In recent years, uncertainty around taxes and fiscal policy set the tone for estate planning: “hurry up and wait” was the order of the day, followed by a year-end scramble to minimize damage from anticipated changes. 2013 brings a reprieve of sorts, with much to do, but a well-marked landscape in which to do it.

From 2001-2012 the federal estate tax exemption was more volatile than the stock market – ranging from $1 million in 2001 to unlimited in 2010 to $5.12 million in 2012. The federal gift tax exemption also changed dramatically, increasing from $1 million in 2001 to $5.12 million in 2012. The increased estate and gift exemptions were set to expire after 2010, but were made permanent beginning in 2013. Hardly an ideal environment for estate planning.

Fortunately, the new estate tax law provides a firm foundation for planning, with its four key elements. First, it keeps the amount exempt from federal transfer taxes high. In 2013, each person has a $5.25 million exemption that he or she can apply to lifetime gifts. Any exemption that is not used for gifts can be applied at the person’s death. There is also a $5.25 million exemption from generation-skipping transfer taxes which apply to transfers to grandchildren. Second, the new law provides for automatic increases each year to reflect federal cost of living adjustments. Those adjustments are significant – resulting in an increase of $130,000 last year. Third, the tax rate for estate, gift and generation-skipping transfers over the exemption is a flat 40%. Fourth, a surviving spouse can now elect to use a deceased spouse’s unused federal estate tax exemption.

Given the dramatic increases in the transfer tax exemptions over the past decade, it is important to do a checkup on existing wills and trusts. Estate planning documents often include formulas that allocate assets to trusts for spouses and descendants based on the desired tax results. That can result in too much being set aside for grandchildren, for example, and not enough for children or the surviving spouse. Also, under the old estate tax laws, it was usually better for a married couple to shelter the maximum amount from estate tax at the first death. Now that unused estate tax exemption can be transferred to the surviving spouse, it may be better to include more in the surviving spouse’s estate to get a higher income

Making the Most of Year-End Estate Planning

tax basis in family assets when the spouse dies. The bottom line? There is no one size fits all approach – each plan should be reviewed and revised as needed.

The increased estate and gift exemptions mean that the 40% tax on gifts and estate transfers is a concern primarily reserved for the most affluent of U.S. citizens. It “leaves very few people who will be subject to the tax,” Reuters noted in a 2013 wrap-up of the changes. “For married couples, the estate tax is usually deferred, even for large estates, because of the unlimited marital deduction. Just 3,800 estates are expected to owe any federal estate tax in 2013, according to estimates from the Tax Policy Center.”I

To some extent, estate and gift tax relief serves as a counterbalance against income tax increases that will hit the highest brackets. “Taxpayers in the top tax bracket will pay higher rates on income, dividends and long-term capital gains,” writes Kiplinger. “But the law also provides relief for upper-income taxpayers concerned about protecting their estates…In the future, less than 1% of taxpayers will have to worry about federal estate taxes.”II

In addition to income tax increases, the new 3.8% Medicare tax also impacts high earners. From a planning perspective, higher tax rates make vehicles with tax favored status attractive, including 529 plans, Roth IRAs, Roth 401k Plans, and charitable remainder trusts. The higher income tax brackets also make charitable gifts more attractive because they can be used to offset higher income tax rates. Finally, trusts for future generations can be set up as “grantor trusts,” so that the income taxes are paid by the donor, rather than the trust. The donor’s payment of income taxes on the trust’s income is not an additional gift to the trust beneficiaries; taking on this tax liability will allow a generous donor to maximize what he or she can pass on to younger generations over time.

Wealthy taxpayers who are willing to plan ahead, fund trusts early on, and leverage the gift tax exemption have opportunities to significantly reduce their estate tax down the line. While some strategies are part of the program every year, here are several of the most appealing ways to ease the tax burden for 2013:

Be strategic about charitable giving

Charitable giving serves the dual purpose of advancing philanthropic goals and reducing the taxable estate. For charitable gifts made in cash by year end, up to 50% of a taxpayer’s “contribution base” (similar to adjusted gross income) can be deducted – a tremendous benefit, especially for families experiencing a major income event.

This may explain why donors nearing retirement register as the most philanthropic demographic. A recent study showed that “not only are Boomers [age 49-67] the largest group numerically, with 51 million individuals comprising 34% of the donor base, they are also the largest contributors, giving an

estimated total of $61.9 billion per year (43% of all the dollars donated).” III

Donors can also be creative about how they give. Deductible charitable gifts can be made by transferring value by any method and in any form to a charity. This includes gifts of cash (currency, checks, credit card transfers, other electronic transfers such as wires, PayPal, payroll withholding, or unreimbursed charitable expenses such as mileage expenses) or gifts of property (art, antiques, vehicles, real estate, or publicly or privately traded securities).

