A decline in the value of assets such as stocks, bonds, commercial real estate and other businesses, coupled with the current economic environment along with market volatility has created many unique planning opportunities. With interest rates at the lowest in modern history, now is the perfect time to consider some estate planning strategies that help “freeze” the value of an individual’s estate and transfer the growth to the individual’s heirs. This article will provide a high-level overview of some of the most popular techniques. We encourage you to reach out to your HBK advisor to see if any of these strategies may benefit you.
Applicable Federal Rate and Intra-Personal Loans
The current applicable federal rate (AFR) is the lowest interest rate that is allowed by the Internal Revenue Service (IRS) for loans and is currently at record lows. The June rates for short-term, mid-term and long-term loans are 0.18%, 0.43% and 1.01% respectively, creating a perfect time to consider related-party installment sales and other intrapersonal loans. This, combined with the impact of reduced and/or discounted asset values, allow for assets to be transferred to family members at a potentially much lower price. Consider a parent that may want to help a child purchase a home, start a business, or purchase investments. A personal loan to the child would allow for the child to do so at a rate below market, and at the same time allow for the growth of the loaned funds to be limited to the low AFR rate. This acts to “freeze” the value of the loaned funds in the parents’ estate, transferring the future growth out to the child estate and gift tax-free. Loans to irrevocable trusts will also accomplish this “freeze” technique, transferring the future growth generated by the loaned assets out of an individual’s estate, to the extent the growth exceeds the AFR.
For families with loans outstanding between family members or other related parties, now may also be a good time to refinance this existing debt on better terms. While this option exists, careful planning must be done in order to avoid unwanted additional tax consequences. Please consult your HBK advisor prior to executing any debt refinancing.
Gifting to Utilize the Gift Tax Exemption
Now is also a good time to evaluate gifting, both on an annual basis and one-time large gifts. Even gifting in its most basic form has added value in today’s market. Depressed asset values allow for donors to gift more assets in an environment where the asset basis may be higher than the current value. Additionally, gifts made now will freeze the value of the lifetime estate and gift exemption used, while also allowing the recipient to enjoy the added gift of future appreciation. Given the concerns about this being an election year, and the possibility that the gift tax exemption will decrease in the future, it is particularly important for individuals with taxable estates to utilize gifting as a means of using the current increased exemption amount ($11.58 million per individual for 2020) before it may be significantly reduced.
Gifting to irrevocable trusts is also a good way to make a gift to an heir without giving the child or grandchild immediate access of the gifted assets, if that is a concern. In general, gifts to irrevocable trusts use a portion of the individual’s lifetime gift tax exemption, and may also use a portion of the individual’s generation-skipping transfer (GST) tax exemption if the assets will remain in trust for grandchildren and future generations. Where children or grandchildren may not be financially competent to use the assets wisely, liable to creditors or may be disabled, the irrevocable trust can be structured to protect the assets long-term. This may also be helpful if there is a fear that a child or grandchild may go through a potential divorce in the future.
While there are many opportunities in the current market there are also concerns to be aware of. When assets are gifted, the individual or trust receiving the asset will have a basis in the asset equal to the lower of the fair market value or the individual’s tax basis that gifted the asset. This could result in increased capital gains tax when the asset is eventually sold. In contrast, if the individual holds on to the asset and transfers it at death, the asset could receive a step-up in basis to the fair market value as of the date of death. Another consideration is the negative impact of gifting or loaning funds will have on future cash flows. (note: death is worse)
Short-term Grantor Retained Annuity Trusts
A Grantor Retained Annuity Trust (GRAT) is an irrevocable trust that, after funding, provides the grantor with a fixed annuity for a period of at least two years, and then distributes the remaining assets to the remainder beneficiaries of the trust. Throughout the GRAT term, the grantor receives the value of the initial assets transferred plus interest calculated at the Section 7520 rate, which is also at a historical low of 0.6% for June. Since the grantor has an economic interest and receives a benefit from this trust, the initial gift is heavily discounted to the point where the gift value is sometimes as low as $0 (this is known as a “zeroed-out GRAT”), resulting in almost no gift tax consequences. If the assets transferred appreciate at a rate greater than the Section 7520 rate, then the beneficiaries of the GRAT will receive that additional appreciation without using any gift tax exemption.
Installment Sale to an Intentionally Defective Trust
With this wealth transfer technique, the grantor sells assets to an Intentionally Defective Trust (IDGT) in exchange for a promissory note, typically structured as interest-only with a balloon payment due upon maturity. The benefits of using an IDGT are three-fold. First, the sale is ignored for income tax purposes. Therefore, no gain is recognized, and the interest payments on the note are not included in the grantor’s taxable income. Second, as discussed above, the grantor, rather than the trust, is responsible for paying any income taxes on trust’s earnings, allowing the trust to grow income tax-free. Third, different than a GRAT, this planning device can be utilized for dynasty trust purposes.
Charitable Lead Annuity Trusts
For grantors with a philanthropic inclination, another type of trust may be extremely valuable in a low-interest rate environment. Like a GRAT, Charitable Lead Annuity Trusts (CLATs) use the Section 7520 rate and result in minimal gift tax exemption being used. However, in a CLAT, a charity receives the initial fixed annuity over the term of the trust, known as the “lead period“, and the remainder is then distributed to noncharitable beneficiaries. A CLAT may be structured to generate an income tax charitable deduction for the grantor in the year of its creation. The deduction is maximized when the 7520 rate is low. Each year, the grantor would be responsible for paying income taxes on the CLAT’s earnings. Alternatively, the CLAT can be structured to pay its own income taxes and to receive an annual deduction for the amount it pays to charity. In that case, the grantor would not be entitled to a charitable deduction on his personal return.
A popular technique that can add value on multiple fronts is known as a preferred partnership freeze. Under this technique, assets are contributed to a limited partnership that has preferred units and common units. The grantor retains the preferred units while gifting or selling the common units to a dynasty trust. This technique effectively freezes the current value of the preferred units, while transferring any future appreciation to the common units owned by the dynasty trust.
Resulting from uncertainty, the current economic climate is an excellent time to consider making long lasting choices for planning purposes. Family wealth transfer planning is truly complex and should never be done in a vacuum. While the opportunities discussed above appear to be great opportunities, they may not the right opportunity and / or timing for every situation. Additionally, many of the techniques can be combined to maximize their effectiveness.
If this article has sparked an interest in selling your business or exploring the opportunities that exist for your business exit strategy, you can find more information about business valuation considerations when exiting a business in our previous HBK article The Landscape Is Changing for Business Owners Looking to Exit.
Please reach out to your HBK advisor and allow us to review your estate plan and evaluate your gifting desires. We are here to make this process easier and happy to help.