2013 Tax Update Letter


Dear Clients and Colleagues:

This letter provides you with a summary of the American Taxpayer Relief Act of 2012 (the “Act”) with respect to the key estate and gift tax provisions, and presents some thoughts on wealth planning in 2013. On Wednesday, January 2, 2013, President Obama signed the Act, which passed Congress the day before. The Act averted the so-called “fiscal cliff” and extends and retains many tax breaks that were scheduled to expire on December 31, 2012. Furthermore, the Act prevents significant hikes in various tax rates that were scheduled to be effective January 1, 2013.

As a result, for the foreseeable future taxpayers can plan with greater clarity and certainty as the Act provides for a “permanent” set of estate, gift, and generation-skipping transfer (“GST”) tax provisions. This means the Act does not “sunset” or revert back to tax provisions effective in prior years. Of course, major tax reform and new legislation by Congress may still be enacted in 2013 or future years. Therefore, you will want to revisit your estate plan to identify any revisions necessary to optimize your planning.

Estate, Gift, and GST Taxes

The top estate, gift, and GST tax rates have been increased from 35% to 40% for decedents dying and lifetime gifts made after December 31, 2012. However, the estate, gift, and GST tax exclusion/exemption amounts remain unchanged at $5,000,000, adjusted for inflation for years after 2011. The inflation-adjusted exclusion/exemption amount increased from $5,120,000 in 2012 to $5,250,000 for 2013, representing an increase in estate, gift, and GST tax exclusion/exemptions of $130,000 for 2013.

Absent passage of the Act, estate and gift taxes would have reverted to the pre-Bush era tax provisions, which would have applied a 55% top tax rate and a $1,000,000 exclusion/exemption from estate and gift taxes. The reversion would have significantly increased the number of potentially taxable estates and minimized tax-free lifetime gifting opportunities. Although the Act curtailed the rise in number of potentially taxable estates, the largest estates now bear the burden of maximum 40% estate, gift, and GST tax rates.

Taxpayers can also now ease any concerns regarding the possibility of a “clawback” occurring on gifts made if high exemption amounts were reduced to lower amounts, in which case some feared that gifted amounts would then be drawn back into, and treated as part of, a taxpayer’s taxable estate. The Act renders the potential clawback issue moot since the exemption amounts were not reduced from $5,000,000 to $1,000,000.

Permanent Portability

The Act makes the availability of a “portability” election between spouses permanent. If portability is elected by the executor of a decedent’s estate, any unused applicable exclusion amount of the decedent is transferred to the surviving spouse. This allows the surviving spouse to combine the deceased spouse’s unused applicable exclusion amount with the surviving spouse’s own applicable exclusion amount to transfers made during life or at death. So, in 2013, a surviving spouse could pass as much as $10,500,000 free of estate tax at his or her death. The availability of portability will allow married couples to simplify their planning by electing portability as an alternative to using a bypass trust as a planning tool. Note: The executor for the deceased spouse’s estate must file a federal estate tax return (IRS Form 706) in order to make the portability election.

Planning Opportunities and Future Considerations

The retention of the $5,000,000 indexed lifetime gift tax exclusion, coupled with the inflation-adjusted exclusion increases of $120,000 in 2012 and $130,000 in 2013 and historically low interest rates, continues what has been a particularly favorable environment for lifetime gift planning. Taxpayers now have a second chance to fully utilize the large lifetime gift tax exclusion if they have not already done so. As mentioned in our 2012 letter, several excellent gift tax planning techniques such as grantor retained annuity trusts (“GRATs”), qualified personal residence trusts (“QPRTs”), and sales of property to intentionally defective grantor trusts (“IDGTs”) are available. However, taxable gifts made after December 31, 2012 in excess of the gift exclusion amount will be subject to a 40% tax rate as opposed to the 35% tax rate for gifts made in 2012.

The annual gift exclusion remains available and has increased from $13,000 to $14,000 per donee (or $28,000 for a married couple splitting gifts). No federal gift tax return is required so long as the taxpayer gives no single recipient more than $14,000 (or $28,000 for a married couple splitting gifts) in cash or other assets in a given year. There is also no limit on gifts made for another person’s tuition payments and medical expenses so long as payments are remitted directly to the relevant institution or service provider. Additionally, although unlimited gifts may be made between spouses who are U.S. citizens, the annual gift exclusion for gifts from a U.S. citizen spouse to a non-U.S. citizen spouse has increased for 2013 from $139,000 to $143,000.

In contemplation of the lifetime gift tax exclusion returning to $1,000,000, some couples who were not utilizing their maximum gift tax exclusions decided to utilize only one spouse’s exclusion in order to retain the other spouse’s exclusion. Since the gift tax exclusion has remained at the indexed $5,000,000 amount, such couples may prefer to elect gift-splitting when reporting taxable gifts for 2012. Gift-splitting between married individuals provides for simpler tracking of gifts and equal utilization of gift tax exclusions.

