Aunty Mae and Inflation: Gifting to Avoid Estate Taxes; Purchasing Power and Inflation

Aunty Mae. Aunty Mae consults an estate planner to update her estate plans. She is 80, in good health, a widow, with $2,000,000 in assets, $400,000 of which is her home, which has with no mortgage. She has $80,000 a year of pension income from her deceased husband and social security; most of this income is not indexed for inflation. She spends $60,000 a year, believes that she has all she needs and saves what she does not spend each year. She is thinking of making some gifts to her grandchild. This is December of 2011 and she is a US citizen. She has a ten year life expectancy.

$1,000,000 Exemption. In December of 2011, the estate, gift and generation skipping tax exemptions for Aunty Mae are $5,000,000. However, the current law is that the estate tax exemption will be $1,000,000 starting January 1, 2013 unless Congress and the President are able to agree on a new tax law by then. If she dies after 2012 and there is no change in the law, then Aunty Mae’s estate could pay up to $550,000 in estate taxes plus any additional estate taxes due to the state in which she lives. This assumes that her assets will not increase in value during the next ten years (her life expectancy); but, her assets are likely to substantially increase in value due to her savings rate, the likely appreciation of her assets and the compounding of her rate of savings. Assuming an average increase of seven percent per year (inflation and return on her money combined) in the value of her assets, her $2,000,000 could be worth $4,000,000 in ten years, causing an estate tax of over $2.6 million. If she placed $1,000,000 in trusts for her four grandchildren in 2011 she would pay no taxes on the $1,000,000 transfer. Over the lifetimes of her grandchildren, this money, carefully invested, could provide several millions of dollars for each of the grandchildren’s retirement. This would allow the grandchild to take risks and pursue their dreams, knowing that their retirement was taken care of. Currently, it does not appear that Aunty Mae should need the $1,000,000 for her future needs.

$5,000,000. If the current $5,000,000 exemption is retained, Aunty Mae would probably not have to worry about an estate tax and could make the gifts to her grandchildren as part of her living trust at the time of her death. But, this is a gamble and potential waste of the limited opportunity to make tax free gifts in 2011 and 2012.

Inflation. Aunty Mae remembers paying $0.19 for a loaf of bread that now costs $2. Some commentators are concerned that the federal government’s level of high debt will motivate the federal government to increase inflation so that the federal government will be able to pay down its debt with future cheaper dollars. With all of the financial turmoil in Europe, there are concerns about hyper inflation. Other commentators are concerned about deflation.

Should Aunty Mae Make the Gifts? If there is hyperinflation, Aunty Mae’s $80,000 may only buy her $20,000 of the same goods and services she now receives for $60,000 and she may need all of her $2,000,000 to live on. Given her concern about the present financial turmoil in the world, she decides not to make the gifts to her grandchildren. Her advisors tell her that her financial security has to be the priority and not potential future taxes of $2.6 million and not the hopes and dreams of her grandchildren.

Tough Love. Aunty Mae’s daughter Karen asks Aunty Mae to pay off the $400,000 mortgage on Karen’s house because the lender is foreclosing and the house is now only worth $300,000. Her son Kevin wants to borrow $400,000 for an investment opportunity. Her son Larry needs $2,500 immediately to pay his back rent on the apartment he shares; Larry has spent the last three months at Occupy Wall Street, prefers to stay at home and write poetry and keeps losing his jobs over fights with his employers because they all fail to understand his personal needs. Also, he needs $1000 to replace his stolen laptop. Often Aunty Mae sends $20,000 a year to Larry to keep him afloat.

No Gifts. The advisors of Aunty Mae all advise her against making any gifts to Karen, Kevin or Larry. They adviser her that there is no certainty in this world of financial uncertainty and that she needs to keep her funds for her own future.

Common Dilemma. Aunty Mae is a fictional person and does not refer to any real person, alive or dead. But, her situation illustrates a common dilemma for people trying to plan their futures today, reduce taxes and provide a brighter future for their children and grandchildren.

