Wealth Transfer Strategies to Consider in an Election Year

With  a  push  by  the  Democratic  party  to  return  federal  estate  taxes  to  their  historic  norms, taxpayers need to act now before Congress passes legislation that could adversely impact their estates. Currently, the federal estate and gift tax exemption is set at $11.58 million per taxpayer. Assets included in a decedent’s estate that exceed the decedent’s remaining exemption available at death are taxed at a federal rate of 40 percent  (with some states adding  an additional state estate tax). However, each asset included in the decedent’s estate receives an income tax basis adjustment  so  that  the  asset’s  basis  equals its  fair market  value  on  the  date  of  the  decedent’s death. Thus, beneficiaries realize capital gain upon the subsequent sale of an asset only to the extent of the asset’s appreciation since the decedent’s death.

If the election results in a political party change, it could mean not only lower estate and gift tax exemption  amounts,  but  also the  end  of  the  longtime  taxpayer  benefit  of  stepped-up  basis  at death. To avoid the negative impact of these potential changes, there are a few wealth transfer strategies it would be prudent to consider before the year-end.

Intrafamily Notes and Sales

In  response to  the  COVID-19  crisis,  the  Federal  Reserve  lowered the  federal  interest  rates  to stimulate the economy. Accordingly, donors should consider loaning funds or selling one or more income-producing assets, such as an interest in a family business or a rental property, to a family member in exchange for a promissory note that charges interest at the applicable federal rate. In this way, a donor can provide a financial resource to a family member on more flexible terms than a commercial loan. If the investment of the loaned funds or income resulting from the sold assets produces a return greater than the applicable interest rate, the donor effectively transfers wealth to the family members without using the donor’s estate or gift tax exemption.

Swap Power for Basis Management

Assets such as property or accounts gifted or transferred to an irrevocable trust do not receive a step-up in income tax basis at the donor’s death. Gifted assets instead retain the donor’s carryover basis, potentially resulting in significant capital gains realization upon the subsequent sale of any appreciated assets. Exercising the swap power allows the donor to exchange one or more low-basis assets in an existing irrevocable trust for one or more high-basis assets currently owned by and  includible  in  the  donor’s  estate  for  estate  tax  purposes.  In  this  way,  low-basis  assets  are positioned to receive a basis adjustment upon the donor’s death, and the capital gains realized upon the sale of any high-basis assets, whether by the trustee of the irrevocable trust or any trust beneficiary who received an asset-in-kind, may be reduced or eliminated.

Example:  Phoenix  purchased  real  estate  in  2005  for  $1  million  and  gifted  the  property  to  his irrevocable trust in 2015 when the property had a fair market value of $5 million. Phoenix dies in 2020, and the property has a date-of-death value of $11 million. If the trust sells the property soon after Phoenix’s death for $13 million, the trust would be required to pay capital gains tax on $12 million,  the  difference  between  the  sale  price  and  the  purchase  price.  Let  us  say  that  before Phoenix died, he utilized the swap power in his irrevocable trust and exchanged the real estate in the irrevocable trust for stocks and cash having a value equivalent to the fair market value of the real estate on the date of the swap. At Phoenix’s death, because the property is part of his gross estate, the property receives an adjusted basis of $11 million. If his estate or beneficiaries sell the property for $13 million, they will only pay capital gains tax on $2 million, the difference between  the  adjusted  date-of-death  basis  and  the  sale  price.  Under  this  scenario,  Phoenix’s estate and beneficiaries avoid paying capital gains tax on $10 million by taking advantage of the swap power.

Grantor Retained Annuity Trust

A grantor retained annuity  trust  (GRAT)  is  an  efficient  way  for  a  donor  to  transfer asset appreciation  to  beneficiaries  without  using,  or  using  a  minimal  amount,  of the  donor’s gift  tax exemption. After the donor transfers property to  the GRAT and until the expiration of the initial term, the trustee of the GRAT (often the donor for the initial term) will pay the donor an annual annuity amount. The annuity amount is calculated using the applicable federal rate as a specified percentage of the initial fair market value of the property transferred to the GRAT. A Walton or zeroed-out GRAT is intended to result in a remainder interest (the interest that is considered a gift) valued at zero or as close to zero as possible. The donor’s retained interest terminates after the initial term, and any appreciation on the assets in excess of the annuity amounts passes to the beneficiaries. In other words, if the transferred  assets appreciate at a rate greater than  the historic low applicable federal rate, the GRAT will have succeeded in transferring wealth!

Example: Kevin executes a GRAT with a three-year term when the applicable federal rate is 0.8 percent. He funds the trust with $1million and receives annuity payments of $279,400 at the end of the first  year, $335,280 at the end of the second  year, and $402,336 at  the end of  the  third year. Assume that during the three-year term, the GRAT invested the $1 million and realized a return on investment of 5 percent, or approximately $95,000. Over the term of the GRAT, Kevin received  a   total  of  $1,017,016  in  principal  and  interest  payments  and  also  transferred approximately $95,000 to his beneficiaries with minimal or no impact on his gift tax exemption. 

