Doctor Who Is Too Busy Defending Earth To Help With Your Estate Plan ? Maybe You Don’t Need Him

There has always been a good case for using your unified credit to make inter vivos gifts rather than leaving it for estate tax.   This year, however, the case is compelling.  If you have left the unified credit untouched, you can make $5,120,000 of taxable gifts in 2012.  Based on current legislation, that will drop to $1,000,000 in 2013.  Being just a tax blogger, I leave it to the political prognosticators to predict what the law will actually be, but I will say that there is a decent chance that we will have gridlock and that any resolution might end up with the number being well under $5,000,000.

So you want to use the entire $5,120,000 in 2012.  Further you want to use a vehicle that will leverage more than $5,120,000 in assets when you gift.  Afamily limited partnership is great for that, as long as you don’t screw it up.There is a problem.  Suppose you value the units in the family limited partnership at $1,000.  You give away 5,120 units to use up the whole unified credit.  Your gift tax return is audited and the conclusion is that the units are really worth $1,200 each.  You have therefore made a taxable gift in excess of the unified credit and owe several hundred thousand dollars in gift tax.  (A case can be made for paying gift tax, but most people do not buy it.)

This is where you could really use the help of a Time Lord like Doctor Who.  Dr. Who understands how stressful taxes can be:

So if the Doctor were available you would have him go forward in time to find out what the final value was and adjust the number of units that you gave (to 4,266 and  change in this case) so that the gift comes out to exactly $5,120,000 at the to be agreed value.  There are two problems with this plan.  The first is that the $1,200 value was probably the result of negotiation and compromise.  So starting at $1,200 might have you ending up at $1,300.  You might hope that this would not turn into an infinite loop, but probably the fourth or fifth time the phone booth materialized in your attorney’s office and the Doctor said to decrease the number of units, it would get rather wearisome. 

Fortunately a recent Tax Court decision shows you how to get to the same result without time travel.  Joanne Wandry made gifts of interest in her family limited partnership.  The gifts were designated as being of a certain dollar amount.  Capital account adjustments were made based on an assumed value, but it was agreed that in the event of an IRS audit or court decision that changed the value, an adjustment of ownership units would be made based on the revised value.  The decision has a lengthy discussion of why the IRS thinks this is a nasty idea.  The discussion might be interesting, but the bottom line is that the technique works.

What the decision does not tell us is how to straighten out the income tax mess that we may have created.  Are we supposed to amend everybody’s returns for the couple of years that the percentage interests were at a different level than was ultimately determined ?  Fortunately, there is a way to avoid that problem.  Make your gifts to an intentionally defective grantor trust (IDGT).  When you make a gift to an IDGT you are holding onto a power that causes you to be treated as the owner of the trust for income tax purposes (like the power to substitute property of equivalent value) even though the gift is a completed gift for transfer tax purposes.  The unit reshuffling would then not have any income tax effect.

Not only is the $5,120,000 unified credit apt to fade away, the ability to take discounts on FLP interests is also up for grabs.  Executing these transactions is not something that should be done in a rush, so you really should get on it now.  Unless you are really good friends with the Doctor and can come back to now, whenever you feel like it.

You can follow me on twitter @peterreillycpa.