By: Randall A. Denha, J.D., LL.M.
The stage has been set for the sort of “perfect storm.” We have a current $5,250,000 transfer tax exemption; historically low asset values; historically low interest rates; transfers that can be made subject to valuation discounts for lack of control and lack of marketability; talk (not action) of limiting the benefit of grantor trusts and other chatter regarding the elimination of certain techniques. With this near “perfect storm”, the goal is to create an estate plan to move as much wealth outside the reach of Uncle Sam. Starting early enough, any estate can reach a point where the estate tax is at or near zero. One way of reaching the zero estate tax goal line is to engage in techniques that are called “estate freezes” by way of intra-family transfers. The primary goal of the intra-family transfer is that such transfers “freezes” the value of the asset being sold at its then value, and removes future appreciation in such asset from the seller’s estate. Estate freeze techniques range from simple gifting strategies, installment sale arrangements to complex arrangements involving private annuities, “grantor retained annuity trusts” (GRATs) and “intentionally defective grantor trusts” (IDGTs). No one approach fits all situations.
As we know, appreciation and inflation will increase estate taxes upon death. As mentioned earlier, any estate-reducing program is more effective if it includes techniques to shift appreciation and income to a person’s intended beneficiaries. For years, estate planning professionals have developed and implemented estate “freezing” techniques so that the estate tax problem would not get worse. Many of the freezing techniques involved creative structuring of family-owned business entities so that the increasing value of a growing business would shift to the next generation. Some of those techniques were perceived as abusive by the IRS, which persuaded Congress to adopt “anti-freeze” legislation that made the freezing techniques ineffectual. In spite of that, there are still some effective techniques that can be used to shift appreciation and to “freeze” the value of an asset for estate-tax purposes.
Techniques Involving Asset Sales
• Annual gifting strategy: The annual gift tax exclusion allows you to give $14,000 per donee per year without incurring federal gift tax. Generally, married couples can double the exclusion amount. This exclusion allows you to distribute your property gift tax free and potentially put your estate into a lower tax bracket.
• Installment Sales: By selling an asset to family members on an installment basis, the potential appreciation on the asset is shifted to the family members. This works only if the purchase price is “full and adequate consideration” and the arrangement is properly documented in order to create a legally enforceable obligation. Upon the death of the payee, the unpaid balance of the note is included in his or her taxable estate for estate tax purposes, but the asset that was sold is out of the estate, including its appreciated value. The installment note can be secured by the property sold.
• Death Terminating Notes: Another version of the installment sale employs the use of promissory notes that, by their express terms, expire upon the death of the payee. This is known as A Self-Cancelling Installment Note or “SCIN”. This type of promissory note has the same advantages as any installment note (including the ability to require security), but in addition to shifting appreciation, the unpaid balance of the note is reduced to zero at death, and there is nothing included in the payee’s estate at death. As with any installment note, the purchase price must reflect “full and adequate consideration”, but that also means the value of the note must exceed the value of the property being sold. Because the note may expire before the payee receives payments equal to the note’s face amount, an additional “premium” must be paid for that feature so that the value of the note is considered adequate to pay for the property. Determining the amount of the “premium” for the death-termination aspect is the primary drawback to this technique. A qualified expert is strongly recommended to make that determination.
• Private Annuities: A private annuity is a contract that provides for specified payments to the named annuitant during the annuitant’s lifetime. This is similar to the death-terminating promissory note, but under a private annuity, the payments never cease so long as the annuitant is alive, even if the annuitant outlives his or her life expectancy. The primary advantage of the private annuity is the fact that the annuity amount can be determined from the IRS valuation tables, eliminating the guess work as to the amount of the periodic payments to be made. Unlike promissory notes used with installment sales, private annuities cannot be secured, putting the annuitant at risk that the payor may become bankrupt. I recommend private annuities for persons with significantly shorter life expectancies, provided two doctors sign a statement that they have a greater than 50% chance of living at least one year; and they actually live at least 18 months.
• Grantor Retained Income Trusts: Most people would like to “have their cake and eat it, too.” If possible, people would retain all control and all benefits from an asset up to their death and then have the value of the asset disappear for estate-tax purposes. Unfortunately, federal gift and estate tax laws do not permit this. The general rule is this: “If you give away the tree, you cannot keep the fruit.” If you give away only part of the tree, you can keep the fruit only from the part you retain.
► Over the years, various trusts have been created that allow the grantor of the trust to retain benefits for a specified period of years so that the present value of the gift of to the children is reduced according to the IRS’ own valuation tables. The longer the retained-interest period, the lower the value of the remainder interest is.
► If the grantor of a retained-interest trust dies before his or her benefits are terminated under the trust’s terms, the asset is subject to estate taxes in his or her estate (and any gift tax paid is credited toward the estate tax). On the other hand, if the grantor outlives his or benefits under the trust, the trust’s assets are excluded, and the only transfer-tax cost is the gift tax paid (or the applicable exclusion applied) on the original value of the remainder interest.
► While this type of trust can save transfer taxes, there is at least one disadvantage: the lost of the stepped-up basis for income tax purposes. Assets included in a decedent’s estate for estate-tax purpose will (under current law) receive a “stepped up” income tax basis equal to the fair market value of the assets at the time of the decedent’s death. In other words, all potential capital gain is reduced to zero. If a retained-interest trust is successful, the asset will not be included in the grantor’s estate at the time of the grantor’s death, so there will be no step-up in income tax basis; the recipient will have the grantor’s original cost basis.
• Qualified Personal Residence Trusts (QPRTs): A “qualified personal residence trust” or QPRT is a type of trust (similar to the GRAT above) that is still permitted under federal law. A grantor can transfer his or her primary residence plus a second home to the trustee of a QPRT that allows the grantor to reside in the home for a designated period of time. At the end of the designated period, the property passes to designated remainder beneficiaries.
► The gift to the trust’s remainder beneficiaries is subject to the federal gift tax, but the value of the gift is the present value of the remainder interest, which is determined under the IRS tables after taking into consideration the term of the grantor’s retained interest, the grantor’s age, and the applicable interest rate published by the IRS monthly.
► If the grantor dies before the retained-interest expires, the home is subject to estate taxes, but since any gift taxes paid are credited back, there is no true penalty. The only cost is the legal expenses associated with creating and administering the trust.
► One psychological drawback to QPRTs is the fact that the grantor no longer has the right to reside in the residence at the end of the term of the grantor’s retained interest. In order to remain in the home, the grantor must pay fair-market rental payments in accordance with a rental agreement to be negotiated at the end of the term. How much rent should be paid? As much as commercially reasonable because the rent paid by the grantor is another good way to make an estate-reducing transfer to the trust’s beneficiaries.
• Grantor Retained Annuity Trusts (GRATs): Grantor retained annuity trusts (GRATs) are similar in structure to charitable remainder annuity trusts. GRATs permit the gift of remainder interests that are discounted for gift-tax purposes under the IRS valuation tables. While longer terms produce lower remainder values, even short-term GRATs can produce significant transfer-tax savings.
• Grantor Retained Unitrusts (GRUTs): Grantor retained unitrusts (GRUTs) are similar in structure to charitable remainder unitrusts. GRUTs are similar to GRATs in their general purpose, but GRUTs are not considered as effective as GRATs in shifting appreciation outside of the estate where the trust’s assets are expected to appreciate. If the assets appreciate inside the GRUT, then any excess appreciation is also paid back to the Grantor. However, for those persons desirous of transferring wealth to their children while retaining an increasing annual return of income, then this technique may be worthwhile.
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.