Client Update: Trusts and Estates 2009 Briefing
January 16, 2009
Significant Opportunities in Today’s Economic Environment
The current historic convergence of low interest rates and depressed asset values makes this an excellent time to engage in several estate-planning strategies for transferring wealth. Here are some of the best strategies to keep in mind:
Intra-family loans present a simple way for parents to transfer significant wealth to their children (or trusts for their benefit) with relatively minor tax consequences. The law requires that related parties charge each other minimum rates of interest on loan transactions in order to avoid the potential for disguised gifts. These minimum interest rates are published each month by the Treasury Department, for loans of varying terms. Current rates permit intra-family loans of up to three years to be made at less than 1.5% interest, loans between 3 and 9 years in length at rates under 3%, and longer term loans at rates under 4.5%. To the extent the children invest the loaned funds and receive investment returns exceeding the interest rate of the loan, the family will realize a generational transfer of wealth with no estate tax or gift tax implication.
While each client’s circumstance will present its own unique planning opportunities, this technique is fundamentally a sale of property by a parent to a “grantor trust” for the benefit of his or her children and/or grandchildren in exchange for a promissory note bearing interest at the minimum rate for intra-family loans. By using a grantor trust, the transaction is designed to avoid the potential recognition of taxable gain to the parent as a result of the sale.
The objective of this strategy is for the trust property to realize a rate of return that exceeds the rate of interest on the note. Therefore, the wealth transfer potential of this technique is enhanced in an environment of lower interest rates and presumed greater potential for appreciation of the subject property. If the property being sold to the trust is a fractional or noncontrolling interest, the possibility of valuation discounting can further enhance the wealth transfer opportunity.
To avoid a potential argument by the IRS that the note is not a true debt, rather a gift of the subject property to the trust coupled with a retained economic interest, the trust should have a value independent of the property being purchased from which to draw upon to make the note payments. Case law indicates that this value should be at least 10% of the value of the property being sold. Therefore, unless the trust already has principal with at least the requisite value, the sale is typically preceded by a gift to the trust equal to 10% of value of the property sold.
Grantor Retained Annuity Trusts
A grantor retained annuity trust (“GRAT”) is an estate-planning technique that allows for the transfer of asset appreciation at minimal or no gift tax cost. The trust is established by the grantor transferring assets into the trust for a term of years. During the term of the trust the grantor receives an annuity payment, at least annually, of either a fixed dollar amount or a fixed percentage of the fair market value of the assets placed in the trust. At the end of the trust term, any remaining principal is distributed to the trust’s beneficiaries. The amount of the grantor’s taxable gift, reported at the time the trust is established, is the fair market value of the property placed in the trust, reduced by the present value of the annuity payments that the grantor has retained.
Because of this valuation method for determining the reportable gift to a GRAT, a lower interest rate environment produces a lower reportable gift. This result occurs because the lower the discount factor used to calculate it, the larger the present value of the grantor’s retained annuity will be. In addition, the potential amount of wealth ultimately transferred to the beneficiaries at the conclusion of the trust term is directly affected by the appreciation potential of the assets placed in the trust. Therefore, to the extent the grantor is able to fund the trust with depressed assets, which he expects to rebound in value during the trust term, the wealth transfer opportunity of the GRAT is enhanced.
GRATs can be structured so that the value of the gift (i.e., the trust remainder) is zero. A “zeroed-out GRAT” involves minimal downside risk because the zero gift value allows the trust to be established with no use of the grantor’s lifetime gift exemption. As a result, if the assets transferred to the trust do not appreciate at a rate greater than the discount factor used to value the annuity, or if the grantor dies during the term of the trust, the grantor is no worse off for having created the GRAT.