Given the increase in the capital gains rate from 15% to 20% for the highest tax bracket, 2013 is an ideal year to donate appreciated stock. Taxpayers get a charitable deduction for the full fair market value deduction of the stock given, including the untaxed appreciation. Typically, the charity then sells the stock and, being tax exempt, can do so tax free. Remember, the process of donating stock takes time. Donors should plan for a full month to complete the transaction, especially at year-end when brokers are inundated with similar requests.

Finally, unless the law is extended, 2013 is the final year in which donors over 701/2 can donate up to $100,000 directly from an IRA to a charity. The donation counts towards the donor’s required minimum distribution, but unlike normal IRA distributions, the amount passing directly to charity is not included in the donor’s taxable income. This giving strategy is especially helpful in states that do not provide a charitable deduction (as in Massachusetts).

It is worth noting that charitable giving is not only part of tax strategy, it is an important part of cultural advancement. Donors are able to channel resources to a mission, whether to fund the arts, the environment, support medical and other health and welfare needs, or – all too often in the past several years – respond to natural disasters or acts of violence.

Even when spurred on by timely events, giving should be part of a long term plan that supports the estate plan and the long term charitable philosophy. As community members respond to an event by donating, they may lose sight of the effect on their plan and on other charities. A donation to a specific community need may come at the expense of other philanthropic efforts. Year-end is an ideal time to reflect on the charitable giving philosophy and make decisions about where to direct donations.

Give smart: use the right vehicles

While families try to plan as far ahead as possible and stay true to a strategy, sometimes year-end comes faster than expected. When time is an issue or donors are uncertain about their philanthropic strategy, they can transfer assets to a family foundation. If they do not have a family foundation, they can establish a Donor Advised Fund (DAF). A foundation or DAF allows donors to allocate funds to charity without immediately specifying a recipient. They can make a general donation, receive a tax deduction in the year the assets are allocated, and distribute the funds over time to various causes. DAFs have quickly become a popular vehicle because of their flexibility and tax-friendly status.

The charitable lead trust is another option, especially for the wealthy donor who wishes to fund a certain level of charitable giving each year and also leverage the amount being left to children. With a charitable lead annuity trust, for example, the donor agrees to pay a certain percentage of the trust’s initial assets to one or more charities each year for a term of years. At the end of the term, any assets remaining in the trust will pass to the donor’s children. The value of the gift to the children at the time that the trust is established is based on the IRS interest rate in effect at the time of the gift. The IRS rates are currently very low (2% for September) and if the trust appreciates in excess of 2% per year, that excess growth passes to the donor’s children free of gift tax.

Maximize family gifts, but be careful gifting low basis assets

In addition to charitable donations, gifts to children and other relatives move money out of the taxable estate. With the gift tax exclusion now set in stone (or at least in dry ink), families can make significant annual gifts that reduce tax exposure. In fact, a cost of living adjustment provides for an additional amount each year that can be gifted tax-free; even those who gave gifts to the maximum lifetime allotment of $5.12 million by the end of 2012 can give another $130,000 in 2013. The annual gift tax exclusion – the amount up to which taxpayers can give to any individual each year without reporting it – has also increased to $14,000, the first such jump since 2009. In addition, there is an unlimited annual exclusion for the direct payment of tuition and medical expenses.

A major advantage of gift giving strategies is that they not only allow for the straightforward tax-free transfer of an asset, they also protect all future appreciation and income earned by the assets after the gift. If individuals do not need certain assets to support their current or future needs, their family can enjoy significant financial benefits of their gifts well into the future.

A word of caution, though: with the federal exemption so high, the temptation to make sizable gifts can lead to higher capital gains taxes when the family later sells an asset that has been given to them. Years ago, with estate tax exemptions low and rates high, it was almost always better to make lifetime gifts than to pay estate tax, even if it meant higher capital gains tax when an asset was sold. That is no longer the case for families with assets below the federal estate tax threshold. If the federal estate tax does not apply, then the only estate tax may be at the state level. State estate tax rates tend to be significantly lower than the current federal capital gains tax rate of 20%. Also, for sales of tangible objects such as art or fine furnishings, the federal capital gains tax rate is 28%.

A vacation home handed over to children, for example, will have an income tax basis equal to the donor’s tax basis. If instead, the vacation home were left to the children at death, it would receive a step up in tax basis equal to date of death value. The home could then be sold without triggering large capital gains taxes.

