Editor: Marcy Lantz, CPA
With interest rates and asset values affected by the pandemic and other current events, tax practitioners have a unique opportunity to assist clients with some exceptionally advantageous wealth transfer planning. In addition, with the lifetime gift tax exemption set to revert to $5 million (adjusted for inflation) in 2026, and possibly earlier if Congress enacts new legislation, married clients with more than $23 million of combined wealth should be considering lifetime gifting strategies now. For clients who are projected to have a federally taxable estate and desire to gift assets to heirs, now may be the right time to implement some of the following planning strategies.
Historically low interest rates
As of this writing, the rates the IRS uses to calculate minimum interest rates to apply to loans (the "applicable federal rate") and the discount rate applied to remainder interests and life estates (Sec. 7520 rate) are the lowest ever published. The September 2020 Sec. 7520 rate was just 0.4%; two years earlier it was 3.4%. The historically low rate leaves a lot of room for clients to do some high-impact planning.
Grantor retained annuity trusts
A grantor retained annuity trust (GRAT) is an irrevocable trust in which assets are transferred with the grantor retaining the right to receive an annuity payment for a specified term of years. The trust assets remaining at the end of the term are distributed to the remainder beneficiaries, usually the grantor's children or grandchildren. A GRAT is a powerful planning technique when interest rates are low, because of the leverage it can provide. If the trust assets realize a return greater than the assumed rate, all of that appreciation is transferred to the beneficiary and is not included in the value of the gift. In addition, as long as the grantor survives for the term of the trust, the gifted assets are not included in the grantor's gross estate under Sec. 2036.
The key aspects of the GRAT are (1) funding the trust with assets that are expected to appreciate or provide income that will fund the annuity payment to the grantor; (2) determining the desired annuity payment amount; and (3) minimizing the gift tax impact of the transfer of the remainder interest to beneficiaries after the annuity term expires. The GRAT term is selected by the grantor but should be reasonable to provide the best opportunity for the grantor to survive the term and not cause the assets to be pulled back into the grantor's estate.
The following example of funding under the current Sec. 7520 rate (0.4% as of this writing) illustrates the importance of funding the trust with assets expected to appreciate:
Example 1: A parent funds a GRAT with $1 million of securities with a five-year term and a grandchild as the remainder beneficiary. If the trust provides an annuity payment of 5% ($50,000 paid to the grantor each year), the present value of the remainder interest is currently calculated to be $752,970. This is the amount of the taxable gift used against the grantor's lifetime exemption on the transfer to the trust.
The key to making this beneficial is funding the trust with assets that will appreciate at a rate greater than the Sec. 7520 rate. If the assets in the trust only provide a 2% annual rate of return, the approximate amount projected to be available for the remaining trust beneficiary is $844,000. However, if those same assets grow at 5% annually, there will be $1 million remaining in the trust. The greater the difference between the Sec. 7520 rate and the actual return on the investments, the better the outcome for a tax-efficient wealth transfer. As long as the parent outlives the term of the GRAT, the trust assets and additional appreciation escape inclusion in the parent's estate for estate tax purposes. This allows the grantor to lock in the value of the gift at funding but to provide a potentially larger actual gift at the end of the trust term.
Should the grantor not outlive the terms of the GRAT, the value includible in the grantor's estate is the amount of trust corpus needed to fund the remaining term of the annuity payable to the grantor at the date of death.
GRAT funding can also be useful for individuals who do not want to use their lifetime exemption amount for gifts during their lifetime or have already exhausted their lifetime exemption. In those cases, a zeroed-out GRAT strategy can be employed. Assume the same GRAT funding as in Example 1 with a couple of minor changes:
Example 2: The trust annuity increases to a $202,405 annual payment to the grantor. This reduces the present value of the remainder interest to zero. There is no gift tax exclusion amount used for this transfer. Assuming the same 5% return as above, the remaining assets after the five-year term are projected to be $158,000.
While a tax-free transfer of $158,000 may not seem like enough to bother with creating a trust and facilitating the annuity payment for five years, the funding amount can be increased to increase the benefit. Funding the trust with $10 million in assets would result in more than $1,500,000 being transferred tax-free at the end of the term, with no reportable gift. In addition, by naming a grandchild as the trust beneficiary, the assets may also be excludable from the next generation's estate if the generation-skipping transfer (GST) tax exemption is properly allocated to the gift.
