March 12, 2009

The combination of recent volatility and depressed values in the financial markets, historically low interest rates, and the deepening recession have created an environment ripe for estate planning and transferring wealth to descendants on a tax-advantaged basis. Hopefully, values will increase again. When they do, the opportunity to leverage and reduce—or even eliminate—your transfer taxes on such favorable terms may be gone.

In the meantime, there are a number of techniques worth considering to make the most of this perfect storm.

Annual Exclusion Gifts and the Lifetime Gift Exemption

As the value of stock, real estate and other assets has generally been declining, now may be a good time to use such assets to make gifts as a means of reducing estate taxes. Currently, individuals can give $13,000 annually to each of any number of donees without incurring any gift tax ramifications. Gifts in excess of this amount are generally taxable, but the first $1 million is shielded by the Lifetime Gift Exemption (in essence using a portion of the exemption available at death to transfer assets free of estate tax). The tax savings are magnified when you factor in future growth, which inures to the benefit of the donee.

A husband and wife with three children, for example, might make gifts of "depressed value stock" using their annual exclusions and Lifetime Gift Exemptions, expecting the stock to recover by 25% over the next three years. If the value of the stock gifted in 2009 was $2,078,000, no gift tax would be due. At the end of three years, the value of the assets that the children then owned would be $2,597,500—an estimated $269,000 in estate tax savings if the parents died that year. However, if the parents survived for an additional 15 years and the stock continued to grow 5% annually, it would be worth approximately $5 million, with an estimated $1.53 million in estate tax savings.

Minimal Interest Intra-Family Loans

An intra-family loan is a simple but attractive estate planning technique that can be executed independent of other strategies and without adverse gift tax consequences. In order to avoid gift taxes, the loan must be made at the Applicable Federal Rate (AFR), which is currently quite low. As of March 2009, the AFR is 0.72% for a loan of three years or less, 1.94% for a three-plus to nine-year loan, and 3.52% for a loan exceeding nine years. Although your family member/borrower will owe you interest on the loan, wealth is transferred on a tax-free basis as long as the funds are invested with a return in excess of the AFR.

Refinancing Existing Loans

Many parents may have made loans to their children or trusts for their benefit, including outright loans and loans issued in connection with sales of assets. The interest rate being charged on the loans may be significantly higher than the current AFR. If the loans can be prepaid without penalty, and if the parent/lender does not need the cash flow, consideration should be given to refinancing the loans at the lower current interest rate. This will reduce the child's cash outflow, allowing the wealth to grow for his or her benefit outside the transfer tax regime.

Grantor Trusts and Installment Sales

If a person creates a trust and includes certain Grantor Trust provisions, the income tax laws treat the trust and the creator as one (i.e., the existence of the trust is ignored). The creator, not the trust, then reports the trust income and pays the tax thereon. In essence, this allows the creator to make tax-free gifts to such a trust benefiting the trust beneficiaries. As the creator is required to pay the income tax on the trust's income, the Grantor Trust grows tax free while allowing the creator's assets that would otherwise be subject to transfer taxation to be reduced by the amount of the income taxes. The tax-free compounding of the Grantor Trust may create the greatest of all estate tax leveraging.

A parent can establish a Grantor Trust and sell appreciating assets to that trust for an installment note bearing interest at the AFR, which is currently very low. Under the Grantor Trust rules, no gain or loss on the sale would be recognized. Although the Grantor Trust would be required to make payments on the note, the growth on the asset sold would inure to the trust beneficiaries. In essence, the parent would be freezing the value of the transferred assets. The sale to the Grantor Trust produces transfer tax benefits when the assets sold appreciate more than the rate of the promissory note, which is likely given the low current AFR and the probability that an asset with a severely depressed value will recover.

Self-Canceling Installment Notes and Private Annuities

Two variations of a promissory note transaction are a self-canceling installment note (SCIN) and a private annuity. A SCIN is simply an installment note that is canceled if the seller/lender (parent) dies. The buyer/borrower (child) receives a windfall if the parent dies prior to the end of the note term, as no further payments will need to be made. This can also result in substantial estate tax savings, as the balance that was due on the note immediately before death is not included in the parent's estate. However, the parent must be compensated for this self-canceling feature, generally by an increased interest rate on the note. Thus, while there may be substantial estate tax savings if the parent dies while the note is outstanding, additional assets will have been paid to the parent if he or she survives the note term.

