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A Proliferation of Ways to Use a Tax Break as Its End Nears

Daniel Acker | Bloomberg | Getty Images

Holiday shoppers and tax filers are known for procrastinating. This year, they're joined by the wealthy who have still not decided whether to make a gift under a generous gift tax exemption that may soon disappear.

Back in December 2010 President Obama and House Speaker John A. Boehner reached an agreement to raise the exemption levels on estate and gift taxes to $5 million a person as part of a deal to extend the Bush-era tax cuts. (This year, that rate was adjusted upward for inflation to $5.12 million.)

As I have often written, this was an amazing giveaway to the superrich. But it also provoked anxiety among those at the next level down — the merely very rich — for whom giving away as much as $10 million a couple, to avoid higher taxes when they die, was not as simple a matter. The gifts represented a larger percentage of their net worth.

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Now, with a little more than two weeks left in the year, tax lawyers and advisers say the wealthy are scrambling to make gifts before the exemption expires.

"We are having this come up daily," said Mitchell A. Drossman, national director of wealth planning strategies for U.S. Trust. "One of the first things I'm asking is, 'Why are they warming up to this idea now? Is it that they didn't want to make the gift? They didn't know how? They didn't get around to it?' "

With so little time left, advisers have come up with quick and easy ways to get the gift done for tax purposes this year.

A simple solution is to forgive any loans made to family members. This is a fairly painless way to use up some of the gift tax exemption because most parents never expected their children to repay those loans and would have forgiven those loans at death anyway.

While giving cash outright is easy, few wealthy people want to do that. The exemption may be at a historically high level, but the wealthy still want to give assets that will continue to grow.

Leiha Macauley, a partner and head of the Boston office at Day Pitney, says one solution is to set up a trust that allows someone to put in cash now and exchange it for other assets in the future, when the person has had enough time to have the assets properly appraised. Using the so-called power of substitution means that cash can become just about anything else next year.

"The power of substitution is key when we're so pinched for time," she said. "Appraisals are not coming out quickly enough. And people giving right up to the limit makes us nervous, because what if the appraisal says something is worth $6.2 million and then the I.R.S. says you owe tax?"

Typical assets that people swap in later include a home, which they then rent back from the trust, or a large life insurance policy, which can be purchased with the cash. But Andy Katzenstein, a partner in the personal planning department at the law firm Proskauer Rose, said he had clients ready to swap more nontraditional assets into trusts. One has a collection of Ferrari sports cars, while another couple has art that is valuable but that they no longer like displaying in their house.

These assets also have the virtue of being relatively painless to part with. The man with the Ferraris can pay the trust rent when he drives one of the cars. (The rent further reduces the estate's value.) The couple with the art already had it in storage.

But Mr. Katzenstein cautioned those choosing this option to know the law, particularly if they plan to keep using these assets. "The devil is in the details," he said. "If you don't follow the rules you get into trouble. Make sure you have a real lease, you pay the rent every month and it also has to be fair market rent."

Mark E. Haranzo, a partner at the law firm Withers Bergman, said he had suggested to clients with private companies that they use the cash as essentially a down payment on a loan to put all or part of their company into a trust for their children. He said the general rule of thumb was to put down 10 percent of the value of the company and then use the company's profits to pay off the loan.

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For the really rushed, Mr. Katzenstein said, another option is to include the power to rewrite the terms of the trust next year if their lawyer does not have time to customize a trust for them before the end of the year. This is done by naming someone to the role of "trust protector" and allowing that person to rewrite the trust at a later date.

"This is a way to get you from the simple thing you set up this year into the thing you want next year," Mr. Katzenstein said. "The only thing you have to be careful of is to make sure the protector doesn't rewrite the trust in his favor. Most people are naming their lawyers."

The one place that stymies these golden giveaways is Connecticut, where there is still a state tax on gifts over $2 million. Mr. Haranzo said Connecticut clients who wanted to give the full $5.12 million in cash would have to pay $240,000 in state gift taxes.

Like many things having to do with tax, there are ways around the state tax. One is to give out-of-state property, like a house on Nantucket or in Florida. Another is to give away art that is kept in another state.

But he said some people were taking the view that the state tax was worth paying, given the size of the savings on federal taxes. "They are saying, 'This is too good of an opportunity for the $5 million exemption — I'll pay the price in Connecticut.' "

For people afraid of giving up control of so much money, there are at least three ways to give the money as a gift and still have access to it.

Ms. Macauley said a few clients were opting to set up trusts that can be unwound up until midnight on Dec. 31. If an agreement is reached that extends the gift tax exemption at the current level — or even does away with the estate and gift tax all together — then the person will be able to hold onto that money. In another situation, if the person who created the trust dies before the end of the year and the assets would be taxed at a lower rate in the estate, then the trust would also be unwound.

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If neither situation comes to pass, then on the last day of the year, the trust becomes irrevocable and the gift is made. Ms. Macauley warned, however, that some lawyers questioned whether the I.R.S. would allow this maneuver.

Another option is to take a loan from the trust to live on. Ms. Macauley laid out a chain of events in which a woman lived in a house worth $3.25 million and had millions more in stock that would incur a hefty tax bill if sold. (At death, the capital gains on the stock get wiped out.) She could give all of her cash to the trust and then borrow it back.

She would have to pay interest on the loan, which would get more money out of her estate. But the loan would not be paid back until she died and other assets were sold.

"If the family sells the house for $3.5 million but she owed $500,000, that lowers the amount of the estate," Ms. Macauley said.

She added: "There is no limit on borrowing, but you have to pass the sniff test. It has to be reasonably secured with an adequate amount of interest."

A third way is to pledge to make the gift in the future through a self-created promissory note. Mr. Drossman said for tax purposes the gift would be recognized when the note was created. The person making the gift also has to pay the trust interest on what is essentially a loan to make a future gift.

"It provides a unique and interesting solution," he said. It works best for people who have their wealth tied up in illiquid assets like real estate or a hedge fund they run.

Of all the strategies, this future gift sounded almost fictional, but Mr. Drossman assured me that it was not. "It's real," he said. "The person who gives this away truly wants this to be real. It's just they don't have the liquidity today but it will be there in two to three years' time."

Here's the rub, though: If Mr. Obama and Mr. Boehner again come to a last-minute agreement as they did two years ago and the exemption levels on estate and gift taxes are unchanged, all this maneuvering could be for naught.

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