The end of 2010 presents an excellent opportunity to take advantage of certain business, tax and estate planning strategies. Below are links to 10 of the most appealing strategies, some of which may not be available after year-end:
- Installment Sales to Grantor Trusts.
- Intra-Family Loans.
- FLP and LLC Discounts.
- Qualified Personal Residence Trust.
- Irrevocable Life Insurance Trust.
- Income Tax Planning – Income/Gain Recognition.
- Exclusion for 100% of Gain from Small Business Stock.
- Outright Gifts.
- Charitable Lead Annuity Trusts.
- GRATs. The end of 2010 presents a great opportunity to plan with Grantor Retained Annuity Trusts (GRATs). A GRAT is an estate planning technique that enables you to freeze the value of an asset transferred to the GRAT for gift and estate tax purposes. This freeze means that future appreciation in the asset is gifted to your children or other beneficiaries at a near zero gift tax cost. The current depressed asset and market values may increase the potential for appreciation of the transferred assets in future years.
In a GRAT, you retain the right to receive the value of the assets at the time of the transfer plus interest in the form of an annuity payment. The IRS-published rate that is used to value the gift to a GRAT is at an all-time historic low of 1.8% for GRATs created and funded in December 2010. Thus, any appreciation above 1.8% for assets you transfer to a GRAT will be transferred to your beneficiaries free of estate and gift taxes. For the time being, a grantor can establish a “zeroed-out” GRAT meaning no taxable gift is made at the creation of the GRAT, and a GRAT can be established for a term as short as 2 years. Further, the transfer to the GRAT is not be deemed to be a sale, so no income taxes are recognized upon the transfer of the assets to the GRAT. Common types of assets transferred to GRATs include closely-held business interests, such as non-voting stock, and marketable securities.
The following example illustrates the benefit of a GRAT:
Example: You transfer $1 million to a “zeroed-out” 5-year GRAT at the current interest rate of 1.8%. You retain the right to receive an annuity payment of $210,930.40 annually for 5 years. At the end of 5 years, you will receive $1,054,652 in annuity payments (the initial $1 million and interest at 1.8%). However, if the GRAT appreciates at a modest 8%, at the end of 5 years, the beneficiaries of the GRAT will receive $231,883.59 free of estate and gift taxes.
One pitfall to be aware of with GRATs is that if you do not survive the term of the GRAT, the assets of the GRAT will be includible in your estate. To limit this mortality risk, you may wish to consider using short-term GRATs or hedging with the purchase of a life insurance policy. Short-term GRATs are also effective in hedging investment risk so that poor performance of the assets transferred to the GRAT in some years does not adversely affect good performance in other years. Congress may soon pass legislation that would require GRATs to have at least a 10-year-term, making them less attractive to individuals who would be more likely to die during a 10-year term than during a 2-year term. In light of this potential limiting legislation, the low-interest rate, and the potential appreciation and recovery from low asset values, GRATs deserve consideration at this time.
- Installment Sales to Grantor Trusts. An installment sale to a grantor trust is particularly attractive in a low-interest rate environment. In a typical scenario, you would sell appreciating assets, such as closely-held business interests, to a grantor trust in exchange for a promissory note. As long as the assets sold to the trust appreciate at a rate greater than the interest rate of the promissory note – currently as low as 1.53% for terms of 3 to 9 years – assets are removed from your estate free of estate and gift taxes.
Because the trust is a grantor trust, there is no gain recognition on the sale to the trust. Further, you continue to pay the income taxes on the income of the trust generated by the assets you contributed thereby further reducing your estate and preserving the assets in the trust by allowing them to grow income-tax free. Installment sales to grantor trusts have certain advantages over GRATs due to the lack of mortality risk, a lower interest rate, better leveraging of the Generation Skipping Transfer (GST) Tax exemption if generations below your children will be beneficiaries, and the ability to structure the note with a balloon payment. On the other hand, GRATs are favorable over installment sales in that GRATs are statutorily sanctioned and thus considered less likely to be successfully challenged by the IRS.
Both GRATs and installment sales to grantor trusts are highly effective with appreciating closely-held business interests in partnerships, LLCs and S Corporations. Further, the grantor can retain the voting interest in the business while transferring non-voting interests.
- Intra-Family Loans. In light of the low interest rates, a simple but effective technique to minimize the appreciation in your estate is to use intra-family loans. Based on current applicable federal rates in December, a loan that ends before 3 years must only carry an interest rate of .32% in order not to be considered a gift, loans that last between 3-9 years must carry an interest rate of 1.53%, and loans with terms of greater than 9 years must use a rate of 3.53%.
- FLP and LLC Discounts. Discounts for lack of marketability and lack of control are commonly applied to value closely-held businesses, family limited partnerships (FLPs) and limited liability companies when such businesses are transferred by a senior family member to junior family members. Utilizing discounts typically reduces the value of the asset being transferred to the junior family member thereby reducing the amount of the gift or the sale price of the asset. This allows the senior family member to remove additional assets from his/her estate outside the bounds of gift and estate taxes. The window for taking advantage of such discounts may be closing. As part of the likely new tax legislation, Congress may eliminate or discourage the use of such discounts particularly in the context of family businesses or non-operating business (e.g., FLPs holding only marketable securities).