Intentionally defective grantor trusts
Another opportunity to consider is the transfer of a family business to a trust in order to freeze the value of the asset for estate tax purposes. This allows future growth in value to occur outside of the grantor's estate while the grantor maintains some control over the assets. This technique, like the GRAT, can be especially advantageous right now, given the low interest rates. The basic premise of an intentionally defective grantor trust (IDGT) is that the value of the gift is established when assets are moved into the trust. The grantor will pay tax on the trust income, but the appreciation in the asset is not included in the value of the gift and therefore does not use more of the grantor's lifetime exemption. The value "freeze" happens when the asset is sold to the trust through an installment note with the goal of shifting income and appreciation in excess of a favorable interest rate to the IDGT. Such a shift only occurs if the rate of return actually realized by the trust asset exceeds the interest on the installment note. That is where the low interest rate comes into play. The current long-term rate applicable to an installment note, the applicable federal rate (AFR), is only 1% as of this writing.
The following example mirrors the GRAT example:
Example 3: The grantor has a closely held business currently valued at $1 million. The business is sold to an IDGT on an installment sale basis. Assuming the term of the note is 10 years, annual note payments, based on an interest rate of 1%, are $105,582. At the end of the 10-year term, if the annual return on the assets in the trust has been 5%, the additional assets transferred to the trust beneficiary are valued at $300,897.
This type of sale only works if the business assets create sufficient liquidity inside the trust to make the required annual note payments.
Just two years ago, the interest rate applied to this same installment sale scenario was 3.02%, which makes the current environment an excellent time to consider this type of wealth transfer. Under these lower rates, the value transferred tax-free is double what it was in 2018.
Not all high-impact planning needs to be complicated. With historically low interest rates a mortgage refinance may be warranted, but there are other loan strategies to consider as well. Related-party loans are an excellent tool for families to transfer wealth and retain some control over the asset. In order for loans to family members to avoid gift tax treatment, interest must be charged, and the minimum rate is the AFR discussed above (1% as of September 2020). A parent can make a loan to an adult child at 1% and save the child significant interest that might otherwise have been paid to a nonrelated lender. In addition, the parent can forgive a portion of the loan principal each year using annual gift exclusion amounts (currently $15,000 a year per recipient). Many families like to use loans as a wealth transfer planning strategy, as it allows the parents to decide each year how much loan forgiveness they want to provide and offers peace of mind for families that like to maintain some control. Also, for families already using these loans as a planning tool, now is an excellent time to consider a refinance of those loans at this new lower rate.
Spousal lifetime access trusts
The spousal lifetime access trust (SLAT) is a special wealth transfer technique that can be particularly attractive when asset values are low. A SLAT is an irrevocable trust set up by one spouse (the donor spouse) for the benefit of the other spouse (the beneficiary spouse). It provides a lifetime interest in the property contributed to the trust to the beneficiary spouse, with the remainder assets going to the specified beneficiaries of the trust (generally, the couple's descendants). Both spouses may set up a SLAT, but, as discussed below, care must be taken to ensure that the trusts are not treated as reciprocal trusts.
SLATs achieve the dual goals of using the lifetime gift exemption for the benefit of descendants while also allowing the donor spouse to retain indirect access (via the beneficiary spouse) to assets gifted into the trust. Most gifting techniques require the donor to give assets away with no control or rights to future income, for fear of Sec. 2036 pulling them all back into the donor's estate. The SLAT strategy is unique and should be considered for high-net-worth clients who wish to minimize their future estate tax liability and yet are concerned about preserving enough value (indirectly) for themselves. In light of the COVID-19 pandemic, many clients are finding this strategy appealing.
It is important to stress the need for careful planning and implementation of the SLAT, as well as to convey a clear understanding of the indirect rights each spouse will have to the other spouse's trust. The grantor is making an irrevocable gift of the assets contributed to the trust, and, to avoid the appearance of a mere reciprocal trust being formed, the grantor cannot expect the assets to actually be available to him or her after the gift is made.
The first important barrier to the plan is the reciprocal trust doctrine, which was judicially created many years ago, beginning with Lehman, 109 F.2d 99 (2d Cir. 1940). Many court cases followed, with taxpayers testing the original theory. The basic premise today is clear: When two interrelated trusts leave the grantors in essentially the same economic position after gifting as they would have been if they had created trusts for the benefit of themselves, any deemed mutual trust value will be included in the decedent's estate under Sec. 2036(a) (Estate of Grace, 395 U.S. 316 (1969)).