It is important to note that several proposals made by the Obama Administration on February 13, 2012 in its Fiscal Year 2013 Revenue Proposals (the “Green Book”) were not addressed in the Act. The Green Book proposed several restrictions on beneficial tax planning vehicles, such as imposing a 10-year minimum term for GRATs; limiting the use of valuation discounts for certain transfers of interests in family-controlled entities; eliminating the tax benefit of grantor status of IDGTs by making assets held in an IDGT includable in the grantor’s estate; and requiring the expiration of GST-exempt status of any trust 90 years after the trust’s creation.

The proposals, if put into effect, would severely limit estate and gift tax planning benefits. Currently, GRATs are valuable planning tools allowing for tax-free transfers of assets with minimal disadvantages. If properly structured, GRATs can be “zeroed-out” with appreciation in excess of a “hurdle” rate of interest effectively transferred in as little as 2 years. The Green Book proposed a 10-year minimum on GRATs, which would hamper planning efforts.

Another valuable planning technique potentially on the chopping block is the treatment of IDGTs. The “defective” status of the IDGT causes the grantor to be treated as the owner of the trust assets for income tax, but not estate or gift tax, purposes. Therefore, no capital gains tax is due from the grantor on sales to the IDGT. The defective status also causes all income incurred by the trust to be taxed to the grantor. By paying such taxes the grantor effectively makes a tax-free gift to the IDGT equal to taxes due. IDGTs are popular vehicles for making irrevocable gifts of appreciating assets for the benefit of children and/or grandchildren. IDGTs can also purchase appreciating assets from the grantor in exchange for a promissory note to effectively remove appreciation in excess of the interest rate charged from the taxpayer’s estate. The Green Book proposed to treat all assets held by a IDGT as includable in the grantor’s estate for estate tax purposes, to subject all distributions from the IDGT to beneficiaries during the grantor’s lifetime to gift tax, and to subject all assets to gift tax if the grantor “turns off” the defective grantor status during his/her lifetime.

It is conceivable that Congress may try to address such proposals in 2013 or later tax reform efforts. We recommend that clients with sizable estates make structured gifts and/or transactions to utilize their exemptions and current allowable planning techniques prior to the date of enactment of any such proposals.

Income Tax

The Act permanently leaves in place the prior six marginal tax brackets (10%, 15%, 25%, 28%, 33%, and 35%), but establishes a new maximum 39.6% bracket for individuals having taxable income greater than $400,000 and married couples having taxable income greater than $450,000. For taxable incomes below the top threshold amounts, the tax rates will remain unchanged. Nonetheless, all taxpayers will find their incomes reduced in 2013 since the Act effectively increased taxes for all wage earners due to the expiration of the 2012 payroll tax holiday. The new 3.8% Medicare (Obamacare) tax levied on net investment income for individuals with taxable income greater than $200,000 and married couples filing jointly earning taxable income greater than $250,000 will also impact taxpayers during 2013.

Starting in 2013, Taxpayers in the top 39.6% income tax bracket will also be subject to the new maximum tax rate of 20% on qualified dividends and net long-term capital gains. Taxpayers under the 39.6% income tax bracket will continue to enjoy the lower 15% tax on such dividends and gains.

Taxpayers subject to the alternative minimum tax (“AMT”) will benefit from the Act’s higher AMT exemption amounts which were made permanent and indexed for inflation starting in 2013. The AMT exemptions have been increased to $50,600 for individuals and $78,750 for married couples filing jointly in 2012, and are indexed for inflation beginning in 2013. On the other hand, personal exemptions and itemized deduction limitations have been reinstated in 2013, indexed for inflation for subsequent years. Individual taxpayers with taxable income greater than $250,000 and married couples filing jointly with taxable income greater than $300,000 will be subject to the limitations.

Taxpayers planning charitable gifts will be pleased to find that the Act extended through 2013 the provision for tax-free distributions of up to $100,000 from individual retirement accounts (“IRAs”) to public charities for individuals age 70-½ or older.

* * *

As always, we look forward to continually assisting you and your family with your estate planning needs. If you have any questions or would like to discuss any of the above in more detail, please feel free to contact one of our estate planning attorneys listed below:

San Jose Office
The Letitia Building
70 S. First Street
San Jose, CA 95113
(408) 286-9800

Palo Alto Office
200 Page Mill Road
Suite 200
Palo Alto, CA 94306
(650) 804-7600

Jim Quillinan
Jennifer Cunneen
Bruce Roberts
Don Sherer
Sabrina Chu
Debbie Bae
John F. Hopkins, Emeritus

Francis W. Dubreuil
Peter LaBoskey
Charles Packer
Darin Donovan
Laurie-Ann D. Look
Richard Schachtili
Michael Varela

Notice: Recently adopted Internal Revenue Service regulations generally provide that, for the purpose of avoiding federal tax penalties, a taxpayer may rely only on formal written advice meeting specific requirements. Any tax advice in this message does not meet those requirements. Accordingly, any such tax advice is not intended or written to be used, and it cannot be used, for the purpose of avoiding federal tax penalties that may be imposed or for the purpose of promoting, marketing or recommending to another party any tax-related matters.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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