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What the Pending Expiration of the $5,120,000 Gift and GST Tax Exemption Means

October 9, 2012

On January 1, 2013, the gift and generation skipping transfer (“GST”) tax exemptions drop to $1,000,000 from $5,120,000.  What does this mean?

Probably nothing for those with less than about $8 million in assets.  If you have more than $30 million… probably something.  In between, you will need to figure it out for yourself.

The gift and GST exemption allows the largest amount ever to be transferred tax-free, but in the long run this will not save any eventual estate tax on that amount assuming the estate tax exemption is not lower when the donor dies.  However, if the gift was not made, the income and appreciation on that amount will continue to be received by the donor, will be included in their estate and will be subject to estate tax when they die.  Making the gift enables the income accumulation and appreciation to pass the estate tax-free to your heirs.  It also can allow your beneficiaries to receive current income from this money without it counting as a gift from you.

Note: In the balance of this blog I will be referring to the exemption amount as $5 million.  I am also not including the $13,000 annual exclusion amount.  Further, these amounts are double if a spouse consents to the gift.

The benefit of making the gift can be illustrated by assuming that the donor makes a $5 million gift to a trust that invests in an S&P 500 index fund and it accumulates for 20 years. Also, assume the fund will pay a 2% annual dividend, the principal will grow at 4% per year and there will be a combined federal and state tax rate on the dividends of 25%.  The gift will grow to about $14 million after allowing for some tax capital gains tax on index changes in the fund.  If the gift was not made, this $9 million increment would be included in the donor’s taxable estate.

Now, assume the gift is invested more aggressively, grows at a higher rate or that the funds are invested in a family business, real estate or newly started business or property development that will also grow at a higher rate.  By using valuation discounts on these items you can push the $5,000,000 up to about $7,500,000 increasing the tax-free wealth transfer by $2,500,000.

Want more?  With proper planning, the $5,000,000 can be leveraged to $70,000,000 of assets transferred using an installment sale to a defective grantor irrevocable trust, or $140 million with a consenting spouse.  If dynasty trust provisions are applied, this fund can escape transfer taxes for generations.

This is not for the meek or for those without sufficient wealth.  You have until December 31, 2012 to get it done.  My advice: Check it out!

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