Protect Your Cash, Stocks, and Bonds with the Right LLC

Age of Uncertainty. In an age of uncertainty, where the global market is changing so fast and is so complex and intertwined that even a super computer or a financial genius will get it wrong a lot of the time, you need to have a strong defense of your financial assets.

Corporations for Businesses. Business people are used to using corporations and LLCs to protect themselves when operating a business. What is less common is to use an LLC to protect their cash, stocks, bonds, precious metals and other liquid assets.

Fred Loses His Nest Egg. Fred bought a two million dollar home when business was booming and put a million down. Now the lender says that the property is only worth $800,000 and has started foreclosure. The house sells at the foreclosure auction for $500,000 and now Fred still owes the bank $590,000 as the balance on the loan which now includes $90,000 of attorney fees, advertising costs and a trustee commission incurred as a result of the foreclosure. Fred has $800,000 in stocks and bonds and the bank gets a court order to get paid $650,000, up from $590,000 due to $60,000 of bank attorney collection fees, out of the stock and bond accounts of Fred. Fred consults his attorney to ask if there is a way to protect his life savings and the attorney advises him that it is too late because Fred already knew about the pending foreclosure and anything Fred did now may be a fraudulent transfer.

What Should Have Fred Done? Fred could have set up a Virginia or Delaware LLC prior to his financial troubles to own just his cash, stocks, bonds, precious metals and other liquid assets. He would not put his home or business into this LLC. Once the Bank comes after him after the foreclosure, the bank lawyer will ask the Judge to issue an order to take the assets owned by Fred’s LLC to pay the balance owned to the Bank. Fred’s lawyer answers that the Bank can’t take the assets owned by the LLC because the LLC, not Fred, owns the assets and the Bank does not have a judgment against the LLC.

Take Over of LLC. The Bank’s lawyer then says, well, if we can’t get the cash directly in the LLC, we will get it indirectly. Since Fred owns 80% of the membership interests in the LLC, the Bank’s lawyer requests that the Judge order a sale of Fred’s 80% membership interests in the LLC. The Bank plans to buy the 80% membership interests at the court ordered auction of the membership interests at a very reduced price, vote a Bank officer in as the Manager of the LLC and then have the bank appointed Manager dissolve the LLC and distribute all of the LLC assets to the members, 80% of which go to the Bank. Result: the Bank gets paid in full, including the $150,000 of attorney’s fees and costs.

Fred’s Counter Offense. Fred’s lawyer counters that the LLC is a Virginia LLC and that under Virginia law, a charging order is the sole remedy of a creditor of a member of a Virginia LLC. In other words, the Judge is prohibited by Virginia statutory law from exercising the normal powers of a Judge to order the sale of the LLC membership interests to satisfy a judgment against a member. The Bank obtains a charging order that says if the LLC distributes, say $10,000 to Fred, the Bank and not Fred gets the $10,000. The Judge enters the charging order and denies the Bank’s request to sell the membership interests in the LLC of Fred. Fred is the Manager of the LLC and the LLC agreement gives Fred the discretion not to make distributions of assets out of the LLC. Fred tells the Bank there will not be any distributions out of the LLC anytime soon and the Bank cannot force distributions out of the LLC.

Settlement. With this stalemate, the lawyers for Fred and the Bank enter into settlement discussions. They settle on Fred paying $95,000 to the Bank in final settlement of all of Fred’s debt to the Bank. Fred makes a distribution out of the LLC to Fred to settle the debt by paying $95,000. Fred saved himself $500,000 or more and retains most of his nest egg.

Not Corporation or Trust. Could Fred have used a corporation or a trust to provide this protection? No, for the corporation, because corporate shares are the same as any other asset and can be seized and sold by court order. See prior blogs for protection of corporate shares. For trusts, unless it is a special asset protection trust set up under special offshore or certain state statutes providing for a special asset protection trust, a trust set up by Fred does not provide Fred this protection under the self settled trust doctrine. In addition, an LLC set up in a state without specific language that the charging order is the sole remedy may not provide any protection for Fred. See our article on Shaun Olmstead v. Federal Trade Commission in our 2010 blog entitled Asset Protection denied with LLC. Also, Fred has to set up the LLC prior to a creditor coming after him under the fraudulent transfer doctrine. More on these doctrines in subsequent blogs.

