During the past month, the COVID-19 pandemic has affected the world’s entire population. The economic fallout also presents a planning opportunity to transfer significant wealth to family members and loved ones that are free of gift and estate taxes. In particular, three recent events have made a number of wealth transfer techniques particularly advantageous: (1) a historically high applicable exclusion amount, (2) low interest rates, and (3) a drop in stock market, business, and real estate values due to the COVID-19 crisis:
- Applicable Exclusion Amount. In late 2017, Congress passed the Tax Cuts and Jobs Act of 2017, which made sweeping changes to the gift and estate tax laws. Congress doubled the estate and gift tax exemption (the “Exclusion”) from $5 million to $10 million. The tax rate for assets in excess of the Exclusion remains at 40%. Adjusted for inflation, the Exclusion for 2020 is $11,580,000 per individual and $23,160,000 per couple. However, the $11,580,000 Exclusion will fall back to $5 million as adjusted for inflation on January 1, 2026 unless Congress acts to extend the current level. Further, if there is a change in the political party in control of the White House in the November 2020 election, it is likely that the Exclusion will drop to between $3.5 million and $5 million as early as January 1, 2021.
- Low Interest Rates. The current interest rates that the federal government requires for certain wealth transfer techniques are extremely low. The Applicable Federal Rate (“AFR”) for April is very low. The Short-Term Annual AFR is 0.91%, the Mid-Term Annual AFR is 0.99%, and the Long-Term Annual AFR is 1.44%. The current IRS 7520 rate is 1.2%.
- Covid-19 Downturn. The stock market has recorded a significant downturn. The Dow Jones Industrial Average recorded the worst start to a year in history in 2020, and the S&P 500 logged its worst quarter since the final three months of 2008. Valuations for businesses and real estate are depressed, and markets remain unclear as the global economy attempts to “restart” and return to “normal” operation.
These three events have brought together certain unique opportunities to transfer significant wealth to family members and loved ones without the imposition of gift or estate taxes as follows:
- Grantor Retained Annuity Trust (“GRAT”). A GRAT is an estate planning technique that can be used to transfer wealth using interest rate assumptions and appreciation of assets. The grantor funds a GRAT using assets that are likely to earn more than the IRS 7520 rate, which is 1.2% for April 2020, during the GRAT term. The GRAT benefits one or more beneficiaries (typically the grantor’s family) and the grantor retains an annuity interest for a term of years (often between 2 and 10 years). Typically, the required annuity payments are structured so that the actuarial value of the grantor’s retained annuity interest is equal to the value of the property transferred to the GRAT, resulting in no gift tax.
In determining the value of the grantor’s retained annuity interest, the IRS assumes that the trust assets will generate a return at least equal to the 7520 rate applicable to the month of transfer. The annuity amount is paid to the grantor during the term of the GRAT, and any property remaining in the GRAT at the end of the term will pass to the beneficiaries with no gift tax consequences. Thus, if the GRAT assets generate a return in excess of the 7520 rate, the increase in value above the 7520 rate will pass to the beneficiaries free of gift tax. To the extent the GRAT assets do not produce a return in excess of the 7520 rate, the grantor will simply receive all of the assets back at the end of the term. It is also important to note that if the grantor dies during the term of the GRAT, the remaining assets in the GRAT will be included in the grantor’s estate. Because of this, it is often recommended for the GRAT to have a shorter, rather than a longer, term. In addition, clients often create a series of short term GRATs and continue to fund each GRAT with the assets they receive from the annuity payments.
GRATs have other advantages. One is that GRATs are grantor trusts for income tax purposes, which means that the grantor of the trust is responsible for the GRAT’s income taxes. While this might not sound like an advantage at first, it actually increases a GRAT’s ability to transfer family wealth in a tax efficient manner. The grantor, through the payment of the GRAT’s income taxes, is effectively making tax-free gifts to the GRAT.
Ultimately, the implementation of one or more GRATs is done with minimal downside risk other than any applicable legal and administrative costs, while providing opportunities to transfer significant wealth, free of gift tax.
- Intentionally Defective Grantor Trust (“IDGT”). An IDGT aims to transfer assets at current values to a trust which moves any future appreciation out of your estate. An additional benefit is the availability of valuation discounts on interests in closely held businesses transferred to the trust; for lack of marketability and lack of control. For example, a couple who have made no prior gifts have a combined Exclusion of $23.16 million in 2020. By transferring closely held business interests to the IDGT which may qualify for valuation discounts, a couple could potentially transfer $35 million in underlying assets, utilizing a valuation discount of 25% to 35%, free of gift tax.
To further increase the effectiveness of an IDGT, a combination of a gift and a sale can be used in which closely held business interests are gifted to the trust and the trust buys additional assets (usually closely held business interests) from the grantor in exchange for an installment note. Again, there is potential for valuation discounts on assets sold to the trust, and by selling assets to the trust there is no gift or GST tax liability if structured properly. This method has no limitation on the total value of assets sold to the trust, only that the trust must make payments back to the grantor for the entire term of the installment note. The note must bear interest at the AFR, which are at historic lows. Upon the sale of assets to the trust, all the assets and all future appreciation in those assets will be outside of the grantor’s estate; however, if the grantor passes away during the term of the installment note the principal and the accrued but unpaid interest left on the installment note will be included in the grantor’s gross estate. Additionally, if structured correctly, the IDGT can have GST tax exemption allocated to it, creating a trust with an inclusion ratio of zero for GST tax purposes.
Like GRATS, IDGTS are grantor trusts for income tax purposes, which means that the grantor of the trust is responsible for the IDGT’s income taxes. The grantor, through the payment of the IDGTs income taxes, is effectively making tax-free gifts to the IDGT.
- Intra family Loans. Making a loan to family members can be an effective way to provide funds to family members for a home, business, or other investment purpose. Principal and interest payments stay within the family rather than going to a third party lender. This can be done without incurring gift tax liability by a person making a loan and taking back a promissory note. The promissory note must bear interest at the AFR, but the note can be structured such that it requires interest-only payments on an annual basis and a balloon payment at the end of the term of the promissory note. Adequate collateral should be given to secure payment and the obligor should have the financial ability to pay off the loan. In some cases, the holder of the promissory note can make yearly “gifts” using the $15,000 (in 2020) annual exclusion to forgive accrued interest and principal.
If you have questions about this article, wealth transfers, or other estate planning matters, please contact Gary L. Longmore and Jason M. Tholen, or a member of the Ray Quinney & Nebeker COVID-19 Response Team for Estate Planning/Wealth Preservation.
Gary Longmore is the chair of the Firm’s Tax, Trusts & Estate Section and is monitoring related legal updates for the COVID-19 pandemic. He is a fellow of the American College of Trust and Estate Counsel (ACTEC). His practice is focused in the areas of estate and business planning, trust and estate administration and taxation. He advises clients on legal and tax issues associated with estate planning, wealth transfer strategies, and business succession planning for individuals, owners of closely-held family businesses, and family offices.
Jason Tholen is a tax, trusts and estate attorney and is monitoring related legal updates for the COVID-19 pandemic. His practice is focused in the areas of estate planning, trust and estate administration and taxation. He advises clients on legal and tax issues associated with estate planning and wealth transfer strategies, including preparing wills, trusts, powers of attorney, health care directives and other general estate planning documents.