Home > Estate Planning > Wealth Transfer Strategies to Consider this Election Year
With a push by the Democratic party to return federal estate taxes to their historic norms, taxpayers need to act now before Congress passes legislation that could adversely impact their estates. Currently, the federal estate and gift tax exemption is set at $11.58 million per taxpayer. Assets included in a decedent's estate that exceed the decedent's remaining exemption available at death are taxed at a federal rate of 40 percent. While many states also have a state estate tax, California does not. As background, each asset included in the decedent's estate receives an income tax basis adjustment. The asset's basis equals its fair market value on the date of the decedent's death. Thus, beneficiaries realize capital gain upon the subsequent sale of an asset only to the extent of the asset's appreciation since the decedent's death. If the election results in a political party change, it could mean not only lower estate and gift tax exemption amounts but also the end of the longtime taxpayer benefit of a stepped-up basis at death. To avoid the negative impact of these potential changes, there are a few wealth transfer strategies to consider before the year-end. Now, many of these are highly technical, so if you want us to walk you through them, give our office a call, and we can set up an appointment.   Intrafamily Notes and Sales In response to the COVID-19 crisis, the Fed lowered the federal interest rates to stimulate the economy. Low rates have a precedent. So what does this mean for you? Donors should consider loaning cash or selling income-producing assets, such as some of those apartments or shopping centers you may own. To who? To a family member and you take in exchange a promissory note that charges interest at the applicable federal rate. What you would be doing is providing a financial resource to a family member on more flexible terms than a commercial loan. If the investment of the loaned funds or income resulting from the sold assets produces a return greater than the applicable interest rate, then you have effectively transferred wealth to a family member without using your estate or gift tax exemption.   Swap Power for Basis Management Assets such as real estate gifted or transferred to an irrevocable trust don't receive a step-up in income tax basis at the donor's death. Instead, the gifted assets retain the donor's carryover basis. This can mean significant capital gains will be realized upon the subsequent sale of any asset that has appreciated. So what to do? You exercise the power to swamp the low-basis assets in the irrevocable trust for one or more high-basis assets currently owned by and includible in your estate for estate tax purposes. In this way, low-basis assets are positioned to receive a stepped-up basis adjustment on death. And the capital gains realized upon the sale of any high-basis assets may be reduced or eliminated. Let's use an example. Roger purchased real estate in 2005 for $1 million and gifted the property to his irrevocable trust in 2015 when the property had a fair market value of $5 million. If Roger dies in 2020, and the property has a date-of-death value of $11 million. If the trust sells the property soon after Roger's death for $13 million, the trust would be required to pay capital gains tax on $12 million, the difference between the sale price and the purchase price, also known as the carryover basis. Let us say that before Roger died, he came to the Moschetti Law Group. He utilized the swap power in his irrevocable trust. He exchanged the real estate in the irrevocable trust for stocks and cash having a value equivalent to the fair market value of the real estate on the date of the swap. At Roger's death, because the property is part of his gross estate, the property receives an adjusted basis of $11 million. If his estate or beneficiaries sell the property for $13 million, they will only pay capital gains tax on $2 million, the difference between the adjusted date-of-death basis and the sale price. Under this scenario, Roger's estate and beneficiaries avoid paying capital gains tax on $10 million by taking advantage of the swap power. So instead of paying 20% Federal capital gains taxes and 13.3% California taxes on $12 million, it is on only $2 million. That is $4 million vs. only $666 thousand. I think the beneficiaries will be glad to have the additional $3.3 million.   Grantor Retained Annuity Trust A grantor retained annuity trust (GRAT) is an efficient way to transfer asset appreciation to beneficiaries without using all or most of the gift tax exemption. After the donor transfers property to the GRAT and until the expiration of the initial term, the trustee of the GRAT (which is often the donor for the initial period) will pay the donor an annual annuity amount. In other words, you pay yourself the annuity. The annuity amount is equal to the applicable federal rate as a specified percentage of the initial fair market value of the property transferred to the GRAT. When zeroed out, the interest that remains should be valued at zero or as close to zero as possible. So, your retained interest terminates after the initial term. Any appreciation of the assets in the GRAT over the annuity amounts? Those pass to the beneficiaries. In other words, if the transferred assets appreciate at a rate greater than the historic low applicable federal rate, the GRAT will have succeeded in transferring wealth! Let's do another example. Kevin executes a GRAT with a three-year term when the applicable federal rate is 0.8 percent. He funds the trust with $1 million and receives annuity payments of $279,400 at the end of the first year, $335,280 at the end of the second year, and $402,336 at the end of the third year. Assume that during the three-year term, the GRAT invested the $1 million and realized a return on investment of 5 percent, or approximately $95,000. Over the term of the GRAT, Kevin received a total of $1,017,016 in principal and interest payments. Also, they transferred roughly $95,000 to his beneficiaries with minimal or no impact on his gift tax exemption.   