Act Now. Don’t wait for financial disaster to strike you before it is too late. Call us for your options for asset protection of your stock and bond portfolio.

If You Are in Your Eighties, It is Time to Get Married; Portability of Your Spouse’s Exemption from Estate Taxes.

New Estate Tax Law. For two years, 2011 and 2012, there is yet another new estate tax with another set of new rules. For two years, the amount that is exempt from estate gift and generation skipping taxes is $5,000,000. One new rule is the portability of your deceased spouse's estate tax exemption.

Portability. The new law allows the surviving spouse to use the exemption from estate taxes that was not used by the first spouse. This was not true under the prior law. Example: John dies in 2011 with a taxable estate of $1 million. In 2011, John had a $5 million exemption from estate taxes and therefore did not use $4 million of his exemption. Mary, his surviving spouse, dies in 2012 with an estate of $8 million. Because Mary gets to use the $4 million unused exemption of John, Mary's estate exemption is her $5 million exemption plus John's $4 million exemption for a total exemption of $9 million and with a $8 million estate, Mary pays no estate taxes.

Qualifying for Portability. You do not have to set up a living trust or make elaborate plans to qualify for portability other than getting legally married (under federal law). To qualify, when the first spouse dies, the deceased spouse's estate must file on time an estate tax return even for estates where no estate tax return is due because there is no estate tax. On that estate tax return, the deceased spouse's estate must make an election to use the "deceased spouse's unused election amount" (DSUEA). Once you make the DSUEA election, you can't change your mind. A downside is that this gives the IRS the right to audit the deceased spouse's return, regardless of the normal time limits on IRS audits. Also, all of this only applies where both spouses die in 2011 and 2012, although many commentators expect Congress to make portability a permanent feature of the estate tax law.

No Serial Marriages. For the enthusiastic tax savers or Zsa Zsa Gabor (married nine times), you cannot accumulate DSUEA by marrying one spouse after the other who dies before you. You only get to use the DSUEA of the last spouse. You may not want to marry someone with a large estate if you plan to use his DSUEA! The charming elderly retired professor living in gentile poverty is now a tax advantage.

Time to Get Married. Fran is 85, has a $10 million taxable estate and is in bad health. She has cohabited with her long time boyfriend Jim of 20 years, but they have not married because Jim would lose his survivorship pension from his prior marriage if they married. Jim has only $200,000 to his name which he plans to leave to his children from a prior marriage. Fran marries Jim. Jim dies in 2011 and Fran gets his remaining exemption of $4.8 million. Fran gives $200,000 to charity before she dies in 2012 with an estate of $9.8 million with her $5 million exemption and $4.8 million exemption of Jim. Her heirs save over $1.7 million in taxes and the cost may only be for Fran to replace the pension of Jim from her own resources. Or, if Fran dies first, through the use of family and marital trusts, she can still use Jim's $5 million exemption and achieve the same result: no estate tax.

Time to Change your Plans. In the past, when there was no portability, we had to move assets from one spouse to another to make sure we captured the exemption from estate taxes. Example: In a plan made in 2008 when the estate tax exemption was $2 million, if one spouse only had $1 million in her estate and the other had $3 million, to eliminate estate taxes by fully using both $2 million exemptions, we had to move $1 million to the spouse with the $1 million in order to even out the two estates in case the spouse with the $1 million estate died first. This could be uncomfortable in second marriages. With portability, this is no longer necessary.

More Flexibility. With the ability to exempt $10 million from estate taxes for a married couple without using exemption planning, we now can have estate plans that do not have to fit into the straight jacket of tax requirements. All of the money can be left to children or a surviving spouse or someone else.

Cautions. By law, unless changed, the estate tax exemption will be $1 million in 2013, with no portability and a rate up to 55%. This means you have to have two sets of plans, one for the current law and another for the future law. Also, for people who provide protective trusts for children and want some of their inheritance to go to grandchildren, there is no portability for the generation skipping tax exemption.

Time to Act. Call us to review your plans to see how you can take advantage of these new sets of rules.