By Jennifer Davis, Keith Grissom and Elizabeth Pack Greensfelder, Hemker & Gale, P.C. | October 2020
St. Louis, MO \ Chicago, IL \ Southern Illinois \ www.greensfelder.com
Introduction .................................................................................................................................................. 3 One-Time or Annual Gifting .......................................................................................................................... 3 Making or Refinancing Loans ........................................................................................................................ 5 Creating Grantor Retained Annuity Trusts ................................................................................................... 5 Utilizing Family Limited Partnerships and Limited Liability Companies ....................................................... 6 Installment Sales to Intentionally Defective Grantor Trusts......................................................................... 7 Charitable Giving........................................................................................................................................... 8 Spousal Lifetime Access Trusts ..................................................................................................................... 8 Conclusion................................................................................................................................................... 10
Greensfelder, Hemker & Gale, P.C. | www.greensfelder.com | Offices in St. Louis, MO | Chicago, IL | Southern Illinois
During times of a robust economy and increasing portfolio balances, many grasp the importance of implementing planning strategies to shift wealth in a tax-efficient manner to the next generation. However, uncertain economic times can also present opportunities, not only to re-evaluate existing planning, but also to implement additional, alternative planning that in the long run could provide significant estate, gift, and income tax benefits.
With the COVID-19 pandemic, we, unsurprisingly, have seen a significant impact on the U.S. economy. Fortunately, today, things are not as bleak as they were only a few months ago. However, only time will tell the long-term impact of the pandemic.
With the current economic uncertainty, the Treasury has responded with a steady decline in interest rates. In particular, the lowest interest rate that may be charged on a loan without causing negative gift tax consequences, the Applicable Federal Rate (AFR), has dropped to a historic low. In January 2020, the mid-term AFR (for loans more than three years and up to nine years) was 1.69%. The mid-term AFR for October 2020 is .38%. The AFR is commonly used for such things as intra-family loans, but it is also used to determine the rates for other planning tools, like Grantor Retained Annuity Trusts. As discussed below, the lower the AFR, the greater the opportunity for planning.
As part of the 2017 Tax Cuts and Jobs Act (TCJA), the lifetime transfer (estate, gift and GenerationSkipping Transfer (GST)) tax exemptions doubled from $5 million plus inflation, to $11,580,000 per individual in 2020. However, built into that legislation was an automatic sunset that will result in the estate, gift, and GST tax exemptions dropping back down to pre-TCJA levels beginning January 1, 2026. These transfer tax exemptions could be decreased even sooner in response to the current economic decline or the outcome of the November election. As such, the risk of the higher transfer tax exemptions disappearing creates a level of urgency for individuals to implement estate planning techniques that utilize the exemptions while they are still available.
While not exhaustive, below are several planning strategies that should be considered in light of the current depressed asset values, low AFRs, and the possibility of the higher transfer tax exemptions decreasing to the prior levels. In addition, there are some considerations for existing planning in the current economic environment.
One-Time or Annual Gifting
Gifting assets can have beneficial estate and income tax consequences for both the individuals making the gifts (the donors) and the gift recipients (the donees). Under the current law, in 2020, each individual may give $15,000 per calendar year to any number of individuals without incurring a gift tax. Married couples can give up to $30,000, per donee, gift tax-free. This amount is often referred to as the annual exclusion amount, and it is indexed for inflation, resulting in occasional increases. In addition to the annual exclusion amount, tuition and medical expenses that are paid for someone else may also be made gift tax-free.
Gifts to an individual in excess of the annual exclusion amount, and that are not tuition or medical expenses paid on his or her behalf, will reduce the donor's remaining lifetime gift and estate tax exemption amount. The gift and estate tax exemption is "unified," meaning that if one goes down, so
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does the other. That is, gifts during your life in excess of the annual exclusion amount will reduce not only your lifetime gift tax exemption, but also your estate tax exemption at death.
In 2020, each individual has a total lifetime gift/estate tax exemption amount of $11,580,000. This exemption amount is indexed for inflation each year; however, this amount is scheduled to revert to the prior levels of $5 million, adjusted for inflation, effective Jan. 1, 2026, and could possibly go down sooner. Fortunately, the IRS has indicated in recent guidance that even if the lifetime gift/estate tax exemption decreases, any previously used exemption will still be utilized at death. In other words, there will be no "clawback" of previously used gift tax exemption at the donor's death, even if the donor made gifts during life in excess of the available estate tax exemption amount at death.
