To Gift or Not to Gift that is the Question

With the reunification of gift and estate tax tables starting in 2011, it might be worthwhile to make gifts at the new $5 Million levels before Congress reduces it. With gift splitting, this means that a married couple could give up to $10 Million to the next generations. The issues: (1) What if they lower the exclusion rate after 2012 to say $2.5 Million and the couple dies in say 2013. Does that mean that the $5 Million already given away is now subject to estate taxes? Under the strict language of the Code that’s a possible conclusion. But what if Mom and Pop’s assets are below the amount of the Tax can the IRS go after the assets given away? That’s more complicated. That goes into the issue of transferee liability. If you receive something subject to a transfer tax and that tax isn’t paid, normally the tax follows the asset. But in this case, the gift tax was paid by the unified credit exclusion and just because that exclusion changed does not make that asset a transferred asset in my view. However, it is something to be concerned about. As we near the end of 2012, it may very well be good to go ahead and make gifts. (2) Liquidity. Ma and Pa may want to limit gifts to ensure liquidity to them. And the only gifts that will work are outright gifts without any retained ownership of them. (You can make gifts in trust for other people, just not yourself-if you did, keep the beneficial interest it would trigger an estate tax on your death). So, folks need to plan what their needs will be long term before such a gift. (3) Vermont residents may be some gift tax issues. So, check with your local attorneys to be sure that you are not running afoul of a state gift tax liability.

Alternative Minimum Taxes

Back in the 1980’s high income individuals and corporations were perceived to be skewing their income through converting capital gains to ordinary income, buying assets and taking advantage of depreciation and tax credits and seemed to owe little or no taxes. To require them to pay “something” Congress came up with the alternative minimum tax. It is a separate tax calculation. Very basically, all deductions, exemptions are disallowed the the taxpayer gets a single exemption of $70,950 for married couples filing jointly The AMT rate is 26-28% depending on income. 26% on the first $175,000 of income and 28% on anything about that (again married filling jointly). The capital gain rate is 25%. Depreciation is calculated at slower rates, tax exempt private activity bonds interest (like Airport and sports arena bonds) are added back into the calculation. Depreciation deductions are limited. Incentive stock option income is added in. Certain farm tax shelter losses are added back in. In a corporate context, long term contracts are re-calculated, key man life insurance proceeds are added back in. Because of the way it works, planning to avoid the AMT is well nearly impossible. For example, a person pays his state estimated income taxes and his real estate taxes in a year when due. Such expenditures may trigger AMT. Or employee business expenses may likewise trigger the AMT. The funny thing is that once you are subject to the AMT, the numbers always turn out the same, no matter what the deductions are. The reason that AMT expiring tax provision is a huge deal is that the trigger number for the AMT will go down from $70,950 to $45,000 in 2011 (for married couples). This means that more taxpayers will be subject to AMT.

What should the boys do?

A little post-mortem estate planning. First the wife’s executor should disclaim $1.0 Million of assets preferably in the stock of the company (we’ll explain later). That way, his estate gets to use its $1.0 Million exemption and her estate gets to use her $1.0 Exemption. This reduces the tax by $500,000. Not there yet. However, since she disclaimed her interest in the business, it is still worth $2.5 Million, but her interest may be subject to some discounts as high as 25%. This means that her interest may only be $1.0 Million. That leaves the IRA and the houses and the condo to be taxed at $700,000. Sell the houses, since there is no capital gains there and pay the taxes with the proceeds. That leaves the $800,000 IRA which can be drawn down over time.

What the kids are looking at?

First, the lawyer says to the kids, “we need to determine the value of your father’s business. It throws out an income stream of $300,000 per year. Assuming that you had to hire a manager for $200,000, that’s a $100,000 a year income stream. Given current income rates the amount of principal needed to generate a dividend of $100,000 would be $2.5 Million. So, the store could be worth as much as $2.5 Million, we’ll need to get an appraisal. The rest of the property is pretty easy to determine, its worth about $1.4 Million. So, your dad’s estate is worth $4.9 Million. There is an exemption of $1.0 Million and that’s it. So there will be an estate tax of approximately $2.0 Million on this estate.” The boys were crestfallen. “$2.0 Million? We can’t come up with that kind of money right away.” “It gets worse”, said the lawyer. “Worse, how can it get any worse?” “Well, on the $800,000 retirement account, you have to pay income taxes to liquidate that account. So, you’re looking at income taxes of about $320,000 to take money out of that account in order to pay the estate taxes.” Bruno, Jr. was heart-broken and a bit angry, “you mean that we’ve worked in that store for 20 years smelling feet and in order to continue to own the store we might have to pay the Government $2.32 Million?” “That’s about the size of it”, said the lawyer. “But there is one piece of good news” said the lawyer. “What’s that”? asked Viggo. “The Government might allow you ten years to pay off the tax”.

What to do in 2011

As much as it pains me to say, there may be only a $1 Million exemption in 2011 for estates. So, let’s look at Bruno who owns Bruno’s Shoe Store located in a condo retail park in Fredericksburg, VA. He also made the smart move in 2005 to add a web-site to sell shoes on-line. This has increased his sales greatly. At the end of 2010 his annual sales are $1 Million. He takes out of the store after paying salaries, inventory and usual operating expenses about $300,000 a year. He owns the business as a Sub-chapter S corporation per the recommendation of his accountant. The Condo is owned by an LLC which he and his wife own together. The condo is worth $125,000 and there is no debt. He and his wife own a home in Chancellorsville worth $300,000 and a cabin at Lake Louisa worth $200,000. His retirement account has $800,000 in it and it leaves everything to his spouse. On January 1, 2011, while he is doing inventory a shelf full of shoes falls on top of him, killing him instantly. When he doesn’t come home for dinner his wife calls the store, no answer and then calls the police who discover his body that evening at the store. They inform his wife who is so grief stricken that she has a heart attack and dies two hours later, leaving two adult children, Bruno, Jr. and Viggo. They both worked in the store th elast two years and want to continue the business. They appear at the offices of Slim Shades the noted estate tax attorney, to get advice about the tax effects of all of this.