With interest rates and asset values affected by the pandemic and other current events, individuals and families have a unique opportunity to implement some exceptionally advantageous wealth transfer planning.
In addition, with the lifetime gift tax exemption set to revert to $5 million (adjusted for inflation) in 2026, and possibly earlier if Congress enacts new legislation, married clients with more than $23 million of combined wealth should consider lifetime gifting strategies now.
There are a variety of strategies that involve trusts that clients can utilize to their advantage to minimize estate taxes and transfer wealth for the benefit of family and/or charities. The more common ones being Grantor Retained Annuity Trust (GRAT), Charitable Remainder Unitrust (CRUT), Charitable Lead Annuity Trust (CLAT) and Intentionally Defective Grantor Trust (IDGT). For clients who are projected to have a federally taxable estate and desire to gift assets to heirs and/or charities, now may be the right time to implement some of the following planning strategies.
Intentionally Defective Grantor Trusts (IDGT)
One opportunity to consider is the transfer of a family business to a trust in order to freeze the value of the asset for estate tax purposes. This allows future growth in value to occur outside of the grantor’s estate while the grantor maintains some control over the assets. This technique can be especially advantageous right now, given the low interest rates.
The basic premise of an IDGT is that the value of the gift is established when assets are moved into the trust. The grantor will pay tax on the trust income, but the appreciation in the asset is not included in the value of the gift and therefore does not use more of the grantor’s lifetime exemption. The value “freeze” happens when the asset is sold to the trust through an installment note with the goal of shifting income and appreciation in excess of a favorable interest rate to the IDGT. Such a shift only occurs if the rate of return actually realized by the trust asset exceeds the interest on the installment note. This is how the low interest rate environment proves advantageous.
The current long-term rate applicable to an installment note, the applicable federal rate (AFR), is only 1% as of this writing. Just two years ago, the interest rate applied to this same installment sale scenario was 3.02%, which makes the current environment an excellent time to consider this type of wealth transfer. Under these lower rates, the value transferred tax-free is double what it was in 2018.
Not all high-impact planning needs to be complicated. With historically low interest rates a mortgage refinance may be warranted, but there are other loan strategies to consider as well. Related-party loans are an excellent tool for families to transfer wealth and retain some control over the asset.
In order to avoid gift tax treatment on loans to family members, interest must be charged, and the minimum rate is the AFR discussed above (1% as of September 2020). A parent can make a loan to an adult child at 1% and save the child significant interest that might otherwise have been paid to a nonrelated lender. In addition, the parent can forgive a portion of the loan principal each year using annual gift exclusion amounts (currently $15,000 a year per recipient).
Many families like to use loans as a wealth transfer planning strategy, as it allows the parents to decide each year how much loan forgiveness they want to provide and offers peace of mind for families that like to maintain some control. Also, for families already using these loans as a planning tool, now is an excellent time to consider a refinance of those loans at this new lower rate.
Spousal Lifetime Access Trusts (SLAT)
The SLAT is a special wealth transfer technique that can be particularly attractive when asset values are low. A SLAT is an irrevocable trust set up by one spouse (the donor spouse) for the benefit of the other spouse (the beneficiary spouse). It provides a lifetime interest in the property contributed to the trust to the beneficiary spouse, with the remainder assets going to the specified beneficiaries of the trust (generally, the couple’s descendants). Both spouses may set up a SLAT, but, as discussed below, care must be taken to ensure that the trusts are not treated as reciprocal trusts.
The SLAT strategy is unique and should be considered for high-net-worth clients who wish to minimize their future estate tax liability and yet are concerned about preserving enough value (indirectly) for themselves.
It is important to stress the need for careful planning and implementation of the SLAT, as well as to convey a clear understanding of the indirect rights each spouse will have to the other spouse’s trust. The grantor is making an irrevocable gift of the assets contributed to the trust, and, to avoid the appearance of a mere reciprocal trust being formed, the grantor cannot expect the assets to actually be available to him or her after the gift is made.
Upon the death of either spouse, the trust assets will pass to the beneficiaries specified by the trust. To avoid the reciprocal trust doctrine, the trust terms cannot be identical, and therefore careful thought should be given to the specific assets contributed, the rights of the spouse, and the identification of beneficiaries for each trust.
Engaging an estate planning attorney with experience with these trusts is very important, as well as providing guidance to the grantor and spouse regarding the important mechanics of these trusts to ensure the best overall tax efficiency of this irrevocable gift.
Taking Advantage of Unique Opportunities
The gift planning strategies discussed above, combined with current interest rates and asset values, may provide unique opportunities to transfer significant wealth more tax-efficiently than at any other time. The extremely favorable circumstances that presently exist for gift planning may not last long, which makes now the perfect time to consider these planning options. As with all estate planning, engaging an experienced estate planning attorney and tax advisor is very important.