An individual may choose to gift assets to family members outright or to a trust created for their benefit, taking advantage of the annual exclusion and the lifetime gift/estate tax exemption. Gifting assets removes not only the value of the assets from the donor's taxable estate for federal estate tax purposes, but also removes any subsequent income and appreciation related to those assets.
While both an outright gift and a gift in trust removes the value of the assets from the donor's estate, gifts to an irrevocable trust can have significant advantages. The trust can be structured so that the assets in most cases will be shielded from the claims of the beneficiaries' creditors and may not be subject to division in the event of divorce.
In addition to the creditor protection benefits of a gift to an irrevocable trust, there are important transfer tax benefits to the donor and the donee. An irrevocable gift trust can be structured so as to remove the trust assets from the taxable estate of the family members who are the trust beneficiaries. Such a trust is sometimes known as a "dynasty trust." This type of irrevocable trust is often structured to also avoid a separate transfer tax, known as the GST tax, which applies to transfers to grandchildren and further descendants. The application of the GST tax can be avoided by allocating GST exemption to the initial and later transfers to the irrevocable trust. Similar to the lifetime gift/estate tax exemption, in 2020, each person has a separate $11,580,000 in GST tax exemption. This amount is also indexed for inflation each year. By allocating this GST exemption to all transfers to the irrevocable trust, the donor can avoid transfer taxation for the trust and the trust beneficiaries for as long as the trust lasts. That is, the trust can be designed to last in perpetuity.
To further maximize the tax savings available with making gifts to an irrevocable trust, the trust could be structured as a grantor trust, meaning that the individual who creates the trust (the grantor) would continue to pay the income taxes on the earnings of the trust as though he or she still owns them. These payments can be made without gift tax consequences or reduction in the annual exclusion amount otherwise available. So, for example, if the irrevocable trust is structured as a grantor trust and owns only gifted business interests, the grantor would continue to pay the income tax on the income and dividends related to the business interests. In addition, because of the grantor trust structure, at a later date income tax planning can be implemented, such as swapping high basis assets with trust assets having a low basis. By including the low basis assets rather than the high basis assets in the grantor's taxable estate, such low basis assets may receive a step-up in basis at the grantor's death to fair market value.
Alternatively, the trust could be structured as a separate taxpayer that would pay its own income taxes or pass the income tax burden to its beneficiaries by making distributions to the beneficiaries. This could be advantageous if the trust beneficiaries are taxed at a lower tax rate or possibly reside in a low- or
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no-income-tax state. If the grantor is unsure whether he or she will always be willing to pay the income taxes on behalf of the trust, the grantor can structure the trust as a grantor trust initially, and later renounce the powers that cause it to be taxed that way, resulting in the trust then becoming a separate taxpayer.
To maximize the type of planning described above, at minimum an individual could begin an annual gifting program to transfer their assets over time, utilizing the annual exclusion amount, thereby retaining their lifetime gift/estate tax exemption. However, in light of the potential reduction in lifetime gift/estate tax exemption amounts, utilizing the exemption now should be considered due to the increased exemption potentially going away. This is further compounded by the opportunity to gift assets with currently depressed values that we hope will eventually increase in value, allowing such future appreciation to accrue to the benefit of the donees.
Making or Refinancing Loans
A simple method for transferring assets in a tax-efficient manner is by making low interest rate loans to family members. For example, a child wants to buy their first home. Rather than the child paying interest to a bank, the parent can loan the child money for the purchase price at an interest rate equal to the Applicable Federal Rate (AFR). The AFR is the lowest interest rate that may be charged on a loan without causing negative gift tax consequences. This allows for the payment to be more economical for the child, and the interest amount to stay within the family rather than being paid to a third-party bank.
The AFR this year is at historical lows. In January 2020, the mid-term AFR (for loans more than three years and up to nine years) was 1.69 percent. The mid-term AFR for October 2020 is .38%.
Intra-family loans can also provide more flexibility for the borrower over a commercial loan. A child or grandchild can use such a loan to start a business, make other investments, pay down higher-interest debt, or as mentioned above, purchase a home or car. The current low AFR as well as depressed asset values may create a higher probability that the rate of return on an investment of the loan proceeds will exceed the interest payments, allowing any future appreciation to pass to the borrower gift and estate tax free. A parent or grandparent may also choose to forgive part or all of the loan payments, periodically, using the annual exclusion amount if they wish to prevent such gift from using up any of his or her lifetime gift/estate tax exemption amount.
