Wealth Transfer Planning Opportunities in the Current Environment
Last updated May 20, 2020
The current COVID-19 crisis and the resulting economic uncertainty have created significant wealth transfer opportunities for those high net worth families who are subject to the Federal estate and gift tax. The Federal exemption, which is the amount of assets that every individual can transfer during life or at death without the payment of estate or gift tax, is $11.58 million for 2020. The Federal exemption is scheduled to decrease to approximately $6.5 million on January 1, 2026. In the current environment of low interest rates and decreased asset values, there are a number of wealth transfer opportunities which should be considered in order to pass assets down to future generations with little or no tax cost. A brief discussion of some of the techniques is as follows:
Transfer to a Grantor Retained Annuity Trust
A grantor retained annuity trust (“GRAT”) is an irrevocable trust to which an individual transfers assets in exchange for an annuity payable over a specified term. Upon the expiration of the term, the remaining assets of the GRAT pass to the grantor’s beneficiaries or trusts for their benefit. By structuring the grantor’s retained annuity to be actuarially equal to the present value of the remainder interest, no taxable gift is made upon the creation of the GRAT or upon its termination when the remaining assets in the GRAT pass to the beneficiaries or trusts for their benefit. The remaining assets in the GRAT are removed from the grantor’s taxable estate without using the grantor’s Federal exemption.
Example: An individual transfers $5 million of marketable securities to a GRAT in June 2020 and retains the right to receive an annuity from the trust for five years. The rate used to value the gift to the remainder beneficiaries, known as the §7520 rate, is only 0.6%. In order to “zero out” the gift, the grantor must receive an annuity equal to $1 million per year. If the assets of the GRAT appreciate or produce income equal to 5% per year, there will be approximately $755,000 of assets remaining in the GRAT at the end of the term which will pass to the beneficiaries or trusts for their benefit. Thus, the grantor will have transferred $755,000 of assets to the remainder beneficiaries without using any portion of his or her Federal exemption.
A GRAT is effective only if the assets appreciate and/or produce income at a rate of return greater than the §7520 rate in effect upon the creation of the GRAT. Given the low §7520 rate and decreased asset values, there is a high potential that the assets will generate a rate of return in excess of the §7520 rate over the term of the GRAT. There is little risk to establishing the GRAT. To the extent that the assets do not generate a rate of return in excess of the §7520 rate, the GRAT is only required to make payments to the grantor utilizing the assets on hand. The grantor or the remainder beneficiaries do not have to fund the shortfall.
Sales to Intentionally Defective Grantor Trust
For owners of closely held businesses or real estate interests, a sale to an intentionally defective grantor trust (“IDGT”) for the benefit of family members should be considered. The goal of the transaction is to transfer the future income and appreciation of the asset to the next generation at a reduced gift tax cost.
The grantor (creator) of the IDGT will make an initial cash gift, often referred to as a “seed gift”, to the trust which utilizes some or all of the grantor’s Federal exemption. The trustee then purchases business interests or real estate interests from the grantor at a discount in exchange for a down payment and a promissory note. The promissory note must provide for adequate interest equal to or greater than the Applicable Federal Rate (“AFR”) to avoid the imputation of an additional gift of foregone interest. To receive the maximum benefit from the gift/sale to the IDGT, the assets in the trust must generate a rate of return that is higher than the AFR.
Example: Assume a grantor gifts cash to an IDGT in the amount of $200,000 using his or her Federal exemption. In June 2020, the grantor sells a minority interest in his or her business with a pre-discount value of approximately $2.8 million and a discounted value (for lack of control and marketability) of approximately $2 million to the IDGT in exchange for a down payment of $200,000 in cash and promissory note in the amount of $1.8 million with a 20-year term. The minimum AFR required by the IRS to avoid an additional gift is only 1.01%. If the assets of the IGDT appreciate at 5% per year, the remaining assets in the IDGT will be worth approximately $5.3 million pre-discount, after making the final interest and principal payment on the promissory note. The grantor will have effectively transferred approximately $5.3 million of assets from his or her estate plus the future income and appreciation by only using $200,000 of Federal exemption.
There is an additional benefit to establishing an IDGT due to the income tax treatment of an IDGT as a “grantor trust” during the grantor’s lifetime. A grantor trust is disregarded for income tax purposes and all of the income and deductions for the trust will be reported on the grantor’s personal income tax return. The grantor’s payment of the income taxes on behalf of the IDGT during the grantor’s lifetime allow the assets of the trust to grow without the payment of income tax by the trust, which means that the grantor is essentially making additional tax-free gifts to the IDGT without using his or her Federal exemption.
Loans to Family Members
Another simple yet effective means to benefit and assist the next generation is through the use of intra-family loans. As discussed above, loans to family members must bear interest at a rate at least equal to the AFR, but with rates at historic lows, borrowing costs are reduced. In addition to new debt, existing debt instruments should be reviewed to determine whether it is advantageous to refinance.
Example: Assume a parent loans cash to a child or grandchild in the amount of $1 million to purchase an asset. The promissory note has a 10-year term and an interest rate equal to the AFR of 1.01%. If the asset appreciates at 5% per year, the asset will be worth approximately $1.5 million at the end of the term. After making the final interest and principal payment on the promissory note, approximately $500,000 of appreciation will have been transferred to the child or grandchild without using any of the parent’s Federal exemption.
Each of the wealth transfer opportunities discussed above is not mutually exclusive and can be combined to achieve a significant amount of wealth transfer. Now is the time to act to take advantage of the opportunities provided by the low interest rates and decreased asset values. Please reach out to any of the members of our Trusts & Estates Group to discuss your estate planning needs.
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