The Perfect Opportunity before the Perfect Storm:

Tax Law Changes and Low Interest Rates Demand Current Estate Planning Attention

For more than eight years, certain congressional Republicans have pushed unsuccessfully for complete repeal of the estate tax. While current law provides that the unified credit equivalent (the amount each person can transfer estate tax-free) increases to $3,500,000 in 2009 and is unlimited in 2010, in 2011 the credit returns to 2001 levels, or $1,000,000. The estate tax rate for amounts over the credit, which is currently 45% (and effectively zero in 2010), also reverts to 55% in 2011. President-elect Obama has proposed fixing the credit at $3,500,000 and the tax rate at 45%. Although any future legislation is speculative, it is widely expected that changes will occur in 2009 and that Congress won’t allow the one-year unlimited credit in 2010 to occur. Therefore, we can and should expect estate tax law changes in 2009 and possibly in the first few months of the Obama administration.

Since the current law effectively reverts back to 2001 levels after 2010, President-elect Obama’s proposed plan is not revenue neutral. Whether the new legislation will include other estate tax provisions to offset the future revenue decrease, and what these provisions might be, is uncertain. However, since 1998, the legislative agenda of the IRS has included elimination of fractional interest discounts on family controlled entities. An increasing number of members of Congress also appear to favor legislation that would eliminate such discounts, so this area is a candidate to be included in the expected legislation.

Discounts of taxable values are often combined with estate planning transactions, such as Grantor Retained Annuity Trusts, sales to Defective Grantor Trusts, or outright gifts of Family Limited Partnership interests to achieve wealth transfer objectives. (Refer to the January 2008 Insight here for more information on Grantor Retained Annuity Trusts and Defective Grantor Trusts). These techniques will still be effective even without such discounts, but discounts do increase the likelihood of their accomplishing their goals of tax-advantaged transfers by increasing the size of the tax-advantaged gift.

Some commentators have suggested that Congress may go even further and change or eliminate some of these techniques themselves. Although it is possible that any such changes may be made retroactive to January 1, 2009, it is more likely that they would be effective only after enactment. Therefore, the opportunity to use any of these techniques, especially if they are combined with family controlled entities, may be closing.

In any event, even if the law doesn’t change, the time to act is especially opportune now. The potential benefits of entering into such planning increased significantly during the past few months. Aside from any discounting on family controlled entities discussed above, the two main factors that determine the effectiveness of these techniques are interest rates and valuation. The lower the interest rate required on any annuity or promissory note received in exchange for a transfer of property, the greater the wealth transfer benefits are for the family. As a simple example, if $5,000,000 in property is transferred to a trust in exchange for a note bearing interest at 2% and the property appreciates at 8%, more than $300,000 passes gift tax-free per year. The IRS publishes the minimum rates monthly and the rates in January of 2009 are the lowest ever by almost one-half percent and almost two percent lower than just a year ago. In addition, with the recent market downturn, these estate planning techniques provide a great opportunity to “freeze” the value of the property at the current depressed value and to pass the upside to one’s beneficiaries. Therefore, aside from any potential estate tax law changes themselves, the current economic environment provides excellent opportunities for estate tax planning.

The downside to any family wealth transfer is the loss of access to the funds, especially given the recent uncertainty in the market and the global economy. However, much of this form of planning simply freezes the value of the estate and can still provide the transferor with access to all the original assets. Additionally, flexibility can be built into the plan to discontinue future transfers if the desired wealth transfer has been achieved or the transferor would like to preserve more assets for himself or herself. Therefore, despite the market uncertainty, the likelihood of estate tax law changes along with the extremely favorable current wealth transfer environment makes this the ideal time for us to help you consider your choices here. Clients facing a permanent exposure to estate tax of 45% on any amount eventually over $3,500,000 (or $7,000,000 for a husband and wife) – assuming that’s the final legislated amount – will probably never see a more appropriate opportunity than right now.

Clay Stevens

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