For an individual who has already engaged in this type of planning, that individual should consider possibly modifying existing loans that have been made to family members in order to take advantage of the historically low interest rates. Refinancing such existing loans is generally a fairly simple process.
Creating Grantor Retained Annuity Trusts
Another popular method for transferring assets in a tax-efficient manner, particularly when interest rates are low and asset values are depressed, is by creating a grantor retained annuity trust (GRAT). A GRAT is a type of trust that allows the grantor of the trust to retain a stream of annuity payments for fixed period of time. Following the end of the term and the last annuity payment, the remaining assets in the trust, or the "remainder," pass to the beneficiaries of the trust, potentially gift tax free.
To create a GRAT, the grantor transfers to the trust property that is expected to appreciate in value. Because the grantor retained the right to receive an annuity payment for a fixed period of time, the
value of remainder, or the gift, is reduced by the value of the annuity retained, as calculated for tax purposes. Consequently, depending on the structure of the GRAT, the remainder may have little to no value for tax purposes, thereby resulting in potentially no taxable gift upon creation. As mentioned above, at the conclusion of the annuity term, the remainder passes to the trust beneficiaries gift tax free.
For income tax purposes, the grantor is considered the owner of the GRAT and is taxed on its income. The value of the retained annuity is determined by the IRS tables based on an interest rate known as the Section 7520 rate, which is based on the AFR. As mentioned above, it is possible to structure the required annuity so that there is no gift for tax purposes upon the initial transfer to the GRAT (known as a "zeroed-out GRAT").
Generally, it is preferable to fund a GRAT with assets that are going to increase in value. By using a zeroed-out GRAT, the grantor can essentially transfer all appreciation on the gifted property in excess of the 7520 rate to the beneficiaries of the GRAT free of gift tax, removing the value of such appreciation from his or her estate. Because many assets currently have depressed values that are likely to increase significantly at a later date, and the 7520 rate is currently historically low, this maximizes the value that can be transferred to family members in a tax-efficient manner.
A drawback of the GRAT is that if the grantor dies before the end of the GRAT term, potentially all of the property in the GRAT will be included in the grantor's taxable estate. A further limitation of the use of a GRAT is that the transferred assets, though excluded from the grantor's taxable estate (assuming the grantor survives the term of the GRAT), may be included in the taxable estates of the beneficiaries of the GRAT, due to the inability to allocate GST exemption to the GRAT at the time of its creation.
The combination of today's depressed asset values and historically low Section 7520 rate make the use of a GRAT potentially very advantageous, especially where the assets are likely to appreciate. Under these circumstances, the use of a GRAT may provide a method for transferring significant wealth taxfree or nearly tax-free.
Utilizing Family Limited Partnerships and Limited Liability Companies
Another commonly used planning technique is the creation of a closely-held business to own family investments, such as a family limited partnership or family limited liability company.1
Many individuals use the family limited partnership structure because it provides continuity of ownership, consolidates management, and proactively implements succession planning. The family limited partnership allows an individual to transfer marketable securities and other property to their family and yet retain a level of central management authority. The individual may choose to gift limited partnership units to family outright, or to trusts for those beneficiaries. A primary benefit of a family limited partnership is that the entity's assets are not owned by the individual limited partners but by the entity, thereby protecting the partner's individual assets from the claims arising from ownership of the entity.
Minority or non-voting interests in a closely held business entity, such as a family limited partnership, are ideal assets to gift. This is because under current law, the value of such interests may be discounted
1 While only a family limited partnership is discussed, the concepts discussed will generally apply the same to both a family limited partnership and a family limited liability company.
for such things as lack of marketability or lack of control, when determining the value for gift tax purposes. The value assigned to such interests for gift tax purposes is "fair market value," or the value at which a willing seller will sell, and a willing buyer will buy, the property being transferred. Since an interest in a limited partnership is generally difficult to sell in the market to any non-related party, and since an owner of such an interest has no control rights with respect to the entity, the interest has a fair market value less than its pro-rata share of the entity's underlying assets.
One caution when using a family limited partnership structure is that recently the IRS has been scrutinizing such arrangements, especially if the individual who created the entity retains ownership interests at death. Thus, in many instances it may be advisable to either gift the ownership interests or sell them, so that the interests are not retained at the time of death. In any event, it is important that the individual properly create and administer the family limited partnership and respect the partnership as a separate and distinct legal entity, and not merely an extension of the owners.
