The Problem
The current scheduled changes in the estate and gift tax rates and exemptions have me struggling to come up with some good ideas for a particular class of people. I am also struggling to come up with a good name for them. I tried moderately wealthy, but I find that unsatisfying and potentially confusing. I have some friends from my bouts of activism who consider me immensely wealthy. So what should I call this class with net worth of say 4 million to 15 million ? How about “midmillionaires”? or “midmills” for short?
Here is the problem the midmills are facing. If they have not already used some of their unified credit they can make taxable gifts of $5,120,000 in 2012 without incurring any gift tax. If they die in 2012, there is no estate tax on the first $5,120,000 and the top marginal rate on anything extra is 35%. (Script writers for Law and Order, take note.) Based on current law, that goes to $1,000,000 and 55% in 2013. It is different than the situation in 2010, which was a really good year for a billionaire to die in. Even though, there was no estate tax in 2010, the gift tax was still in place. The only thing you could do to help your heirs was hurry up and die.
The Thinking at Forbes.com – Except For The Tall Guy With The Beard
I have been scouting around for some really good advice. Interestingly the emerging Forbes.com consensus appears to be that there is really nothing special about this year. Kelly Erb, The Tax Girl, told me her office is generally working on the assumption that next year will end up being like this year. My esteemed editor, Janet Novack, points out that since we have had a unified credit equivalent, it has never gone down. When I asked Deborah Jacobs what somebody with an $8,000,000 net worth should be doing, she said that they should hang onto their money, because they might need it. The author of Estate Planning Smarts, Ms. Jacobs thinks the tendency of techniques appropriate to ultra high net worth people to migrate down to the midmills is ridiculous – “Increasingly wealth managers are out of touch with reality“.
The Secret Formula From The Lab ?
I spoke with Janine Racanelli who heads up the Advice Lab for J.P.Morgan Private Bank. She did not let me in on any of the secret formulae they were cooking up in the advice lab, but she emphasized the need for getting moving sooner rather than later and the value of family limited partnerships. She is of my mind that, despite over forty years of contrary experience, maybe the unified credit could go down. J.P. Morgan has a proprietary system where you can input your current holdings and lifestyle assumptions and based on a variety of market assumptions it will come up with how much you can safely give away without switching to cat food in your final years. I suspect the model is based on some sort of Monte Carlo simulation. I think when most people put what they have and what they want to spend in those things, it usually comes out that they are a couple of million in the hole, but I suspect it would be a worthwhile exercise.
The Man From Worcester Has The Best Answer So Far
Matt Erskine runs a boutique firm in Worcester, Mass that:
offers succession planning and specialized family office services to owners of unique assets – from multi-million dollar family businesses, numismatics collections, fine art and Americana collections, to commercial and residential real estate holdings and family compounds.
As you can see from this post , he takes the possibility of a drop in the unified credit pretty seriously. His technique for determining the feasibility of gifting does not require high powered computing ability:
Here is what I recommend for the $5 MM to $10 MM clients:
1. Draw up a “personal balance sheet” that shows their assets, and their current and projected liabilities. The difference is the client’s “Discretionary Equity”2. Based on the client’s individual tax, financial and risk profile, break the Discretionary Equity into short term (< 1 year), intermediate (1-5 year), long (5-10 year) and secular (10+ year) investment tranches.
3.Depending on the client’s age, only consider placing those investment assets that they consider secular into a gifting program.
4. Consider using tangible assets (artwork, collections, legacy real estate) that are secular investments, and which the client is not getting any income from, for gifting.
That turned a light bulb on for me. A lot of midmills have a significant portion of their net worth in some asset – legacy real estate, for example – that they do not want to ever sell. They probably want it preserved down the generations. The transaction described in the Estate of Joanne Harrison Stone, which I recently wrote about is typical. She put 740 acres in a family limited partnership and gifted it over several years to children and grandchildren using annual exclusion gifts. The IRS tried to pull it back into her estate, but the plan stood up, despite some execution errors, which I encourage you to avoid.
If you are a midmill with some illiquid item or items such as real estate or an art collection which you hope will be a family legacy and some liquid assets, you should look very hard at a 2012 gift of the legacy item. If you have a 10 million dollar estate which is half art work and half liquid assets, your heirs will have to use all the liquid assets to pay the estate taxes on the art work at the scheduled 2013 rates and unified credit.
The Valuation Problem
So suppose you put your legacy real estate in a family partnership. (Deborah Jacobs will remind you to put in some cash to pay the bills. That would have made things easier for Ms. Stone’s heirs). You give away interests worth $5,000,000 (Leave the $120,000 as a cushion). Your gift tax return gets audited and the IRS says the interests are worth $8,000,000. That is about a million in cash you have to come up with and you were planning on living on that cash.
The Solution to The Valuation Problem
A recent Tax Court case Wandry v. Com, which I wrote about last month provides the solution. You make your gift be $5,120,000 worth of limited partnership interests as the value is finally determined in the event of audit. The IRS does not like this technique, but it has stood up. Laura Saunders recently wrote about the case in the Wall Street Journal. I think I’m not getting credit for noticing it sooner because I was entranced by the time travel aspects of being able to reset the value and indicated that it was like having Doctor Who help you with your estate plan, which might not have been that bad if I hadn’t posted on April 1, when some other contributors were cutting up a bit.
Conclusion
I’m still not done. I will keep searching for good ideas for the midmills, but if you see merit in the ideas that have been put out so far, you need to start moving. If there is political gridlock in December, estate attorneys are going to be awful busy then.
You can follow me on twitter @peterreillycpa.
Originally published on Forbes.com on May 2nd, 2012