Planning for Imminent Tax Changes

November 9, 2012

On Tuesday, President Obama was elected to a second term in office. The congressional election results indicate the potential for continuing gridlock between the House of Representatives and the Senate. The election results add to the uncertainty of whether we will return to pre-Bush era tax rates if there is no political compromise before year-end.

If Congress does not act before year-end, then, on January 1, 2013, significant income and estate tax rate changes will become effective. The highest tax bracket for ordinary income, including wages, interest and rental income, will return to 39.6% in place of the present highest bracket of 35%. An important change for people who rely on dividends from stocks and mutual funds is that dividends once again will be taxed at ordinary income rates rather than the present flat rate of 15%. The estate tax rate is scheduled to increase to a flat rate of 55% in place of the present flat rate of 35%. Another estate tax change is that the present $5,120,000 gift and estate tax exemptions are scheduled to decrease to $1,000,000.

In light of these changes, we are assisting our clients in making personal and business decisions before the end of 2012. Given the potential for a drastic increase in the income tax rate on dividends, we are advising many businesses with retained earnings to make dividend payments. We are also working with high net-worth clients to structure gifting plans that will allow them to use all or part of their $5,120,000 gift tax exemption this year before the exemption returns to $1,000,000 in 2013.

Some strategies for making significant gifts this year are particularly popular because they allow the client to have indirect access to the gifted funds. For instance, a client may create a trust in an asset protection jurisdiction, like Nevada, Alaska, South Dakota or Delaware, and name a spouse as the beneficiary of the trust. As long as the spouse is alive, the client can derive indirect benefit from the trust by being supported by the spouse, while the spouse is being supported by the trust. If necessary in the future, the client may be added as a discretionary beneficiary of the trust and thus derive a direct benefit from the trust.

President Obama’s February 2012 budget proposals also encourage the creation of trusts to hold assets that will not be subject to estate tax but may still be considered as owned by the client for income tax purposes. Currently, a client with this type of a trust, called a grantor trust, may pay the income tax on dividends, interest, and other income earned by the trust. In this way, the trust increases in value more quickly by re-investing all of its income, thus maximizing the value of assets passing free of estate tax. Under President Obama’s proposal, this type of trust would be subject to estate tax. However, if such a trust is created before year-end, it is likely to be grandfathered under the current rules.

Many clients are employing valuation strategies to transfer interests in closely held businesses. Currently, non-voting and minority interests in closely held businesses may be valued using lack of control and lack of marketability discounts. These valuation discounts can make the gift of non-voting and minority interests significantly more attractive for tax purposes. Under the President’s budget proposal, these discounts would be eliminated.

If you have questions regarding the above, please contact Shanna Yonke, the author of this article, or any of the attorneys in the Trusts & Estates Practice Group of Ruder Ware.

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This document provides information of a general nature regarding legislative or other legal developments, and is based on the state of the law at the time of the original publication of this article. None of the information contained herein is intended as legal advice or opinion relative to specific matters, facts, situations, or issues, and additional facts and information or future developments may affect the subjects addressed. You should not act upon the information in this document without discussing your specific situation with legal counsel.

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