GRATs also can be established in a series of short-term “rolling” GRATs (each typically “zeroed-out”), in which the grantor plans to roll each annuity payment into a new GRAT as that payment is received. An effective term for each GRAT in the series is often two years. This technique maximizes the opportunity for the remainder beneficiaries to capture significant short-term asset appreciation, while minimizing the chances that the wealth transfer could be stunted by a single event of a short-term drop in asset values during a GRAT encompassing a longer period of time.
Charitable Lead Annuity Trusts
A charitable lead annuity trust (“CLAT”) is a trust instrument that provides for the payment of a fixed dollar amount to one or more charitable beneficiaries, at least annually, for a specified term. At the end of the term, the trust principal is distributed to family members, typically the grantor’s children (or trusts for their benefit). Similar to a GRAT, the grantor’s gift to the CLAT’s remainder beneficiaries is calculated at the time the trust is created as the fair market value of the assets placed in trust reduced by the present value of the annuity payable to charity. The grantor also receives a gift tax charitable deduction for the present value of the annuity. As a result, the wealth transfer opportunity of this technique is enhanced by an environment of lower interest rates (which cause the present value of the charitable annuity to be increased), and when depressed assets having significant appreciation potential can be used for the grantor’s initial gift to the trust.
For families already making significant charitable gifts on an ongoing basis, a CLAT presents an opportunity for substantial family wealth transfer, and eventual estate tax savings, by in effect applying a more organized structure to their existing charitable activities. A CLAT can also be integrated into your estate plan to initiate upon death, providing a significant estate tax charitable deduction while perpetuating a lifetime legacy of giving.
New in 2009
Effective January 1, 2009, the annual gift tax exclusion increased from $12,000 to $13,000 per recipient, and the federal estate tax exemption increased from $2 million to $3.5 million. The rate of tax on estate values above the exemption will be 45%. The lifetime federal gift tax exemption will remain unchanged at $1 million.
Of significance to Illinois residents is the “decoupling” of the federal and Illinois estate tax exemptions. Currently, both the federal and Illinois estate tax exemptions are $2 million. However, next year, when the federal exemption increases to $3.5 million the Illinois exemption will remain at $2 million. This decoupling will create a planning dilemma for married couples who have planned to fully utilize both of their federal estate tax exemptions. Until now, such planning has been possible without causing either federal or Illinois estate tax at the time of the first spouse’s death. In 2009, however, claiming the full federal estate tax exemption at the first spouse’s death would cause an Illinois estate tax (up to roughly $210,000 at current rates).
For most couples, it is not possible at the time of writing their estate plan to make an informed decision whether it might be a more advantageous tax strategy to use the full federal exemption of the first spouse to die, “trading off” the payment of some Illinois estate tax, or forego a portion of the first spouse’s federal exemption to avoid an Illinois estate tax liability. We therefore recommend that our clients implement a wait-and-see plan design, which defers that tax decision until the first spouse has died, empowering the surviving spouse to make an informed planning decision when sufficient information has become available.
The Future of Federal Taxation
Under current law, the federal estate tax is scheduled to be repealed on January 1, 2010, and then reinstated on January 1, 2011, with an exemption of only $1 million and a top marginal rate of 55%. It is difficult to predict the priorities of the next Congress, but it is widely anticipated that Congress will address the federal estate tax during 2009, preempting the scheduled 2010 repeal. During his campaign, President-elect Barack Obama’s position was to oppose estate tax repeal. Instead, for 2010 and thereafter, he favored freezing the federal exemption at the 2009 level of $3.5 million, and the federal rate at the 2009 level of 45%.
We are required to notify you that pursuant to regulations governing practice before the Internal Revenue Service, unless expressly stated otherwise, any tax advice contained herein cannot be used, and is not intended to be used by a taxpayer for (i) the purpose of avoiding tax penalties that may be imposed on a taxpayer under the Internal Revenue Code, or (ii) the promotion or marketing of any tax-related matter or program.
If you have any questions regarding the above information and how it applies to your situation, please do not hesitate to contact Ira S. Neiman or the Shefsky & Froelich attorney with whom you work.