The discounts that may already be applied to minority or non-voting interests in a closely held business entity, coupled with asset values that are already depressed, make now a prime opportunity to consider utilizing such a family limited partnership planning strategy. Transferring such interests ultimately means that a greater amount of assets can be transferred without using as much of an individual's lifetime gift/estate tax exemption amount.
Installment Sales to Intentionally Defective Grantor Trusts
A popular planning technique is an installment sale to an Intentionally Defective Grantor Trust (IDGT) in order to freeze the value of assets in an individual's estate. Under this technique, the grantor sells assets (such as closely held business interests) to a trust in exchange for an installment note. A small "seed" gift is typically also made to the trust to ensure enough equity to support the loan and to allocate generation-skipping transfer (GST) tax exemption. The trust is structured as an IDGT so that there should be no income tax consequences resulting from the sale. In addition, during the grantor's life, the interest payments on the installment note will not be deemed taxable income to the grantor, and the payment of taxes on the trust's income provides an additional gift-tax-free benefit to the beneficiaries.
As described in our previous post, closely held business interests and family limited partnership interests provide a greater benefit because the interests will typically be sold at a discount, typically for an amount less than the pro-rata share of the entity's underlying assets.
The installment note that will be held by the grantor typically has an interest rate equal to the Applicable Federal Rate (AFR). Thus, to the extent that the assets in the trust produce income or increase in value in excess of the interest due under the note, such increase will accrue to the benefit of the beneficiaries of the trust. Again, because many assets currently have depressed values that are likely to increase significantly at a later date, and the AFR is historically low, this maximizes the value that can be transferred to family members in a tax-efficient manner.
If properly structured, it is also possible to engage in income tax planning such as swapping high basis assets with trust assets having a low basis, at a later date. By including the low basis assets, rather than the high basis assets in the grantor's estate, such low basis assets will receive a step-up in basis at the grantor's death.
Finally, unlike a transfer to a grantor retained annuity trust (GRAT), GST tax exemption can be allocated to the IDGT at the time of the initial transfer, so that the trust assets will be able to be passed from generation to generation free of transfer taxes. That is, the IDGT can be designed to last in perpetuity.
For installment sales that have taken place in earlier years, the current environment may call for a reevaluation. If the promissory note is still outstanding, a modification of the note may be considered to lower the interest rate. If the note is underwater that is, the value of the assets in the trust have a value lower than the remaining note balance the grantor could consider selling the note in a second, similar transaction, or contributing the note to a GRAT.
For those who are charitably inclined, planning techniques are available that may provide for both income and transfer tax savings in the current economic and low interest rate environment. These techniques include making charitable contributions of assets to private foundations or donor advised funds. However, charitable lead trusts are another particularly beneficial charitable giving vehicle in today's environment given the current low interest rates.
A Charitable Lead Annuity Trust (CLAT) specifically could be an advantageous technique for charitably inclined individuals. A CLAT is an irrevocable trust that provides for the payment of an annual fixed dollar amount to a designated charity until the end of a specified term (the charitable lead interest), and which, at the end of the payment period, distributes the remaining trust assets (the remainder interest) to non-charitable beneficiaries. These beneficiaries are typically members of the donor's family.
The CLAT may be funded during the donor's lifetime or at his or her death. Assets transferred to an inter vivos (during lifetime) CLAT will not be included in the donor's estate for estate tax purposes (assuming the donor did not retain any powers over the trust and is not the non-charitable remainder beneficiary). If the assets of an inter vivos CLAT are included in the donor's estate, the donor will be entitled to a charitable estate tax deduction for the value of the charitable lead interest, determined as of the donor's date of death. A testamentary CLAT will also result in an estate tax charitable deduction, and the non-charitable remainder interest will be subject to estate tax. The GST tax rules must also be considered when the remainder beneficiary will be the donor's grandchildren or any beneficiary who qualifies as a skip person.
The current low interest rate environment makes CLATs even more attractive. So long as investment performance in the CLAT exceeds the rate used to determine the annuity amount at creation, a greater portion of assets pass to the remainder beneficiaries, potentially with minimal gift tax impact. Thus, with the variety of charitable giving vehicles available, a CLAT is another charitable giving technique to consider.
Spousal Lifetime Access Trusts
A Spousal Lifetime Access Trust (SLAT) is a type of trust that provides an opportunity for the grantor of the trust to utilize his or her remaining estate and gift tax exemption while also allowing the grantor's spouse to benefit from the assets transferred.
