By Kal Grant
For many individuals, this is a difficult financial time. However, for those who have substantial wealth to transfer to younger generations, temporarily reduced asset values and historically low interest rates have created an unprecedented opportunity to transfer significant wealth.
The opportunity is greater than ever because estate planning transactions where an asset has been moved outside of a donor’s estate for estate tax purposes are most successful when the appreciation of an asset occurs after the transaction. The appreciation can be the result of normal market growth, a sale of a business – or the return to “normal” after a pandemic. Moving an asset outside a donor’s estate can be accomplished by gifting or selling the asset. Using a multi-generational trust with the gift or sale adds even more benefit.
Under current law, every individual in 2020 has a combined federal lifetime gift and estate tax exemption of $11,580,000 ($23,160,000 for a married couple). When an individual makes a gift during her lifetime, she uses some of her exemption, reducing what remains available during lifetime and at death. For example, if this year she were to gift an asset now worth only $1,000,000 to someone other than her spouse, then she would have $10,580,000 of exemption remaining. If the asset gifted then doubles in value through the economic recovery, the recipient of the gift has an asset worth $2,000,000 and she will have moved the asset and $1,000,000 of appreciation out of her estate.
That same individual can structure the gift so that it is made to a multi-generational dynasty trust for the benefit of her children and grandchildren (and their descendants). Through the use of a trust, not only has she moved the appreciation out of her estate, but the entire asset can stay out of her children’s, grandchildren’s and future descendants’ estates – potentially freeing the asset from future estate and gift tax for many generations. Another benefit of a dynasty trust is that the assets held in the trust are protected from a beneficiary’s creditors. The trust assets can also protect the assets from the claims of a divorcing spouse, subject to the laws of the jurisdiction in which the beneficiary resides.
In addition to the temporarily low asset values, upcoming changes to the federal estate and gift tax exemption also make this an important time to consider gifts. As noted above, every individual currently has a gift and estate tax exemption of $11,580,000, which amount is indexed for inflation. However, under existing law, the exemption is automatically reduced by approximately half at the end of 2025. Furthermore, it is possible that the exemption could be reduced even more with a change in the administration, congress, and/or in response to the country’s economic strife. Therefore, individuals with large estates may want to consider using their current exemptions prior to the end of this election year in order to take advantage of the currently higher exemptions and in order to take advantage of depressed portfolio valuations.
Grantor Retained Annuity Trusts (GRATs)
Individuals who have used up all of their gift and estate tax exemption already, or who merely wish to transfer only the appreciation on an asset (versus giving away the underlying asset itself), may want to consider a GRAT. With a GRAT, the grantor, the individual wishing to make the gift, transfers assets to a specially designed irrevocable trust. Over the term of the GRAT (usually 2-10 years), the GRAT is required to pay back an annuity to the grantor. At the end of the term, the assets still in the trust pass to beneficiaries the grantor selected when he set up the GRAT (the “remainder beneficiaries”).
The difference between the value of the asset and the present actuarial value of the annuity payments is considered a gift from the grantor to the remainder beneficiaries. The value of the asset is determined when the gift is made, even if that value is only momentarily low. The value of the annuity payments is determined based on an IRS specified interest rate (currently 1.2% in April 2020, and dropping to .8% in May 2020). For a GRAT created in April, the assets in the GRAT only have to appreciate more than 1.2% a year over the GRAT term to make the GRAT an effective gift. It is even possible to structure a GRAT so the value of the gift is $0. With a $0 gift, none of the grantor’s exemption amount is utilized for the gift, so even if the GRAT “fails” (i.e., nothing passes to the beneficiaries because the GRAT’s assets either decline or do not appreciate in excess of the IRS interest rate), there is no tax cost to the grantor.
In a volatile or depressed market like the one we are in now, a grantor can select one or more assets with temporarily low values for a GRAT and give to the remainder beneficiaries all of the benefit of the market recovery, even if it takes several years for the asset to regain its value. If the asset only regains part of its value during the term, any increase of more than 1.2% for an April GRAT will be given to future generations with no tax cost.
