As my readers should have figured out by now, my methods of investigation are pretty simple: I keep digging until I find something.
Between preparing an estate planning update presentation (for clients and whoever else invites me – hint, hint!), and my own obsession with the new state of estate taxes, I finally uncovered the major loophole in the 2010 law.
2010 Estate Planning Loophole: Gifting to grandchildren with or without Dynasty Trusts!
Let’s start from the beginning.
Laws, as well written as they might be, tend to always leave an inch of unintended room. This particularly applies to the estate and financial planning sector. Clever planners figure out the gaps in the law, and then rush get as much through with whatever advantages they can grab. Then Congress wises up and closes it down.
Short history of generation skipping taxes. Planners at some point figured out that wealthy families could avoid a ton of estate and gift taxes by skipping a generation (ie…gift to your grandchildren instead of your children). It was such a massive loophole in the wealth transfer tax system that in 1976 Congress started imposing the Generation Skipping Tax (“GST”). They eventually made it so onerous – causing close to an 80% loss to taxes in the worst tax years – that individuals generally would only gift to their grandchildren up to their lifetime GST exemption (generally the same or near the lifetime estate tax exemption – which had been $3.5 million in 2009).
Basically, the GST had been what I call a penalty tax. Congress’ goal – prevent this type of end run around the transfer tax system.
Flash forward to 2010. Not only is there not GST, but the maximum gift tax rate this year is 35% (down from 45% in 2009 and going up to 55% in 2011). Remember, the GST tax rate was the same as the gift/estate tax rate.
Here is an easy example (not precise but helpful in understanding the opportunity here): Donor exceeds GST exemption by making a $1 million gift in 2009 to his grandchildren. Assume this taxpayer has used up his lifetime gifting exemption and is already in the highest gift tax bracket. The tax on this gift would have been $697,500! (and this isn’t taking into account state estate taxes!) Net gift to grandchildren – $302,500.
What if same scenario happen in 2011? Total gift and GST taxes of $797,500 – and only $202,500 left for the grandchildren. There is your 80% tax!
What about 2010? Total gift tax of $350,000, remaining gift to grandchildren: $650,000.
Compare the three years for this imaginary $1 million gift to grandchildren:
2009 – $302,500 net gift after taxes;
2010 – $650,000 net gift after taxes;
2011 – $202,500 net gift after taxes.
Get the picture.
This is not just one of those little loophole’s in the tax code; this is the Lincoln Tunnel.
I mentioned above use of Dynasty trusts. These trusts apparently take advantage of any GST planning to maximize avoidance of estate, gift and GST taxes for future generations. Too complex for this post – but probably the preferred vehicle for taking advantage of this year off in the GST without handing over the keys to the Ferrari to an 18-year-old.
The major question attorneys will need to address is the risk that Congress actually does what it says it planned to do: retroactively reinstate both the estate and GST taxes.
What would be the legal risks involved? Could the IRS impose a retroactive law that would effectively raise a tax from 35% to 80%?
Something tells me that the government has to live with its laws. The law today is a 35% tax on any generational wealth transfers. If you make the gift and pay the tax, how can Congress claim you should have known that we were really meaning to tax you at 80% (but we couldn’t get our act together in December).
Still, it’s risky and litigation costs could be tremendous.