Preparing Your Clients for Inevitable Tax Hikes

The congressional supercommittee failed to satisfy its mandate, missing its Nov. 23 deadline for finding $1.2 trillion in cuts to the federal budget. Now $1.2 trillion in automatic cuts are scheduled, and neither party is happy.

The supercommittee's failure may mark the end of a decade that saw income tax rates lowered and the gift and estate tax exemption increased. With the supercommittee's failure and elections looming, there seems little chance that an agreement can be reached to extend the Bush era tax cuts set to expire at the end of 2012.

Is there anything we can do to shore up our clients' portfolios for what could be a massive tax increase in 2013?

The automatic cuts don't start until 2013, giving Congress time to rescind or amend the legislation that forced the automatic budget reduction measures. But according to government affairs expert Andrew Friedman, the supercommittee's inability to reach a compromise is symptomatic of greater problems in Congress—problems that could very well lead to a massive increase in taxes for everyone, rich and poor alike.

Proponents of extending the Bush tax cuts beyond 2012 face a steep uphill battle in Congress. Given the supercommittee deadlock and "the parties' competing views on taxes," the chances of Congress passing a comprehensive tax bill before next year's election are slim. And if Congress can't come together before the election to avoid the biggest tax increase in history, they're unlikely to reach agreement afterward.

When our current Congress returns to Washington after the election, President Barack Obama will still be in the White House and everyone involved will have even less incentive to find a workable compromise. And even if Congress passes legislation extending the Bush tax cuts, Obama has said he will veto any bill extending the cuts for families earning over $250,000 a year. Regardless of whether he wins re-election, the president will be emboldened to follow through on his veto promises without another term to worry about.

Planning for 2013

The prospect of Congress allowing the Bush tax cuts to expire en masse was once unthinkable; but a total lapse is looking a lot more likely. What can we do over the next year to prepare for the possibility of the largest tax increase in history?

Gifting will be more important in 2012 than before. A couple can make up to $10,240,000 in gifts without being subject to transfer taxes. Wait until 2013 and that limit could drop to $2 million. The over $8 million difference could amount to $4.4 million in additional estate taxes. In the first scenario a couple can transfer $10 million in net gifts, for example, with no transfer tax paid.

In the second scenario, the couple's beneficiaries net only $5.6 million in gifts from the couple's estate. And the beneficiaries in the first example also receive all appreciation in the $10 million gift transfer tax free. If the gift is made twenty years prior to the death of the second spouse to die, its value likely will have doubled at least once outside the grantor's estate.

Introduce life insurance into the estate planning equation and the exemption can be levered up to provide millions in transfer tax free dollars. Utilizing 2012's $5,120,000 generation skipping transfer tax exemption amount and the tax savings multiply. Bring a life insurance funded family bank or dynasty trust into the mix and your clients can leave a legacy to generation after generation. A $10 million gift can grow for generations without transfer tax liability, turning into a legacy of $100 million or more.

Wait a mere 13 months and these opportunities could be gone forever.

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See also The Law Professor's blog at AdvisorFYI.