When it comes to estate and wealth transfer planning, timing is everything. If you take the necessary planning steps when tax and market conditions are optimal, you can ensure that your wealth is passed on to your beneficiaries in a tax advantaged manner. In 2012, with legislative uncertainty related to future estate and gift tax exemptions (the amount that can be passed on before estate tax arises) and the estate tax rate, many estate planners wisely counseled taxpayers to take advantage of favorable conditions and shield their estates from potential tax increases. After significant debate, Congress moved to maintain favorable estate tax conditions, extending a great opportunity for planning.
“Permanent” Changes Don’t Eliminate Urgency
After a period of uncertainty over the future of exemption amounts and estate tax rates, in the end, the American Taxpayer Relief Act of 2013 (“The Act”) didn’t actually change the estate tax landscape significantly. The estate tax exemption, lifetime gift tax exemption, and generation skipping transfer tax exemption were all set at $5.25 million for 2013 and indexed for inflation for later years. The exemption will increase to $5.34 million in 2014 and continue to increase with inflation in future years barring legislative change. The Act did raise the top estate tax rate from 35 percent to 40 percent, but the rate remained far below the 55 percent rate from the 1990’s that was discussed as a possibility.
What does the new law mean for taxpayers? First, it means that conditions are still historically favorable for estate and gift tax planning. Second, it doesn’t necessarily mean anything for the future beyond the next few years. Taxpayers should understand that new legislation could alter the estate tax climate at any time – making estate planning just as important and urgent as ever.
Rising Real Estate Values Can Provide Opportunity
The real estate market in South Florida has been in a steady rebound in recent years following the bubble and subsequent collapse in 2008, but according to the Case-Schiller index, average values are still about 41 percent below the peaks set in 2006. While projecting future real estate conditions remains a challenge, current real estate values could actually represent a significant opportunity for estate planning. By utilizing what is commonly called “estate freeze,” property owners may be able to transfer assets now rather than later, locking in the current value of the assets for transfer values and excluding future appreciation from estate tax at the donor’s death. This can potentially mean using less of available exemptions, and shielding significant wealth from gift and estate tax.
To get the process started, you should first get an estimated current value inventory of your asset portfolio. The next step requires determining which assets are most likely to appreciate in value. If $5 million worth of real estate is transferred now, and later appreciates to $7.5 million, only $5 million of the $5.25 million exemption would be used, leaving room for additional gifting. The same property, if transferred at a later date at a value of $7.5 million, could result in approximately $900,000 in estate tax liability. (($7.5 million – $5.25 million exemption) x 40% estate tax rate = $900,000 tax liability.)
In Estate Planning, Lack of Control can be a Good Thing
Whether you are talking about your business, your assets or your temper, the words “lack of control” generally carry a negative connotation. In the world of estate planning, the exact opposite is often true. That’s because valuation discounts can reduce the taxable value of certain types of assets when only a fractional interest is passed on to a specific party or entity. By giving a fractional interest in an asset, an estate may be able to reduce the tax value of that gift significantly, shielding significant asset value from estate tax.
There are two primary types of potentially valuable discounts. Lack of marketability discount may be available when transferring less than 100 percent interest in an asset, while obtaining a minority interest discount may be possible when transferring an interest of less than 50 percent. Minority interest discount, also known as lack of control discount, generally carries a greater discount than lack of marketability alone. Both of these discounts may apply when you are moving a fractional interest of a business or real estate out of an estate.
As an example, let’s consider a married couple that jointly owns a business valued at $25 million. They want to gift a 30 percent interest to each of their two children (7.5 million each). Due to the fact that they are only giving a fractional, non-controlling interest to each child, the marketability of that minority interest may be significantly impaired. (A minority interest in a business or real estate asset to an outside party would be significantly less marketable due to the lack of control that comes with that minority holding.) A qualified valuation may substantiate a 35 percent discount in the transferred share of the business. By utilizing discounts, the value transferred for estate tax purposes would be equal to only 65 percent of the $7.5 million, or less than $5 million to each child. Instead of exceeding their combined lifetime exemption and paying significant estate tax, the couple now has flexibility to gift even more out of the estate from different assets before reaching their estate and gift tax exemption limits. With the parents now owning only 40 percent of the asset, they now have yet another opportunity for discount for estate tax purposes at death.
The potential tax benefit of the scenario above is substantial. The discounts from the initial transfers would keep the couple under their lifetime exemption limits. They would be able to transfer 60 percent of the asset, or $15 million in value, without incurring any gift tax. Without the discounts, that 60 percent share of the company would generate approximately $2 million in tax liability. When you consider that discounts may also be possible when the remaining 40 percent interest is transferred, an additional $1.5 million in savings could be realized. Use of the lack of control discount, along with current lifetime gift and estate tax exemptions, could reduce the total estate and gift tax related to the transfer of the business from as much as $6 million to approximately $2.5 million.
While these discounts can provide substantial tax savings, there are no guarantees that they will remain available indefinitely. There have been ongoing discussions in Washington about disallowing minority interest discounts on family gifting. That means this opportunity for tax savings won’t necessarily be around in the future, providing another compelling reason to sit down with a qualified estate planner sooner rather than later.
Now is the Best Time for Estate Planning
The combination of high exemptions, relatively low estate tax rates, increasing real estate values, and the possibility for discounts creates an almost perfect storm for favorable estate planning. While current conditions are almost ideal, the only certainty when it comes to estate tax law is change, making it imperative that planning take place as soon as possible. Comprehensive estate planning requires an in-depth understanding of both the family and the assets involved, so working with a trusted advisor is imperative. You will also need to coordinate numerous outside advisors during the process including estate planners, tax planners, lawyers, valuation experts and more. At Caler, Donten, Levine, Cohen, Porter & Veil, P.A., we work hard to understand our clients and to coordinate our team of advisors to bring maximum value. Give us a call today to discuss your estate planning options. We are ready to get to work to help you protect the wealth you have created.