ever and are especially useful for assets such as income producing real estate, closely held business interests with a predictable dividend, stock in start-ups with high growth potential, and publicly traded securities deemed long-term holds in a taxpayer’s portfolio. Timing is still crucial with GRATs, however, as their minimum term has been the subject of much discussion in Congress and there is some concern that their utility will be diminished through legislative action.

Intra-family loans
While not a gift tax planning strategy per se because no actual gift is made, the current low interest rate environment offers a fantastic opportunity for you to transfer wealth to lower generations by making loans at the statutorily fixed interest rates. The following chart illustrates the prevailing rates for loans made to family members in May 2012 depending upon the length of the loan (and assuming annual compounding):

Term of Loan	Lowest Applicable Federal Rate for May 2012
Less than 3 years...	.028%
More than 3 but less than 9 years...	1.30%
More than 9 years...	2.89%

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The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

Posted at 1:09 PM by makeenan@nixonpeabody.com | Category: Estate Tax; Generation-Skipping Transfer (GST) tax; Gift Tax | Permalink | Email this Post | Comments (0)

9/14/2010

IRS Notice on Economic Substance

By Forrest Milder

Over the years, several theories have been applied by the courts in considering whether a transaction was undertaken for tax avoidance reasons so that the transaction should not be “respected” as a matter of federal income tax law. Courts differed in how they considered this issue and which tests they applied. Some in government thought there should be a uniform standard for the application of these tests, often referred to as the “economic substance doctrine”, and in March, 2010, Congress passed, and the President signed into law, the “Health Care and Education Affordability Reconciliation Act of 2010 .Part of the 2010 Act included the “codification” of the economic substance doctrine in Section 7701(o) of the Internal Revenue Code. The new law is effective for transactions entered into after March 30, 2010.

On September 13, 2010,the IRS published a notice on the new economic substance doctrine that is found in Section 7701(o). In my humble opinion, it is remarkable in its failure to actually say anything "new". It largely recites the statute, and then says that the IRS will rely on existing authorities to interpret the applicable tests.

As a quick refresher of the rules and commentary on the notice --

(1) 7701(o) has a two part test -- (A) the transaction must change, in a meaningful way (apart from tax effects) the taxpayer's economic position, and (B) the taxpayer must have a substantial purpose (apart from Federal income tax effects) for entering into the transaction. The IRS makes clear that this is a "conjunctive test", by which they mean to remind taxpayers that BOTH tests must be passed.

(2) The notice mentions the provision of section 7701(o) stating that these rules apply only if "economic substance is relevant to a transaction", although it provides no additional guidance on that issue.

(3) If the taxpayer wants to rely on "profit" as a motivation, the computation must be based on the present value of the pre-tax profit.

(4) A 40% penalty will apply, rather than a 20% penalty, if the taxpayer does not disclose the transaction on his/her/its return. The notice states which forms should be used.

(5) Under regulations to be issued, foreign taxes will be considered in determining pre-tax profit.

(6) As I noted above, the notice includes words like"the IRS will continue to rely on relevant case law" throughout.

(7) The notice does not mention tax credits, or other congressionally-favored tax incentives . Some will remember that footnote 344 of the Technical Explanation that accompanied the Act included a sort of "savings provision", suggesting that these rules did not apply to transactions which featured those Congressionally favored tax provisions. So, we seem to still be awaiting guidance on that front.

For more information, please contact Forrest Milder at 617-345-1055 or fmilder@nixonpeabody.com.

Posted at 3:09 PM by lmozlin@nixonpeabody.com | Category: Corporate Tax; Estate Tax; Gift Tax; Individual Tax; Partnerships & Funds; Tax Controversy | Permalink | Email this Post | Comments (0)