The year 2020 will long be remembered for the grave health and economic issues triggered by the COVID-19 pandemic. But thereâ€™s one reassuring fact: Life after the economic shutdown will eventually resume.
For higher net-worth individuals, the current historically low interest rates and depressed asset values make this is an ideal time for exploring opportunities to transfer significant amounts of wealth to beneficiaries on very favorable tax terms. Moreover, while strategies that minimize gift and estate taxes often involve making lifetime gifts, other estate planning techniques can be even more effective when assets presently have depressed values.
The biggest reason for transferring wealth during the current economic climate can be summed up in one word: taxes. The 2017 Tax Cuts and Jobs Act (TCJA) effectively doubled the federal estate, gift and generation-skipping tax exemptions to $11-million per person. â€”Although this amount is set to decrease by 50 percent in 2026. In addition, states also impose sizable estate taxes.
To reduce the burden of these taxes, many wealthy individuals, while theyâ€™re still living, use one or more techniques that remove assets from their taxable estates and give them to their intended beneficiaries. When the gift is temporarily depressed, assets are expected to recover their value and you are able to gift more shares at a lower price. For example, if you had a family partnership and had a value per share of $20 in 2019 but you had a revaluation in 2020 of $15, youâ€™re able to gift 33% more in shares.
Grantor Retained Annuity Trusts
With this technique, known as a GRAT, an individual transfers assets that are expected to increase significantly in value to an irrevocable trust. The trust provides for an annuity payment to be made back to the individual, and at the end of the term the assets are distributed to the beneficiaries or are held in further trust for them.
The amount of the annuity payments can be set so the gift tax value of the annuity payments is equal to the gift tax value of the assets transferredâ€”a so-called â€œzeroed outâ€ GRAT, for which the individual doesnâ€™t have to use any of their estate and gift tax exemption.
The Internal Revenue Service (IRS) assumes the trust assets will generate a return of at least the applicable Section 7520 rate in effect for the month the assets were transferred to the trust. If the assets enjoy any growth exceeding the Sec. 7520 rate, the beneficiaries pay no gift tax. The 7520 rate determines the amount of annuity payments that must be made to â€œzero outâ€ the GRAT.
This is an especially favorable time to fund a GRAT. First, if the GRAT is funded with depressed assets, those assets may be more likely to appreciate going forward and clear the so-called hurdle rate, or minimum rate of return. In October 2020, the 7520 rate is 0.4â€”an extreme historic low. This means that for a GRAT to be successful, its assets would only have to appreciate at a rate greater than 0.4 a year.
Even if the assets in GRAT do not appreciate faster than this hurdle rate, they would simply return to the person who created the GRATâ€“putting the person in the same position than if they had done nothing.
That said, legislative changes could be ahead to restrict GRATs as vehicles for transferring appreciation to beneficiaries with minimal or no gift tax. Moreover, candidates in the 2020 presidential election are proposing changes, and interest rates are expected to rise at some point. There could be no better time to consider the advantages of grantor retained annuity trusts.
An intra-family loan is a simple and effective strategy to shift wealth with minimal tax consequences and is especially desirable when interest rates are low. With an intra-family note, a personâ€”usually one or both parentsâ€”loans money to a family member or to a trust for a family member, usually at the lowest rate that will not cause an Applicable Federal Rate (or â€œAFR,â€ which is the minimum rate of interest that must be charged for the transaction to not be considered a taxable gift by the IRS). The current very low rates provide wealth-transfer opportunities, making intra-family loans an attractive way to shift wealth with few tax consequences for both parties.
An intra-family loan does not specify how the borrower may use the proceeds. Thus, the borrower can use it in a variety of waysâ€”from starting a business to funding an investment with potential to outperform the interest rate. Loans must be made at or above the AFR, which is set monthly. The October 2020 AFR for a mid-term loan of 3 to 9 years, which most intra-family loans use, is .38%.
Unlike conventional loans, intra-family loans can be structured for the borrowerâ€™s maximum advantage. For example, a balloon note and interest-only payments for the length of the loan, (with the principal due when the loan expires,) can provide the greatest opportunity to grow the principal.
It’s important to remember that an intra-family loan is still just thatâ€”a loan. It is made with the borrowerâ€™s full commitment to repay. The promissory note should include the loan terms, and the individual who loans the money must track both interest and principal payments. If the loan is not properly documented and followed, the IRS could reclassify the loan as a gift and tax it accordingly. At the same time, if the borrower defaults or the loan is outstanding at the time of your death, the Will of the person making the loan can provide for it.
Swap Powers & Assets Review
Higher net-worth individuals who have trusts, or who are planning to establish one, should be familiar with swap powers and how they work. When the holder of a trust wants to own a certain asset that is held inside their irrevocable trust, swap powers have the ability to do this without negatively affecting income, estate or gift taxes. Many irrevocable trusts contain this power, which permits the grantor to substitute non-trust assets for those owned by the trust.
A swap power allows the settlor (or someone who doesnâ€™t have a beneficial interest in the income or assets of the trust) to transfer personally owned assets into a trust in exchange for trust assets of comparable value.
When the grantor has capital gains, substituting another asset for those publicly traded securities before the grantor status is terminated could be smart income tax planning. If the capital losses remained owned by a non-grantor trust that didnâ€™t have the ability to generate future capital gains, those losses could end up trapped within the trust. Moreover, contributing rapidly appreciating assets to a trust is a smart estate planning technique to remove future appreciation from a taxable estate.
When exercising swap powers, the trustee must be under a fiduciary obligation to ensure the assets swapped are of the same value. The transaction may not leave the trust beneficiaries in a better, or a worse, economic condition. Since non-publicly traded assets are most frequently the subject of a swap transaction, itâ€™s vital to obtain appraisals or business valuations to confirm that the assets being exchanged are of comparable value.
Creating and maintaining a trust require the coordinated efforts of the financial planner, the CPA and estate planning attorney. But the financial planner has the burden of ensuring that swap powers are both included in the trust and utilized.
Charitable Lead Annuity Trusts
For high income earners who want to transfer family wealth andâ€” at the same timeâ€” do good for others, current low interest rates make a charitable lead annuity trust (CLAT) an attractive strategy. Not only is the donor locking in a lower interest rate, but more wealth will ultimately be passed to heirs.
A CLAT can be initiated during the life of the donor or at death. The donor transfers assets to the trust, designates the charity to receive the annual income stream along with the term of years. When the term of years expires, the remaining assets in the trust pass to the non-charitable beneficiariesâ€” free of both gift and estate taxes.
As with a GRAT, the IRS uses the Section 7520 rate to value the charitable annuity. So, if CLAT assets outdo the IRS rate of return, the non-charitable beneficiaries will receive the appreciated, non-taxable balance.
REDW Wealth financial planning advisors are experienced with strategizing wealth planning opportunities that help our clients maximize income and reduce taxes. Please contact Paul Madrid, Principal and REDW Wealth Practice Leader to start a conversation.