One of the best ways to shift assets to the next generation is to fund a generation-skipping trust that is a grantor trust for income tax purposes. That way the donor will pay the tax bill on the trust during

the donor’s lifetime and the trust assets can grow free of the annual income tax hit. A generation-skipping trust shelters assets from estate tax for so long as the assets remain in trust. The generation-skipping trust can be established in states such as New Hampshire, that allow the trusts to go on indefinitely. Generation-skipping trusts also offer important benefits in terms of creditor protection for beneficiaries. That helps protect the assets in the event of a beneficiary’s divorce. While it sounds counter-intuitive, the generation-skipping trust can also benefit the children. The trust can be drafted so that the trustees have discretion to make distributions to them as needed.

Once the generation-skipping trust is funded, it can be used to purchase assets from the donor if it is set up as a grantor trust for income tax purposes. The purchase allows the trust to lock in the value of the assets now before they appreciate further. The sale can be structured as an installment sale, so that the trust can pay back the donor over time, with interest set at the minimum federal rate, which is much lower than commercial rates. Because of uncertainty about how these transactions may be taxed if the donor dies while the loan is outstanding, the sale should be structured to pay off the loan well within the donor’s life expectancy.

Grantor retained annuity trusts or “GRATs” continue to be a great way to transfer assets to children without using up gift exemption. With a GRAT, the donor transfers assets to a trust and receives an annual annuity that is designed to zero out the value of the gift passing to children based on the IRS valuation rules. The federal interest rate used to value a GRAT is very low right now – 2% in September – so GRATs provide an ideal way to transfer appreciation in excess of the assumed federal rate to the children free of gift tax. For example, if a donor transfers $5 million to a GRAT with a 2-year term and the assets appreciate at an annual rate of 7% vs. 2%, the remainder passing to children after two years gift tax free would be almost $400,000.

Finally, don’t forget to do the simple things well each year. Each individual can transfer up to $14,000 per person per year as an “annual exclusion gift.” You can make the gifts outright or to a trust that qualifies for the annual gift exclusion called a “Crummey Trust.” You can give cash or marketable securities, which are easy to value, or interests in any other type of asset. If you give an interest in a family limited liability company or partnership or closely held stock, real estate or tangible objects, such as art, you will need to obtain an appraisal. A bit of effort in making full use of annual exclusion gifts will be well rewarded. The $14,000 annual exclusion adds up fast – if grandparents give to a grandchild’s trust every year for 21 years and the assets grow at a modest rate, the trust will have over $1 million in assets by the time the grandchild is 21.

There is also an unlimited gift tax exemption for direct payment of tuition and medical expenses. The expenses must be paid directly to the provider – the donor cannot reimburse the child or grandchild for an expense that has already been paid. Tuition for any age student enrolled in an academic program, even some preschool programs, qualifies for the gift exemption. Given the high cost of private education at all grade levels, and the high cost of both public and private colleges, the unlimited exemption for direct payment of tuition enables families to transfer millions of dollars gift tax free to younger generations. Many of us are surprised at how much we spend on medical expenses,

including health insurance payments and co-pays, prescription medicines and treatments and eye care and dental care. Parents or grandparents can help by paying those expenses directly on behalf of their children or grandchildren.

Avoid the year-end scramble

Whichever strategy is employed to move assets out of the estate, thoughtful planning allows individuals to make the most out of their current environment. With a more certain tax landscape in 2013, there are opportunities to make informed decisions that will benefit families for the next several years and for generations to come.

To make the most of opportunities to reduce taxable estates this year, taxpayers should be sure to check into:

• Charitable donations of appreciated stock

• Charitable donations of up to $100,000 from IRAs (for those 701/2 or older)

• Funding a charitable lead annuity trust to support annual charitable giving and provide for children in the future

• Funding the family foundation or donor advised fund

• Making annual gifts to family members of up to $14,000 per individual

• Directly paying tuition and medical expenses

• Giving an additional $130,000 this year if you maxed out your lifetime gifts in 2012

• Funding a GRAT

• Funding or adding to a generation-skipping trust.

EndnotesI “New estate tax rules call for new planning tactics,” Amy Feldman, Reuters, February 26, 2013II “2013 tax planning gets easier,” Sandra Block, Kiplinger, April 2013 III “Charitable giving: baby boomers donate more, study shows,” Deborah Jacobs, Forbes.com, August 8, 2013

Copyright © 2013 Hemenway & Barnes LLP

This advisory is provided solely for information purposes and should not be construed as legal advice with respect to any particular situation. This advisory is not intended to create a lawyer-client relationship. You should consult your legal counsel regarding your situation and any specific legal questions you may have.