Estate Planning Strategies for Uncertain Times

Margaret Amsden

Among the many rumors surrounding tax reform, several concepts have surfaced regarding what lies ahead with respect to the estate tax. In general, the question is whether the estate tax is going away. Many believe that despite this being a possibility, if it were to go away, it is also likely that it will be back with 10 years.

In spite of this uncertainty, it is important to remember there are still estate planning strategies that can be utilized today, regardless of what happens with tax reform. Some examples of these strategies are:

Zeroed-out transfers to Grantor Retained Annuity Trusts (GRATs)

Installment sales to Intentionally Defective Grantor Trusts (IDGTs)

It wasn’t long ago that individuals were seeking opportunities to utilize what remained of their lifetime gift and estate tax exemption for fear of it being reduced with the phase out of President Bush’s tax cuts. It should be noted that while we are once again in a state of uncertainty, the difference is that we are facing a potential removal with later reinstatement of the estate tax, rather than a reduction in the exemption amount. For this reason, strategies involving IDGTs and GRATs may be useful alternatives to utilizing an individual’s lifetime gift and estate exemption and hence preserving a tax-free step-up in basis at death.

Zeroed-out Transfers to GRATs:

Transferor transfers assets to a trust and retains the right to receive a fixed dollar amount for a period of time. This fixed dollar amount is referred to as the retained annuity interest.

The transfer is considered a gift to the extent the value of the transferred assets on the date of transfer exceeds the present value of the retained annuity interest.

The transfer becomes a “Zeroed-out Transfer” by making sure the value of the retained annuity interest is as close as possible to the value of the transferred assets on the date of transfer, resulting in minimal gift tax consequences.

After the GRAT term expires and the required annuity payments have been paid to the transferor, the transferor’s interest terminates and any remaining assets  left in the trust are distributed to the beneficiaries, or the trust continues on for some period.

The present value of the retained annuity interest is determined using a required rate of return under IRC Section 7520. This is often referred to as the 7520 rate.

Assuming the assets transferred to the GRAT appreciate at a rate greater than the 7520 rate during the term of the GRAT, the GRAT will result in a tax-free shifting of value to the remainder beneficiaries of the trust.

If the transferor dies before the end of the GRAT term, the assets in the GRAT will be included in the transferor’s estate.

Installment Sales to IDGTs:

The grantor establishes an irrevocable trust with certain provisions that result in the trust being characterized as a grantor trust.

The grantor sells assets to the trust, however, due to the terms of the trust, is treated as selling the assets to himself, and as such, does not have any income tax consequences from the sale.

The grantor takes back an installment note in exchange for the transferred assets so the trust can pay for the assets over a period of time.

The sale must be for full and adequate consideration in order for the grantor to avoid any gift tax consequences (i.e. the face value of the note must be equal to the fair market value of the assets sold to the trust).  Depending on the type of assets transferred, they may qualify for valuation discounts which will increase the overall benefit of this strategy.

Interest is required to be charged and paid at the applicable Federal rate (AFR), however no interest income is recognized by the grantor because the IDGT and the grantor are viewed as one taxpayer.

Assets are generally not includable in the grantor’s estate.

The grantor still pays the income tax on the earnings from the trust’s assets, although any cash associated with the earnings will eventually pass to the beneficiaries of the trust, resulting in gift tax-free transfer of the tax paid by the grantor.

If the grantor dies or the grantor trust status terminates prior to the installment note being paid off, the grantor or grantor’s estate would recognize taxable income equal to the amount of gain represented by the unpaid principal of the note.

In reality, there is a considerable amount of planning that goes into utilizing either of these strategies and they are not the right strategy for everyone. One thing that makes both of these vehicles attractive right now is the AFR and 7520 rates are still considerably low. Also, it is important to note that while the explanations can be simplified, another consideration that must be taken into account is the administrative cost to implementing one of these options, which would include the upfront cost of valuing the property being sold or transferred and drafting the related documents as well as the ongoing cost of compliance.

While utilizing an individual’s remaining lifetime exemption may seem like the right solution and a valid estate planning technique, it may be worthwhile to think about preserving that exemption in order to obtain the tax-free step up in basis at death. Zeroed-out transfers to GRATs and installment sales to IDGTs offer some alternatives that may help individuals accomplish the same objectives through different means. To learn more, contact Clayton & McKervey.