We all share a common goal of reducing the amount of tax we pay. Unfortunately, few people take full advantage of the chance to minimize tax liability through careful planning. January 2011 ushered in a new era of federal transfer tax planning opportunities that never existed before, and they may not exist for long.
A "transfer tax" is one that applies when a person transfers assets to someone else without receiving equal value in return. Estate tax on transfers at death is the most well known, but two other types of transfer tax play an equally important role in planning. Gift tax applies to lifetime transfers. Generation skipping transfer ("GST") tax comes into play for lifetime or after death transfers to someone who is two or more generations younger. When and how you transfer assets also determines future capital gains tax treatment.
During the past decade, transfer tax rules changed almost every year, which made planning difficult. Amounts excluded from estate and GST tax rose steadily from $1 million in 2001 to $3.5 million in 2009. In 2010, estate and GST taxes disappeared. Gift tax exclusions remained stuck at $1 million throughout that period. The tax rates declined from 55% to 45%. In 2011, the tax laws were supposed to revert to a $1 million exclusion and 55% tax rate again.
Congress made a surprising move in late December 2010 that greatly improved transfer tax planning. Instead of falling back to old rules with lower exclusions and higher rates, we now have new rules with even higher exclusions and lower rates.
All three federal transfer taxes are now the same. Each person can transfer up to $5 million during life or after death without any federal transfer tax. That means married couples can pass $10 million to future generations, tax-free. The new exclusion amounts adjust with inflation. The tax rate on anything above the exclusion is 35%.
There are many other tax planning tools available to further reduce or eliminate transfer taxes for amounts above the available exclusions. Special use valuation rules allow you to reduce the taxable value of farm property. Conservation easements are also a method of reducing the taxable value of farmland. The type of business entity in which you hold your farming operation or land may also reduce the taxable value, while protecting the assets and facilitating easier transfer of the farm.
We also still have unlimited marital and charitable deductions. This means that any transfers between spouses or to qualified charities do not incur any transfer tax. Under the prior law, complex tax formulas were necessary to make sure both spouses fully used their exclusions. Under the new law, if the first spouse to die does not use all of his or her available exclusion, the surviving spouse can use it later without the need for complicated planning. This new "portability" of unused exclusions may not be the best solution in every case, however, as it may limit other important planning goals.
A simple example illustrates the financial benefits of the new tax law. Assume that Frank and Fanny Farmer built a successful farming operation, which, with other assets, put their net worth at $10 million. If the tax law had changed back to a $1 million exclusion and 55% tax rate, the IRS would get $4.4 million in federal estate tax on the Farmers’ deaths before the farm could pass to their children. The tax bill could even climb to $4.95 million if they did not both use their exclusions wisely. Under the new law, the estate tax bill is zero!
It could be even better. With a little extra planning, Frank and Fanny could use their GST exclusions to transfer their entire estate to their children, grandchildren and future generations for decades to come with no more transfer taxes. Even the future appreciation on those assets would escape later transfer taxes. Essentially, they could shelter the family farm from future transfer taxes. At the same time, their plan could protect their entire estate from future creditors, divorces and other devastating events that could later wreak havoc on their family farm.
Just because the new transfer tax rules ease some of the financial pressure, they do not make planning any less important. Tax planning will always be crucial since maximum benefits do not come automatically. Taxes are only one consideration in the big picture, though. The real point of planning is to pass your legacy to your loved ones with as little complexity, conflict and stress for them as possible. That can only happen if you properly coordinate a good succession plan for your family farm with your personal estate plan. One without the other is incomplete planning.
Of course, there is a catch! There is a narrow window of opportunity because all of these new transfer tax rules only last for two years. They automatically expire on December 31, 2012. After that, nobody knows what may happen. The rules may stay the same or get better, but they may be worse. It is wise to act now while you have the chance. Leaving the fate of your family farm to future sessions of Congress is a dangerous idea.
Careful transfer tax planning can reap far greater overall savings than any other type of tax planning. It can mean the difference between the success and failure of the legacy you have spent a lifetime creating. Estate taxes do not destroy family farms – lack of good planning does. There are tools available to deal with transfer taxes, but you have to use them wisely to get the full benefit.
Minimizing tax liability is a worthy goal, but it requires good planning. Wishing for full estate tax repeal is an admirable dream, but that is not the reality today. The new transfer tax rules provide the best opportunity for farm succession and estate planning that we have seen in decades. However, without quick action on your part to create a concrete and comprehensive plan, your goals are merely a wish.
Editor’s Note: Tom O’Diam is an estate and business succession planning attorney in Dayton, Ohio, and is a certified specialist in estate planning, trust and probate law. You can reach him at (937) 458-0574 or by e-mail at firstname.lastname@example.org.