The creation of a SLAT is a popular technique that can be used to take advantage of the increased estate and gift tax exemption amount, particularly when there is a risk that the exemption will be reduced. Currently, the estate and gift tax exemption ($11,580,000 in 2020) is set to revert back to $5 million, adjusted for inflation, beginning Jan. 1, 2026, though it is possible there could be a reduction in the exemption amount sooner. For this reason, an individual may wish to consider creating a SLAT prior to the exemption being reduced.
To take advantage of the higher estate and gift tax exemption, the grantor transfers an amount equal to his or her remaining lifetime estate and gift tax exemption in assets such as cash, marketable securities, and/or closely held business interests to a new trust that primarily benefits the spouse. Although a lesser amount can be transferred, to maximize the use of the increased exemption amount, it is important that the amount of the transferred assets exceed the amount to which the exemption is reduced in the future. This is because the U.S. Treasury and the Internal Revenue Service (IRS) have already stated that any exemption used under the increased exemption amount will not be subject to "claw-back" if and/or when the exemption amount decreases (essentially the exemption is "use it or lose it"). For example, if an individual who has $11,580,000 in estate and gift tax exemption remaining makes gifts equal to $11,580,000, and the exemption is later reduced to $5 million (adjusted for inflation), then the individual would be treated as having no exemption remaining. The individual will not be penalized for having made gifts in excess of the lower exemption amount and will have fully utilized the increased portion of the exemption amount. Alternatively, if an individual has $11,580,000 in exemption remaining, makes gifts equal to $5 million, and the exemption is later reduced to $5 million, the individual would still be treated as having no exemption remaining and will have lost the opportunity to use $6,580,000 of estate and gift exemption.
Following the creation of the SLAT, the value of the transferred assets, income from such assets, and any appreciation is removed from the grantor's and the spouse's taxable estates (except any amount of distributions made to the spouse). Upon the death of the spouse, the remaining trust assets pass to the remainder beneficiaries of the trust (typically the grantor's descendants). This will occur even if the grantor is living. Generation-skipping transfer (GST) tax exemption can be allocated to the SLAT at the time of the initial transfer, so the trust assets will be able to be passed from generation to generation free of transfer taxes. That is, the SLAT can be designed to last in perpetuity. However, the assets will generally not be available to the grantor if a divorce occurs or the spouse predeceases the grantor.
The terms of the SLAT and the manner of funding the SLAT can be varied to provide more planning flexibility. For example, the SLAT could be structured in a manner so that the grantor can make a qualified terminable interest property (QTIP) election to qualify the gift for the marital deduction if the grantor decides that the use of his or her exemption does not make sense. The decision to make a QTIP election could be made as late as October 15 of the year following the year of creation of the SLAT. Also, rather than gifting assets to the SLAT, the SLAT could instead be funded by the grantor selling assets to the SLAT in exchange for a promissory note. This too could provide flexibility by allowing the grantor to either undo the transaction by requiring that the note be paid back if the transfer does not make sense, or by forgiving the note by the end of the year, resulting in a gift to the SLAT to utilize the grantor's exemption amount.
Frequently, spouses may each choose to create a SLAT as grantor in order to use both of their increased exemptions. If this is the case, it is important to carefully structure the trusts to minimize a challenge by the IRS under the "reciprocal trusts doctrine." This doctrine generally states, for example, that if a
husband creates a trust for his wife, and the wife creates a nearly identical trust for the husband, then the two trusts may be "un-crossed" and treated for transfer tax purposes as if each spouse had created a trust for himself or herself. This can be avoided by varying the terms of the trusts such as by changing the remainder beneficiaries or allowing one of the spouses to have a power of appointment over the trust assets.
Given the current uncertainty with respect to potential changes to the exemption amount, the flexibility of a SLAT, both in structure and manner of funding, make it a useful tool for individuals concerned about a reduction in the exemption amount who still want to maintain a certain level of asset access.
While strong economic times may make the idea of the need for tax-efficient wealth transfers obvious, uncertain economic circumstances can also provide a unique opportunity for new planning, which can include updating existing planning strategies.
Jennifer Davis [email protected]
Keith Grissom [email protected]
Elizabeth Pack [email protected]
These materials have been prepared by Greensfelder, Hemker & Gale, P.C. for general informational purposes only and does not constitute legal advice or an opinion of counsel. Each legal problem is different, and you should not act on any of the information contained herein without first consulting legal counsel. The choice of a lawyer is an important decision and should not be based solely on advertisements.
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