By: Randall A. Denha, J.D., LL.M.
The remaining days of 2012 are not easy ones for us estate planners. As planners, we need to be mindful of the increased lifetime transfer tax exemption (currently $5.12 million) and balance this with a client’s need to not only engage in the process of gifting (to reduce their transfer tax exposure) but also the possibility that they may need the moneys back at some future point. This is not easy. In fact, with the increased lifetime transfer tax exemption, it’s an easy task for a planner to assess the situation of their very wealthy clients and quickly suggest that they give away as much of their lifetime exemption as possible before the planning window closes at the end of the year.
The reality is that, regardless of a client’s net worth, it is difficult to give up control of something irrevocably, even where it would appear that the transferred property will never be needed. Fear of “donor’s remorse” can cool the enthusiasm of wealthy clients, despite the opportunity for hefty estate tax savings.
Generally, there are several concerns that a client considers before making a gift:
1. What is the significance of the tax savings achieved?
2. Is there a possibility of reclaiming the property down the road if needed?
3. If it can’t be reclaimed to what extent might I use and enjoy the benefits of the property?
4. If I can’t reclaim or use the property, how much control over it might I maintain?
In light of the foregoing, the following six planning opportunities are available for clients hesitant to let go of assets, each with a different dynamic between the four competing urges referenced above.
The good news is that all of the techniques below work wonderfully, even for smaller transfers. And here is a breakdown of the six techniques:
1) Do You Trust Your Spouse?
A spousal lifetime access trust (SLAT) allows indirect access to the transferred property. The client can transfer separate property to a trust in which his or her spouse has an interest in during his/her lifetime in the form of rights to income, certain withdrawal privileges and discretionary distributions for health, maintenance, education and support. In some cases, the spouse can even be the trustee who decides when distributions are to be made. Proceeds from life insurance on the grantor inside the trust are not includible in the taxable estate of either spouse. Sometimes insurance is purchased on the beneficiary spouse and owned by the donor spouse to make up for the amount of moneys that are not accessible any longer.
2) Borrow from a friendly entity
If you can’t continue to own or have indirect access, then consider the ongoing opportunity for the use of the property, especially if it is liquid. The standard provisions of most trusts give the trustee power to make loans of property, even to the grantor. A properly drafted loan agreement with reasonable terms between the client and trust allows the grantor use of the trust principal. Interest payments based on the applicable federal rates (AFR) and made to the trust are not subject to gift taxation. At death, any existing indebtedness is repaid back to the trust and is not included in the taxable estate. Un-borrowed funds that remain in the trust can be used to purchase life insurance or premiums can be made with the interest payments made on the loan by the client to the trust each year. Either way, the Grantor has use of the money and is not forced to pay back the money during lifetime.
3) Lend to a Friendly Entity
Under a private financing arrangement the client can lend money to a trust in return for a promissory note and interest payments each year in the amount of the AFR, which is currently very low. The spread between what the money can earn in the trust and the AFR can be used to fund life insurance in the trust whose proceeds will be outside the taxable estate. When time comes to repay the loan principal, all the appreciation on the property and much of the income it earned has been kept out of the estate. If, under a worst possible circumstance scenario, the trust defaults on a payment or the entire loan, the amount in either case is a potentially taxable gift from the lender. Disadvantage: The loan amount is ultimately included in the taxable estate, but any excess funds the trust earns as a result of the loan will be excluded from the taxable estate.
4) Consider a Family LLC
Creating a family limited liability company with a minority controlling interest allows the client to maintain control while getting the bulk of the asset value out of the taxable estate. The normal valuation discounts, especially in a depressed market, and minority interest and marketability discounts allow for further leverage of the lifetime exemption. Disadvantage: The small ownership interest maintained by the client limits the extent to which he or she might benefit from the use of the property. Clients need to be very diligent about the operation of the entity and its accounting for interests.
5) Use It, Then Lose It
Exemptions or exclusions to protect transfers from gift taxation might be hard to come by in some situations, especially after December 31. There are various transactions which allow for a Grantor to make a gift and still retain an income interest, such as a grantor retained annuity trust (GRAT) or intentionally defective irrevocable trust (IDIT) which can allow for tax-favored transfers from the taxable estate using both the discounting techniques that are also common to family LLCs. Disadvantage: In a GRAT, if the donor does not survive the period certain, the property reverts back to the taxable estate. Protection against the potential tax cost of this mishap is often accomplished through the purchase of life insurance on the donor during the terms of the income stream. With an IDIT, the sale portion removes the asset from the estate but any remaining promissory note balance will be included in the estate.
6) Charity Begins at Home
The focus of planning efforts can often become too narrow. Sometimes potential estate tax liability is not an issue – especially when a client has no heirs, has heirs for whom they have already provided sufficiently or have some that they just plain don’t like. The intended beneficiaries may be nonprofit entities and the client, aware that all transfers at death are protected by the unlimited charitable estate tax deduction, plans to do nothing during life. In these cases, I suggest the advantages of some form of a charitable remainder trust (CRT) or its simpler form, the charitable gift annuity (CGA – the poor person’s CRT) which gets property to the non-profit done gift tax-free, but also can generate an income stream to the donor and provide a current income tax deduction that might play a significant role in other current planning needs.
The ability to help a client view and assess a planning situation as something more than just an irrevocable transfer with some gift tax savings is a valuable service. Informed suggestions that will motivate them to seek the more specific and in-depth advice of their legal and tax advisors may well result in the implementation of a plan where insurance protection is desirable and, at the same time, allow your client to experience various degrees of “eating their cake and having it, too!”
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.