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Making Tax Saving Gifts, Protecting Assets and Your Personal Rainy Day Fund

Roger McClure May 31, 2012

$5,000,000 Exemptions Disappearing Fast. The $5,000,000 exemptions from estate, gift and generation skipping taxes are set to expire by law on December 31, 2012. To prevent this from happening, Congress and the President have to agree to a new law before then. In the heated political debates of a Presidential election year, it looks likely that if anything is done, it will be done at the last moment and no one can predict what the new tax law will be.

Fred’s Business. Fred has a business worth $5 million and other assets such as his home and savings worth $2,000,000. Under current law, if Fred dies in 2013, the federal estate exemption will be $1,000,000. If Fred is a DC or Maryland residence, then Fred could pay DC or Maryland state estate taxes in additional to federal taxes. This means with a $7,000,000 estate, Fred’s federal and state estate tax bill could be over $3,000,000. The estate tax of $3,000,000 is due nine months after death in cash, unless you follow all of the technical rules to request more time to pay the tax and the Internal Revenue Service decides, in their discretion, to grant you more time to pay the tax. If you don’t pay the tax on time, there can be a 25% penalty, monthly interest and a forced sale of the assets of the estate. Basically, this means that the business has to be sold to pay the estate taxes, perhaps at fire sale prices. The business is gone and Fred’s family loses its source of income and most of its savings.

Fear of Gifting. A lot of people are waiting on the sidelines and not planning to make large gifts this year, even though for sound tax planning, they should.The biggest fear of an older person is that they will not have enough money to live on and will be wandering the streets as a bag lady. The US and European governments are running large deficits and many well informed observers think that this could cause high inflation, government cut backs, higher health care costs and higher prices for energy and other imported goods. A cushion of $2 million today could only have the buying power of $200,000 in ten years. This has happened in the past and is happening today to retirees in other countries.

Tax Dilemma. In the past, to make a gift and to make sure that it was a completed gift and out of your taxable estate, you had to follow strict rules and could not retain any ability to get any of the money you gave away. If you retain too many strings, then the IRS will take the position that you never really gave the money away and it is still subject to estate taxes in your estate. Following the Fred example, if, on paper, Fred gave his business to his children but retained all of the income and control of the business, then the IRS would be likely to say the full value of the business was still part of his estate.

APT to the Rescue. Virginia has passed a new Asset Protection Trust (APT)and about 11 states have similar provisions. If you comply with the state APT standards and the IRS rules for making a completed gift, then you can protect your assets, save estate taxes and still retain the ability to receive some of those funds in case one of the disaster scenarios actually happens. In other words, you are able to make the gift, but can get some of it back if you really need it.

First: Comply with State APT. To accomplish this, your first have to comply with the State Asset Protection Trust requirements. See our blog on the Virginia APT requirements.

Second: Comply with Tax Requirements. In Private Letter Ruling (PLR) 200944002, the Service laid out a road map on how to set up an APT where the assets will not be part of your taxable estate, even though you could still receive distributions if you need them. This is what you should do:

(1) Qualified Independent Trustee. You have to use a trustee, such as a trust company or a CPA that fulfills the requirements under the tax code and the Virginia APT law as a qualified and independent trustee. The trustee cannot be you or your family members. You can use Trust Protectors to remove wayward Trustees.

(2) Rules for Distributions or Property Use. Use and distributions of trust assets must either be in the sole discretion of the Trustee or follow the tax rules for a qualified residence trust, charitable remainder trust or IRS qualified annuities.

(3) You Cannot Change the Beneficiaries if the Trust Terminates or You Die. You decide who you want to receive the money after your passing or after a set time period and the lawyer puts these rules in the trust agreement. Once the heirs are designated in the trust agreement, you can’t later change who will receive the funds after you.

(4) No Power to Reacquire the Property. You can’t have a right to get the property back.

(5) No Taxes Paid. The Trustee may not use the income or assets of the trust to pay your income or estate taxes.

(6) Your Creditors Cannot Reach Assets. The trust has to qualify under the applicable state statute as an Asset Protection Trust. If your creditors could reach the assets in the trust, then the assets can be part of your taxable estate. This is where the APT adds a new dimension to make this whole thing work. Without the APT features, the IRS may seek to bring the assets back into your estate.

Auntie Mae. Auntie Mae has $4,000,000 in various investments and income from social security, her deceased husband’s pension, her own retirement funds, and a paid off house. She lives on her pension income and she saves all of her investment income. Auntie Mae has always spent her money carefully and she is unable to change these lifelong habits. Her tax advisors tell her that with a $1 million exemption from estate taxes, she will pay over $2,000,000 in estate taxes given her savings rate and life expectancy. Her advisors suggest that she could safely give away $2,000,000 this year and not pay any gift or estate taxes at this time on this gift. She is afraid that she will need the money in the future. She decides to set up an APT that meets all of the State and tax legal requirements. During her lifetime, she has the comfort that if she does run low on funds, her trustee (her trusted CPA) will send her money for her living expenses from the APT. After she dies, it turns out that she never used any of the money from the $2,000,000 she put in trust for the education and future of her grandchildren. After she passes, the assets in the trust are worth $3,000,000 and there is no estate, gift or generation skipping taxes on the $3,000,000. Her grandchildren have a solid start in life with $3,000,000 of protected assets.

Don’t Try this at Home. This type of planning requires careful professional help and an understanding that the IRS has not issued final and reliable regulations in this area. The above PLR is a private letter ruling. This means that it cannot be used as support in your case; it can only be used by the taxpayer who obtained the ruling. However, the “tax logic” of the PLR is persuasive and largely based on other prior IRS rulings.

This blog cannot be relied upon as tax advice or to avoid penalties. Do not take any action based upon this information in this blog without consulting your own tax advisors.