Installment Sale to an Irrevocable Trust

This strategy is similar to the intrafamily sale. However, the income-producing assets are sold to an existing irrevocable trust instead of directly to a family member. In addition to selling the assets, the donor also seeds the irrevocable trust with assets worth at least 10percentof the assets being sold to the trust. The seed money is used to demonstrate to the Internal Revenue Service (IRS) that the trust has assets of its own and that the installment sale is a bona fide sale. Without the seed  money,  the  IRS  could  recharacterize  the  transaction as  a  transfer  of  the  assets  with  a retained interest instead of a bona fide sale, which would result in the very negative outcome of the entire interest in the assets being includible in the donor’s taxable estate. This strategy not only  allows donors to  pass  appreciation  to their beneficiaries with  limited estate  and  gift  tax implications,  but  also  gives donors the  opportunity  to  maximize their  remaining gift  and generation-skipping  transfer  tax  exemptions  if  the  assets  sold  to  the  trust  warrant  a  valuation discount.

Example: Scooby owns 100 percent of a family business worth $100 million. He gifts $80,000 to his irrevocable trust as seed money. The trustee of the irrevocable trust purchases a $1 million dollar interest in the family business from Scooby for $800,000 in return for an installment note with interest calculated using the applicable federal rate. It can be argued that the trustee paid $800,000 for a $1 million interest because the interest is a minority interest in a family business and therefore only  worth  $800,000. A discount is justified because a minority interest does not give the owner much, if any, control over the family business, and a prudent investor would not pay full price for the minority interest. Under this scenario, Scooby has removed $200,000 from his taxable gross estate while only using $80,000 of his federal estate and gift tax exemption.

Spousal Lifetime Access Trust

With the threat of a lowered estate and gift tax exemption amount, a spousal lifetime access trust (SLAT) allows donors to lock in the current, historic high exemption amounts to avoid adverse estate tax consequences at death. The donor transfers an amount up to the donor’s available gift tax  exemption  into  the  SLAT. Because  the  gift  tax  exemption  is  used, the  value  of  the  SLAT’s assets  is  excluded  from  the  gross  estates  of  both  the  donor  and  the  donor’s  spouse. An independent trustee administers the SLAT for the benefit of the donor’s beneficiaries. In addition to the donor’s spouse, the beneficiaries can be any person or entity including children, friends, and  charities. The  donor’s spouse  may  also  execute  a  similar  but  not  identical  SLAT  for the donor’s benefit. The SLAT allows the appreciation of the assets to escape federal estate taxation and, inmost cases, the assets in the SLAT are generally protected against credit claims. Because the  SLAT  provides  protection  against  both  federal  estate  taxation  and  creditor  claims,  it  is  a powerful  wealth  transfer  vehicle  that  can  be  used  to  transfer  wealth  to  multiple  generations  of beneficiaries.

Example: Karen and Chad are married, and they are concerned about a potential decrease in the estate and gift tax exemption amount in the upcoming years. Karen executes a SLAT and funds it  with  $11.58  million  in  assets.  Karen’s  SLAT  names  Chad  and  their  three  children  as beneficiaries and designates their friend Gus as a trustee. Chad creates and funds a similar trust with $11.58 million that names Karen, their three children, and his nephew as beneficiaries and designates  Friendly  Bank  as  a  corporate  trustee  (among  other  differences  between  the  trust structures). Karen and Chad pass away in the same year when the estate and gift tax exemption is  only  $6.58  million  per  person.  Even  though  they  have  gifted  more  than  the  $6.58  million exemption in place at their deaths, the IRS has taken the position that it will not punish taxpayers with a claw back provision that pulls transferred assets back into the taxpayer’s taxable estate. As a result, Karen and Chad have saved $2 million each in estate taxes assuming a 40 percent estate tax rate at the time of their deaths. 

Irrevocable Life Insurance Trust

An existing insurance policy can be transferred into an irrevocable life insurance trust (ILIT), or the trustee of the ILIT can purchase an insurance policy in the name of the trust. The donor can make gifts to the ILIT that qualify for the annual gift tax exclusion, and the trustee will use those gifts  to  pay  the  policy  premiums.  Since  the  insurance  policy  is  held  by  the  ILIT,  the  premium payments and the full death benefit are not included in the donor’s taxable estate. Furthermore, the insurance proceeds at the donor’s death will be exempt from income taxes. 

When Should I Talk to an Estate Planner?

If  any  of  the  strategies  discussed  above  interest  you,  or  you  feel  that  potential  changes  in legislation will negatively impact your wealth, we strongly encourage you to schedule a meeting with us at your earliest convenience and definitely before the end of the year. We can review your estate  plan  and  recommend  changes  and  improvements  to protect  you  from  potential  future changes in legislation.  

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