Installment Sale to an Irrevocable Trust This strategy is similar to the intrafamily sale discussed before, except here the income-producing assets are sold to an existing irrevocable trust instead of directly to a family member. In addition to selling the assets, you also seed the irrevocable trust with assets worth at least 10 percent of the assets being sold to the trust. Why? To demonstrate to the Internal Revenue Service (IRS) that the trust has assets of its own and that the installment sale is a bona fide sale. Without the seed money, the IRS could recharacterize the transaction as a transfer of the assets with a retained interest instead of a bona fide sale. This would be very bad: The entire interest in the assets would be includible in your taxable estate. But this strategy not only allows you to pass appreciation on to your beneficiaries with less estate and gift tax consequences but also lets you maximize your remaining gift and generation-skipping transfer tax exemptions if the assets sold to the trust warrant a valuation discount. Example time. Wally owns 100 percent of his real estate investment business worth $100 million. He gifts $80,000 to his irrevocable trust as seed money. The trustee of the irrevocable trust purchases a $1 million interest in the family business from Wally for $800,000 in return for an installment note with interest calculated using the applicable federal rate. It can be argued that the trustee paid $800,000 for a $1 million interest because the interest is a minority interest in a family business and, therefore, only worth $800,000. A discount is justified because a minority interest does not give the owner much, if any, control over the family business, and a prudent investor would not pay full price for the minority interest. Under this scenario, Wally has removed $200,000 from his taxable gross estate while only using $80,000 of his federal estate and gift tax exemption.   Spousal Lifetime Access Trust With the threat of a lowered estate and gift tax exemption amount, a spousal lifetime access trust (SLAT) allows you to lock in the current, historic high exemption amounts to avoid adverse estate tax consequences at death. What happens is that you transfer an amount up to your available gift tax exemption into the SLAT. Because the gift tax exemption is used, the value of the SLAT's assets is excluded from the gross estates of both you and your spouse. An independent trustee administers the SLAT for the benefit of the beneficiaries. In addition to your spouse, the beneficiaries can be any person or entity, including children, friends, or charities. Your spouse may also execute a similar but not identical SLAT for your benefit. The SLAT allows the appreciation of the assets to escape federal estate taxation. In most cases, it is a useful asset protection strategy because the assets in the SLAT are generally protected against creditor claims. Also, because the SLAT protects against both federal estate tax and creditor claims, it is a powerful wealth transfer vehicle that can be used to transfer wealth to multiple generations of beneficiaries. For example, Karen and Chad are married, and they are concerned about a potential decrease in the estate and gift tax exemption amount in the upcoming years. Karen executes a SLAT and funds it with $11.58 million in assets. Karen's SLAT names Chad and their three children as beneficiaries and designates their friend Gus as a trustee. Chad creates and funds a similar trust with $11.58 million that names Karen, their three children, and his nephew as beneficiaries and designates a Bank as a corporate trustee, among other differences between the trust structures. Karen and Chad pass away in the same year when the estate and gift tax exemption is only $6.58 million per person. Even though they have gifted more than the $6.58 million exemption in place at their deaths, the IRS has taken the position that it will not punish taxpayers with a clawback provision that pulls transferred assets back into the taxpayer's taxable estate. As a result, Karen and Chad have saved $2 million each in estate taxes, assuming a 40 percent estate tax rate at the time of their deaths.   Irrevocable Life Insurance Trust An existing insurance policy can be transferred into an irrevocable life insurance trust (ILIT). The trustee of the ILIT can purchase an insurance policy in the name of the trust. You can make gifts to the ILIT that qualify for the annual gift tax exclusion, and the trustee will use those gifts to pay the policy premiums. Since the ILIT holds the insurance policy, the premium payments and the full death benefit are not included in the taxable estate. Furthermore, the insurance proceeds at the death will be exempt from income taxes.   When Should I Talk to an Estate Planner? If any of the strategies discussed above interest you, or you feel that potential changes in legislation will negatively impact your wealth, we strongly encourage you to schedule a meeting with us at your earliest convenience and definitely before the end of the year. We can review your estate plan and recommend changes and improvements to protect you from potential future changes in legislation.
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Tilden Moschetti
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