Sales to Irrevocable Trusts
Another option for individuals who have already used their lifetime exemption with previous gifts, or who wish to transfer only the appreciation of an asset, is a sale to an irrevocable trust in exchange for a promissory note. The promissory note can be structured at an extremely low interest rate (currently 0.99% in April for a 9-year note, and .58% in May). The note typically pays interest only on an annual basis, with a balloon payment of the principal at the end of the note’s term. The interest-only nature of the note (in contrast to a GRAT, which must amortize principal) can allow for a substantially greater transfer of wealth over time. Furthermore, the irrevocable trust can be structured as multi-generational trust, an option not available for a GRAT.
One of the most common planning techniques, the grantor trust, can exponentially add to the value of a number of planning techniques. This is particularly true for a sale to a trust in exchange for a promissory note. A grantor trust is a trust for which the grantor pays the income taxes. Unburdened by income taxes, a grantor trust can increase in value much more rapidly than it would if it were paying taxes. Perhaps just as importantly, when a grantor sells an asset to a grantor trust, the grantor does not have to recognize gain on the sale. The grantor is treated as selling the asset to himself.
With each rise in the minimum interest rate that must be charged, the effectiveness of a sale to the trust diminishes. By acting now to set up a grantor trust and the promissory note, a grantor can lock down the current low interest rate for the full term of the note.
Charitable Lead Trusts (CLTs)
A CLT is a very effective method for transferring wealth and making a charitable gift during difficult times. Following the transfer to a CLT, a series of payments is made to one or more charities for a defined period of time (the term of the CLT). At the end of the term, the remaining trust assets will pass to non-charitable remainder beneficiaries selected by the grantor of the CLT. The actuarial value of the interest that passes to the non-charitable remainder beneficiaries at the end of the charitable term is the taxable gift portion of the transaction.
The value of the remainder interest, the gift, is calculated at the time of the funding of the CLT using the same interest rates used to calculate the value of a GRAT. When interest rates are very low, the calculated remainder interest will be lower, which makes the CLT an efficient way to transfer wealth. Like the GRAT and the sale to the irrevocable trust, the assets in the CLT only have to appreciate at a rate faster than the stated low interest rate to make the transaction successful. The grantor of a CLT can even designate a family foundation or a donor-advised fund as the recipient of the stream of payments during the charitable lead term. Given the current low interest rates, a CLT is a good option for those clients who want to benefit family members and who are charitably inclined.
One of the simplest methods for transferring wealth when interest rates are low is an intrafamily loan. With an intrafamily loan, parents can provide a financial resource to their children for a specific purchase, or for investing in a new business or asset. The rates used for intrafamily loans are the same rates used for a sale to an irrevocable trust, discussed above (currently .99% in April for a 9-year note, and .58% in May). Additionally, these loans can offer greater flexibility than commercial loans, as payment terms may be structured based on the specific needs and circumstances of the family members.
With the cost of borrowing so low, it will be much easier for a family member to use his or her loan to fund an investment that outperforms its interest rate. The difference between the low interest rate on the loan and the rate of return on the assets purchased with the loaned money passes to the family member receiving the loan, without using any federal gift tax exemption.
It’s important to keep in mind that even in a favorable environment, the loan must be repaid and should provide for annual payments of interest as a minimum repayment requirement. An imprudent investment, or a further downturn in market conditions, could leave a borrower without the means to repay the loan when due. Also, keep in mind that interest payments will be treated as taxable income to the lender, unless the borrower is a grantor trust under which the lender (parent) pays tax on the income realized by the trust. Nevertheless, low interest rates, coupled with depressed market values of minerals, real estate, securities, and business interests, make the intrafamily loan a potentially important strategy to add to an estate plan right now.
This may be an opportune time to consider transferring wealth to descendants or other beneficiaries. Individuals can make outright gifts of assets with temporarily low values or can choose to give away only the appreciation of an asset through the use of a GRAT or a sale of assets to a trust in exchange for a promissory note carrying a low interest rate. Additionally, for those clients who are charitably inclined, now is a good time to consider funding a CLT. Individuals may make loans to family members without making any gift at all for tax purposes. As difficult as conditions are, the combination of depressed asset values, low interest rates, and the impending changes to tax laws make all these strategies more attractive than ever.
Please note: This article and any resources presented on the JW Coronavirus Insights & Resources site are for informational purposes only, do not constitute legal or medical advice, and are not a substitute for legal advice from qualified counsel. The laws of other states and nations may be entirely different from what is described. Your use of these materials does not create an attorney-client relationship between you and Jackson Walker. The facts and results of each case will vary, and no particular result can be guaranteed.