As the year comes to a close, we take this opportunity to remind our clients, colleagues and interested parties of several important issues that might impact upon their tax, estate and asset protection planning, to reflect upon a few significant developments in 2013, and to offer suggestions for effective year-end tax planning.
Part 1: Year-End 2013 Tax Planning and Anticipating 2014 Taxes
Historic Opportunity to Avoid Estate Tax on $10.5 Million of Assets
In addition to taxing your income during life, and your estate at death, the IRS also can tax gifts you make. The rationale is to prevent someone from giving his or her assets away during his or her life in order to avoid the estate tax. Thus, gifts are subject to tax, whether made during your life or at your death.
However, in January 2013, Congress enacted a law that allows a person to gift up to $5.25 million of assets exempt from gift tax and thus get $5.25 million out of the reach of the estate tax ($10.5 million for a married couple). This means that if your net worth is below $5.25 million ($10.5 million for a married couple), you could avoid gift and estate taxes entirely, and pass your assets to loved ones, free of tax. If your net worth is above $5.25 million, the first $5.25 million can still go to your loved ones, tax free. The exemption from gift and estate tax has never been higher. To take advantage of this historic opportunity, you should consider outright gifts to loved ones, as well as gifts in trust and gifts for children’s or grandchildren’s educational needs. Moreover, gifts can be in the form of cash, stock, real estate, partnership or LLC interests, or other assets.
If your assets are owned by family limited partnerships (FLPs) or limited liability companies (LLCs), then even more can be gifted out of your estate via the principle of discounting, as discussed below. However, one need not own an LLC or FLP to make gifts and avoid tax. But, if you do own an FLP or LLC, you can get even more out of the reach of taxation.
There are two ways to gift assets and lower estate tax. The first way is via annual gifting. The amount that an individual may gift to another individual, without tax consequences or a reporting requirement, is currently $14,000 per annum, per recipient. Gifting is an effective strategy to reduce estate tax liability. For example, if a husband and wife each gift $14,000 to three children, the value of the couple’s estate is decreased by $84,000 ($14,000 x 2 (parents) x 3 (children)). The husband and wife can make these gifts annually, and remove $84,000 each year from their estate.
In addition to annual gifts of up to $14,000 per recipient, a second way to lower the value of your taxable estate is via a lifetime gift. You may utilize your “unified lifetime credit” to avoid gift taxes and make one or more gifts equal in total value to $5,250,000 ($10,500,000 together with your spouse; total value for all gifts). Such a lifetime gift is in addition to annual gifts of up to $14,000 per recipient. You will be required to file a gift tax return, but the gift taxes will be offset by your $5,250,000 unified lifetime credit. A husband and wife, together, may make joint tax-free gifts equal in total value to $10,500,000 in this manner. Read the last sentence again. Yes, $10.5 million in assets passing to your heirs, free of tax.
Clients with FLPs should consider gifting an equivalent amount of limited partnership interests, so as to decrease the value of their estate. As long as clients retain their General Partner (GP) interests, clients will continue to control all assets within their partnership. Yes, you can escape the estate tax and still control the assets.
Here’s how you can get even more than $5.25 million ($10.5 million for a married couple) out of the reach of taxation, if you own FLP interests:
Gifting of partnership interests works hand-in-hand with the principal of discounting of those interests. The IRS recognizes a discount in the value of an LP interest. The discount is due to a lack of marketability of an LP interest on the open market (it is very difficult to sell a limited partnership interest to an outsider), as well as a lack of control by a limited partner (as contrasted to full control by the general partner). Thus, LP interests are not “worth as much” in the eyes of the IRS, while the value of the underlying FLP asset remains unchanged. This is a rare instance where the IRS recognizes a value less than the actual asset value. Once discounted, more LP interests can be gifted tax-free to the next generation, which results in more assets passing out of an individual’s taxable estate and thus decreased estate taxes. In some cases, after applying a 50% total discount to the value of the LP interests, as much as $20,000,000 of their estate may be gifted by a married couple. Thus, for example, a $10 million gift of LP interests in an FLP that owns $20 million of assets transfers 50% of the total LP interests without discounting. If the same $10 million gift is of LP interests discounted 50% for lack of marketability and lack of control, 100% of the total LP interests is transferred. It is important to understand that only LP interests are gifted, not the underlying FLP assets.
In the current recessionary economy, now is the time to consider gifting assets that are presently at abnormally low values. Lower stock and real estate values have created further built-in discounts for many assets. When the economy rebounds, these assets will begin to increase in value, and that future appreciation will occur outside your estate.
It is possible that the federal government will make unfavorable changes to the estate and gift tax laws in order to compensate for huge government deficits. If passed by Congress, proposed legislation will eliminate the ability to discount the value of FLP gifts. Clients should consider taking advantage of current favorable laws while they still exist. Also consider that the $5.25 million exemption can change. Within the last few years alone, the exemption has wavered between $1 million, $3.5 million and, in 2010, there was no estate tax (temporarily). Given the federal deficit, the $5.25 million exemption should not be considered final. Indeed, President Obama’s proposed budget assumes a reduction of the exemption back to $3.5 million. Now is the time to capitalize on this window of opportunity to avoid gift and estate taxes on a significant amount of wealth.
Clients should also keep in mind that on the state level, the exclusions from state estate taxes can be much lower. In New York, any estate over $1 million is subject to as much as 16% estate tax. New Jersey imposes an inheritance tax on estates over $675,000. In Connecticut, the exemption is now $2 million and the estate tax rate is 12%. (Connecticut, along with Minnesota, are the only two states in America which also impose a gift tax.)
– You can lower the value of your taxable estate, and pass $5,250,000 ($10,500,0001 married couple) to your heirs, tax free;
– If you own an FLP, you can gift Limited Partnership (LP) interests to your heirs, and take advantage of discounting, to get even more out of your estate, tax-free (up to $21,000,000 in 2013 and $21,360,000 in 2014).
– You can keep your General Partner (GP) interests and still control the FLP and its assets, even if you give away all of the Limited Partnership (LP) interests.
– The gift and estate tax exemption might be reduced.
We realize that gifting and discounting are not simple concepts, and we welcome your questions. We can advise you as to appropriate FLP discounts, prepare memoranda of gift for you, as well as the partnership valuation and gift valuation calculation letters (necessary for the IRS). Please contact us for further information.