Upon the death of either spouse, the trust assets will pass to the beneficiaries specified by the trust. To avoid the reciprocal trust doctrine, the trust terms cannot be identical, and therefore careful thought should be given to the specific assets contributed, the rights of the spouse, and the identification of beneficiaries for each trust, as in the following example.
Example 4: J makes an $11 million gift of assets into a SLAT for the lifetime benefit of his wife, K. K can withdraw income and has some ability to withdraw assets, if necessary. When K dies, the assets will pass to their children. J uses all of his lifetime exemption, even though, as a married couple, J and K might indirectly benefit from the income K can take from the trust. K also sets up a SLAT using her $11 million lifetime gift exemption for the benefit of J. When J dies, however, the trust assets will pass to their grandchildren. K also might indirectly benefit from the income that J is allowed to access. Alternatively, K could designate the same trust beneficiaries as J (their children) but include different withdrawal rights for J and/or use other powers in the trust (this is just one example).
Since the SLAT is a split gift between the beneficiary spouse (who is the income beneficiary) and the remainder beneficiaries, the value of the gift is computed using the Sec. 7520 table for the future value passing to remainder beneficiaries. The portion of the gift received by the spouse is potentially subject to the unlimited marital deduction, assuming the spouse is a U.S. citizen (Sec. 2523) and Regs. Sec. 25.2523(b)-1 is complied with. Therefore, significant wealth can be transferred to the SLAT to use up the lifetime gift tax exemption. With the current Sec. 7520 rate at 0.4% (as of September 2020), presumably, any assets transferred to the trust should be able to exceed this annual rate of return, effecting a more tax-efficient transfer and avoiding tax on future appreciation of the assets.
Example 5: J transfers $13 million of assets into the SLAT for his wife K's benefit in September 2020, and K is 50 years old at the time of transfer. The life estate value for K is $1,449,630, and the taxable gift to nonspouse beneficiaries is $11,550,370, using the Sec. 7520 rate table. If the assets are estimated to appreciate at 3% over her lifetime and generate 3% of income each year, and K withdraws no more than the 3% annual income, then approximately 2.6% of the annual appreciation would avoid estate tax upon K's death, equating to more than $17 million if she lives to her full life expectancy.
- An indirect benefit is received in the form of income and potential access to trust assets, if needed;
- Gift and GST exemptions can be used now, before the exclusion decreases in 2026 (or earlier if Congress acts);
- Current values of assets are potentially lower than they will be for many years, due to the impact of COVID-19 on the economy; and
- Future appreciation avoids the estate tax.
- Divorce or death ends the indirect access to assets or income for the spouse who made the gift;
- Careful legal drafting and maintenance is necessary to ensure trusts are not considered to be "reciprocal";
- If assets are withdrawn from the trust, this strategy can be inefficient and waste the estate tax exemption; and
- If the value of assets declines significantly, it is an inefficient estate tax transfer.
This summary of SLATs has merely touched on the scope of the specific rights required to avoid the reciprocal trust doctrine. Engaging an estate planning attorney with experience with these trusts will be crucial, as well as providing guidance for the grantor and spouse regarding the important mechanics of these trusts to ensure the best overall tax efficiency of this irrevocable gift.
Taking advantage of unique opportunities
The gift planning strategies discussed above, combined with current interest rates and asset values, provide a unique opportunity to transfer significant wealth more tax-efficiently than at any other time. The extremely favorable circumstances that presently exist for gift planning may not last long, which makes now the perfect time to assist clients in considering these planning options.
Marcy Lantz, CPA, CSEP, is a partner with Aldrich Group in Lake Oswego, Ore. Ms. Lantz would like to thank the following practitioners for their help editing the December Tax Clinic: Michael T. Odom, CPA, CVA, partner at Fouts & Morgan CPAs PC in Memphis, Tenn.; Carolyn Quill, CPA, J.D., LL.M., principal at Thompson Greenspon CPAs & Advisors in Fairfax, Va.; Kristine Boerboom, CPA, CMA, MBA, partner at Wegner CPAs in Madison, Wis.; and Todd Miller, CPA, partner at Maxwell Locke & Ritter in Austin, Texas.
For additional information about these items, contact Ms. Lantz at 503-620-4489 or firstname.lastname@example.org.
Contributors are members of or associated with CPAmerica, Inc.