- Qualified Personal Residence Trust. A Qualified Personal Residence Trust (QPRT) may be an attractive estate planning technique due to depressed real estate values and the 35% gift tax rate. A QPRT is an irrevocable trust in which you transfer your interest in a residence to the trust in exchange for the right to live in the residence for a term of years. At the end of the term of years, the residence passes to the beneficiaries you name in the QPRT. At the time of the transfer, the gift to the QPRT is the value of the residence less the present value of your retained interest (the right to live in the residence). QPRTs are beneficial from a gift and estate tax standpoint because (i) any appreciation in the value of the residence will be outside your estate; (ii) the gift is reduced by the value of your retained interest; and (iii) gift taxes have a lower effective rate than estate taxes because they are tax-exclusive. If you do not survive the term of the QPRT, the residence will be part of your estate as if the residence was never transferred to the QPRT. While QPRTs are not as favorable in a low-interest environment, the following example illustrates the benefits of a QPRT even while interest rates remain low:
Example: Assume you transfer a residence currently valued at $500,000 to a QPRT with a term of 8-years at the current interest rate of 1.8%. The taxable gift is valued at $440,695 and the value of your retained interest is $59,305. If the property appreciates 5% a year, after 8 years it is valued at $738,728. Accordingly, $298,033 has been removed from your estate.
- Irrevocable Life Insurance Trust. An Irrevocable Life Insurance Trust (ILIT) is a trust established to own life insurance on your life. This type of trust is structured and utilized so that the life insurance proceeds payable to your beneficiaries are not subject to gift, estate, or income taxes.
- Income Tax Planning – Income/Gain Recognition. Long-term capital gains are set to increase from 15% to 20% in 2011 and dividend rates are set to increase from 15% to 39.6% in 2011. Accordingly, investors considering rebalancing their portfolio may want to complete any sales of low-basis assets in 2010 to take advantage of the 15% long-term capital gain rate. Business owners should consider making dividend payments in 2010 before dividend rates increase to 39.6% in 2011.
- Exclusion for 100% of Gain from Small Business Stock. Individual investors that make an investment before year-end in the original issuance of qualified small business stock (“QSBS”) may qualify for exclusion of gain upon the sale of the investment up to the greater of $10 million or 10 times the investor’s aggregate tax basis in the investment. A QSBS must typically be a C corporation and have gross assets of $50 million or less.
- Outright Gifts. Gifts to children and grandchildren in 2010 will enjoy a historically low gift tax rate of 35%. The top marginal gift and estate tax rate is scheduled to increase to 55 percent as of January 1, 2011 if Congress does not take action to prevent or reverse the increase. Paying gift taxes is generally favorable to paying estate taxes because of the tax-exclusive nature of gift taxes (i.e., gift or estate taxes are not levied on the gift taxes paid assuming the donor survives the gift by at least three years). On the contrary, the estate tax is tax-inclusive, meaning estate taxes are paid on the funds used to pay the taxes. In addition, any post-gift appreciation will be out of your estate. If an individual has a potential estate large enough to cause a federal estate tax to be owed if he or she died in 2011, then that individual should postpone large taxable gifts in 2010 until December 31st, because if that individual died in 2010 and without making the large gift, the assets would pass free of federal estate tax because of the estate tax repeal for 2010 only.
Accordingly, outright gifts made in 2010 directly to grandchildren and other lower-generation recipients (“skip persons”) will avoid the GST tax, which is scheduled to be reinstated on January 1, 2011 at a flat rate of 55 percent. If there is an existing irrevocable trust under which only grandchildren or other skip persons are the beneficiaries, it is advisable to consider making distributions in 2010 from that trust to the beneficiaries, because those distributions will be free of GST tax. On the other hand, it may be extremely risky, or may cause future GST tax reporting problems, if a gift other than a direct, outright gift is made to a grandchild or other skip person by means of a trust, especially where the trust has both grandchildren and children as beneficiaries. Keep in mind that as in past years, an asset given away in 2010 will have the same cost basis in the recipient’s hands that the donor had, while the same asset would receive a new basis equal to its fair market value if the asset passed at death in 2011.
- Charitable Lead Annuity Trusts. Charitable-minded clients should consider setting up Charitable Lead Annuity Trusts (CLATs) due to a historically low IRS discount rate – currently 1.8%. In simple terms, a CLAT is a trust that pays a fixed annuity to one or more charities for the life of an individual or terms of years. The donor receives a gift tax deduction for the present value of the charity’s annuity interest, and the donor owes and pays a gift tax only on the discounted future value of the remainder interest. In addition, if the donor structures the CLAT as a “grantor trust” so that all the future income earned by the CLAT is taxed to the donor personally, the donor can claim an income tax charitable deduction, in the year of the gift, for the present value of the charity’s annuity interest. At the end of the period, the trust assets are distributed to the remainder beneficiaries of the trust.
A CLAT is particularly attractive in a low-interest environment because a lower interest rate increases the income tax deduction and increases the amount of assets that pass to the remainder beneficiaries free of estate or gift taxes (assuming the assets appreciate at a rate higher than the IRS discount rate).