This post discusses a potential planning technique whereby taxpayers can utilize their $5 million exemption amount in 2012 without parting with substantial assets.
Many taxpayers are scrambling to make gifts prior to year-end, whether it be to utilize the $5 million exemption in place today or to make taxable gifts before the rates skyrocket to 55%. However, many people are not in the position to utilize their entire exemption amount prior to January 1, 2013. The reasons for not to wanting to make a large gift now can be of a great variety. For instance, some may not have significant assets currently but could be expecting to earn or inherit large sums of wealth in the future, while others may either have liquidity concerns or simply do not want to part with their assets. Unfortunately, many experts predict that gift tax rates will go up in the future.
One way a taxpayer can utilize the larger exemption amount today (or use the lower rates still in effect in the case of taxable gifts) is through the use of making a gift of a promissory note. To the extent a person issues a promissory note, i.e., makes a promise to pay a transferee an amount of money or other property in the future, and does not receive adequate and full consideration in exchange therefor, that person has made a taxable gift. However, in this situation, the transferor has not actually departed with any funds to make the gift. This is the benefit of making a gift of a promissory note.
In order for a gift to be respected for federal wealth transfer purposes it: (a) cannot be an arm’s length and bona fide business transaction made at arm’s length; (b) it has to be a real or bona fide gift; and (c) enforceable under local law. Notwithstanding (b) in the previous sentence, according to longstanding case law, the donative intent of the transferor is irrelevant. Instead of looking to intent, the tax laws look only to what the transferor gave up and what he received in return. In the event that a transferor gave away more than he got back, there is a gift.
In the case of a gift of a promissory note, the transfer will be respected as a completed gift for tax purposes as long as the gift is one which is enforceable under local law. This may require the gift either to be structured as an enforceable agreement (including offer, acceptance and consideration).
Making a gift before the end of the year in the form of a promissory note in the amount of the exemption amount permits a taxpayer to benefit from the entire $5 million exemption amount without losing control of his or her assets. This is a great year end planning tool, but taxpayers need to make sure to seek qualified counsel since there are many pitfalls that need to be avoided, including making sure the promissory note is enforceable under local law, ensuring that the note is structured appropriately and calls for sufficient interest payments, ensuring use of an appropriate trust structure (if any), and others. Obviously, the concern of clawback applies just like it would in any other scenario.
With the exemption amount set to revert to $1 million and rates ready to rise to 55 percent, many taxpayers find that now may be their last time to utilize a $5 million dollar exemption. Gifting a promissory note to a beneficiary may be a good
way to utilize the exemption amount without losing control over a substantial
amount of one’s assets.
Ruben Conitzer