In the typical private annuity transaction, a parent transfers property to a child in return for an unsecured promise to make a fixed, periodic payment to the parent for life. If the fair market value of the property transferred equals the present value of the annuity actuarially determined by the Section 7520 Interest Rate (equal to 120% of the AFR, rounded to the nearest two-tenths of one percent), there is no gift tax due. Similar to the SCIN, a private annuity produces a benefit when the parent dies prior to his or her life expectancy, and a disadvantage if the parent outlives his or her life expectancy. Both the SCIN and the private annuity are even more beneficial when interest rates are low.

GRAT: Grantor Retained Annuity Trust

A GRAT is a Grantor Trust whereby the trust pays the creator a predetermined annuity for a given term in exchange for the creator's contribution of property to the GRAT. At the expiration of the term, the GRAT assets pass to the named beneficiaries (e.g., descendants or trusts for their benefit). The creator would be making a gift at the time of the creation of the trust equal to the value of the transferred property less the value of the retained interest (actuarially determined using the 7520 Rate). If the creator survives the term, any assets remaining in the GRAT pass to the named beneficiaries without further gift taxation—regardless of the value. However, if the creator dies during the GRAT term, the assets are fully included in the creator's estate (in essence unwinding the transaction). A lower interest rate increases the value of the annuity retained by the grantor and thus reduces the value of the gift of the remainder in a GRAT. The GRAT produces transfer tax benefits when the return on the assets transferred exceeds the 7520 Rate—2.4% for March 2009.

Many factors affect the value of the gift upon creation of a GRAT: the creator's age, the 7520 Rate, the value of the property being transferred, the term of the GRAT and the annuity percentage. Because the creator can control the term and annuity rate, the GRAT can even be structured to produce no taxable gift (e.g., a two-year term with an annuity equal to 51% of the value of the property contributed). Such a "zeroed out" GRAT would allow appreciation of the assets in excess of the 7520 Rate to pass to descendants free of any transfer tax. Again, with a very low current 7520 Rate, along with the probability that an asset with a severely depressed value will recover, this tax-free scenario can likely be accomplished. However, the clock may be ticking on this "zeroed out" GRAT technique as there has been talk of Congress changing the law to limit the annuity amount and require a minimum remainder/gift value (e.g., 10% of the value of the GRAT).

CLAT: Charitable Lead Annuity Trust

A CLAT is similar to a GRAT, but with the term annuity being paid to a charity. At the expiration of the CLAT term, the remaining assets pass to the named beneficiaries (e.g., children). Not only would the value of the charitable lead interest pass free of any transfer tax, but a CLAT can also be structured to provide the creator with a current income tax deduction. The creator would be making a gift to the remainder beneficiary at the time of the creation of the CLAT equal to the value of the remainder interest (actuarially determined, but with an option to use the 7520 Rate for the month of the transfer or either of the prior two months.) The annuity payment is typically designed to offset the value of the contributed property, so that there is little or no taxable gift upon creation of a CLAT. A lower interest rate results in a larger gift or estate tax deduction for the annuity interest going to the charity and a smaller value for any gift of the remainder interest going to the descendant. A CLAT produces transfer tax benefits when the return on the assets transferred exceeds the 7520 Rate.

QPRT: Qualified Personal Residence Trust

A QPRT is a trust whereby an individual transfers a personal residence to family members at a reduced transfer tax cost. Typically, a parent transfers the residence in trust and retains the exclusive right to occupy the residence for a term of years. Upon expiration of the QPRT term, the residence would pass to children (or other named beneficiaries) without further transfer taxation. The parent is making a current gift of the residence, but the value is reduced by his or her retained interest. While lower interest rates generally mean a lower value for the retained interest and thus a larger gift, the dynamics of a QPRT should not be ruled out. If the current state of the economy has significantly depressed the value of the residence, and if the value is expected to recover, then this technique can render a significant benefit. In essence, the QPRT would freeze the current value of the residence for transfer tax purposes and allow the growth to inure to the benefit of the remainder beneficiaries without further transfer taxation.

Act Now

Although the confluence of recent economic events has created a rare opportunity for proactive estate planning, low interest rates and depressed asset values hopefully will not last long. Therefore, it may be important to act now in order to leverage these estate planning techniques while the conditions are ripe.

This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.