Tax and estate planners have always joked about the certainty of only two things in life: death and taxes. However, we seem to be at a unique point in time where both the death tax and income taxes can only be described as uncertain. For instance, 2011 is close, and we still don’t know how dividends and capital gains will be taxed. This makes it frustratingly difficult for investment strategies, end-of-year considerations, and tax planning. We also don’t know what the 2011 estate tax rate will be, and whether people who passed away in 2010 have truly escaped the estate tax. With many aspects of federal taxation completely vague and uncertain, now is a good time to consider strategies to lessen the bite of expected tax increases.
First, let’s discuss simple strategies. Because tax rates will be going up after January 1, 2011, it’s a good idea to speed up any expected income and receive the income before the end of 2010. Normally, tax practitioners suggest deferring income, but in this case, it may be prudent to receive it sooner, because tax rates will most likely be lower in 2010 than 2011. So, for example, if it’s possible to receive a bonus in 2010 rather than after the first of the year, you may save some money in taxes.
Likewise, we can expect taxes on capital gains to rise. Thus, if you have been considering selling appreciated stock or real estate, it may behoove you to sell it in 2010 rather than next year, when the capital gains tax rate will likely be five percent higher. It may also be prudent to delay the sale of losing stocks until 2011, when the losses can be used to offset gains that will be taxed at the higher rate.
Beyond these simple strategies of timing income and selling assets, there are more sophisticated strategies that may have a more significant and longer-lasting impact on your taxes. Consider the following:
Should you die in 2010? Clearly a morbid, and of course facetious, question, but contemplating and preparing for one’s demise could definitely assist one’s survivors afterwards. While it was a long-standing joke among tax and estate planners that 2010 would be a good year to die because there is no estate tax imposed in that year, in practice, this is less than certain. It is still entirely possible that Congress could implement an estate tax retroactive to January 1, 2010. So, for example, the children of George Steinbrenner, who died in 2010 leaving behind an estate valued in the billions , may not actually escape the estate tax bite after all. If the estates of people who passed in 2010 are suddenly made to pay a retroactive estate tax, then we can surely expect court challenges. The bottom line: prudent estate and tax planning is necessary now, because of the uncertainty of the estate tax.
Consider a Dynasty Trust. Such a trust allows the preservation of assets for one’s immediate and remote descendants, along with offering asset protection from creditors, as well as delay of the estate tax bite for many generations. The trust can distribute income to beneficiaries (who will pay income tax on these distributions of income), but principal is preserved, asset-protected and grows tax-free. The estate tax would potentially apply at the eventual distribution of principal, many generations down the line, but your descendants would have many years to plan around the estate tax.
Consider a Charitable Remainder Trust. One of the uncertainties facing taxation is how much will capital gains tax increase? Contributing appreciated assets, such as stock, family businesses and real estate to a Charitable Remainder Trust during 2010 is a good way to avoid capital gains tax. You and your beneficiaries can enjoy distributions from the trust, and at the end of the trust term, a remainder equal to ten percent of the original contribution to the trust may go to a qualified charity. You will receive an additional tax benefit, a deduction equal to the present value of the remainder that may be left to charity. The benefits: an income stream for you and your beneficiaries, philanthropy of your choice, a charitable deduction and significant capital gains tax minimization.
It is also possible to minimize the tax on appreciated assets by exchanging such assets for a foreign annuity policy. The exchange of assets for an annuity policy is not taxable nor reportable (at least until 2012). Further, capital gains within the annuity policy would not be taxable. Annuity payments can be deferred until retirement or advanced age, at which point tax would be due on the income component of the annuity payments. Moreover, the annuity policy and the assets within the policy would be completely asset-protected from future creditors. For complete tax elimination, a foreign life insurance policy can be incorporated, which would allow one to borrow against the cash value of the policy, completely free of taxation (the amounts borrowed, rather than having to be repaid, would be deducted from the ultimate death benefit). Such tax strategies involving foreign annuities and foreign life insurance offer the most advanced asset protection from civil creditors, as well as significant tax minimization or even tax elimination.
Closer to home, consider owning assets within a Family Limited Partnership (FLP) and taking advantage of leveraged gifting in order to reduce your taxable estate. Year-end gifting is an easy, tax-efficient way to reduce one’s taxable estate. This year, the message is all the more significant because legislation currently pending in Congress would limit the tax benefit of such gifting. The amount that an individual may gift to another individual, without tax consequences, is now $13,000. Additionally, you may utilize your “unified lifetime credit” to make tax-free gifts of $1,000,000. People with FLPs should consider gifting an equivalent amount of limited partnership interests, so as to decrease the value of their estate.
Gifting of partnership interests works hand-in-hand with the principal of discounting of those interests. The IRS recognizes a discount on the value of limited partnership interests. Once discounted, more FLP interests can be gifted tax-free to the next generation, which results in decreased value of an individual’s taxable estate and thus decreased estate taxes. FLPs also offer the additional significant benefits of excellent asset protection from future creditors, centralization of investments, family succession, and participation of younger family members in management of family assets and investments.
In the current recessionary economy, now is the time to consider gifting assets that are presently at abnormally low values. The decline in the stock and real estate markets 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.
Furthermore, it is likely that the federal government will initiate unfavorable changes to the estate and gift tax laws in order to compensate for government deficits. If passed by Congress, pending legislation will eliminate the ability to discount the value of FLP gifts. Therefore, it is prudent to take advantage of current favorable laws while they still exist.
In fact, whether because of the uncertainty surrounding tax changes, or the certainty that taxes will go up, the above strategies should be considered, separately or in combination, in order to preserve and protect one’s assets. It is wise to be proactive and take advantage of tax minimization strategies now, rather than react after-the-fact to a changing tax regime.