Highlights Of Some Advanced (And Not So Advanced) Estate Planning Techniques
For those of you with substantial assets or who have already used your federal estate tax exemption amount (i.e., $5,120,000 in 2012 or $5,250,000 in 2013) to make large gifts to family members, trusts or others, this Article will highlight some additional planning techniques for you to consider to help minimize the growth of your estate and your federal estate taxes at death. The combined federal gift and estate tax exemption amount (the “Federal Exemption Amount”) increased to $5,340,000 in 2014. For others, this Article will highlight some important techniques that you should consider in your estate planning.
This Article is only a high-level summary of the techniques outlined herein. Please consult with a member of McGrath North’s Tax Group for a more detailed discussion of these planning techniques, along with any related pros, cons and restrictions.
1. Grantor Retained Annuity Trust. Under current law, you may use a zeroed-out grantor retained annuity trust (a “GRAT”) as a technique to pass assets to your designated beneficiaries free of gift and estate taxes.
With this technique, you would transfer assets to the GRAT in return for annuity payments, which would be equal (in total) to the original, fair market value of the transferred assets over the GRAT term (selected by you) plus interest at the hurdle rate set by the IRS for the month the GRAT is funded (e.g., 2.20% for April 2014) (the “Hurdle Rate”). The payment of the annuity to you during your life should not be a taxable event. The ideal assets for a GRAT are assets that (a) are expected to appreciate, (b) produce income or dividends, and/or (c) may be easily valued.
If the assets in the GRAT appreciate at a rate in excess of the Hurdle Rate, any funds remaining in the GRAT after the term ends should pass to your designated beneficiaries free of estate or gift taxes. Although you should not be viewed as making a gift to the beneficiaries of the GRAT, we recommend filing a Gift Tax Return to report the GRAT transaction as a $1 gift to start the statute of limitations running for gift tax audit purposes.
To illustrate this idea, if you fund a 5-year GRAT with $2,000,000 in April 2014, and the annuity payments are back-loaded (with each annuity payment increasing 20% over the previous annuity payment), you should receive approximately $2,151,000 back over the 5-year period (i.e., the original fair market value of the transferred assets plus appreciation at the Hurdle Rate). If the GRAT assets appreciate at 6% per year, the balance of approximately $302,000 (remaining after the final annuity payment) should pass to your designated beneficiaries free of estate and gift taxes. A GRAT generally should not be used for generation-skipping transfers.
If you die during the term of the GRAT, you should not be in a worse position, estate-tax wise, for having implemented the GRAT (other than the legal costs to set up the GRAT) because the assets in the GRAT should receive a step-up in basis to date of death value. However, in such event, you would not receive any benefit from the GRAT. Thus, we recommend setting the term of the GRAT for a period that you are likely to survive.
2. Sale to Funded Irrevocable Trust and/or Purchase of Life Insurance. If you have already established an Irrevocable Dynasty Trust or other Irrevocable Trust (“IT”) and funded the IT with assets, you could sell additional assets to the IT in exchange for a Promissory Note. This technique helps freeze your estate with respect to the transferred assets at the value of the transferred assets plus the interest due on the Promissory Note. Under current law, any appreciation in the transferred assets (in excess of the interest due on the Promissory Note) should pass to the designated beneficiaries of the IT free of estate and gift taxes. Although this technique involves a sale of assets to the IT and not a gift, we recommend reporting the sale on a Gift Tax Return to start the statute of limitations running for gift tax audit purposes.
If the IT is a “grantor trust”, the sale will be a non-taxable event and you will pay the income taxes generated by the IT’s assets during your life. This is a great benefit to the beneficiaries of the IT as your payment of such income taxes allows the assets in the IT to grow on an income-tax free basis for the beneficiaries. In addition, under current law, your payment of such income taxes is not treated as a gift to the beneficiaries of the IT, and helps reduce your taxable estate. The beneficiaries of the IT may be your children, grandchildren and/or others, and the IT may be designed as a generation-skipping trust to benefit multiple generations.
To illustrate this idea, if you sell $2,000,000 in assets to the IT for a 9 year Promissory Note and (a) the transferred assets appreciate at 6% annually, (b) annual interest is paid on the Note at 1.81% (i.e., the April 2014 rate), and (c) all principal is due at the end of the 9-year term, the wealth transfer to the designated beneficiaries of the IT after 9 years could amount to approximately $957,000. The benefit would be even greater if the IT is a “grantor trust” and/or the assets transferred (x) appreciated more than 6%, (y) produced income or dividends, and/or (z) could be discounted for lack of control, vote and/or marketability (e.g., non-voting stock in a corporation or non-voting interests in a limited liability company).
An IT is also a great vehicle to purchase life insurance on your life, if you are insurable. The IT could also purchase life insurance on a child’s life, if desired, especially if the IT is intended to help support multiple generations. The income from the assets in the IT could be used to pay the premiums on the life insurance policy. If structured properly, the life insurance proceeds should not be included in your estate and should be available for the IT beneficiaries after your death free of estate and gift taxes.
3. Additional Gifts Utilizing the Increase in Federal Exemption Amount. As mentioned above, the Federal Exemption Amount increased from $5,250,000 in 2013 to $5,340,000 in 2014 (i.e., an increase of $90,000). You may use this $90,000 increase to make additional non-taxable gifts to family members, trusts or other persons. If you are married, you and your spouse may make additional non-taxable gifts of $180,000 as a result of such increase.
In addition, if the Federal Exemption Amount increases in 2015 and subsequent years for inflation, as scheduled, you may make additional non-taxable gifts each year to your desired beneficiaries to reflect each year’s increase.
4. Payment of Tuition and Health Expenses for Family or Others. You may pay tuition for your children, grandchildren and/or others directly to the applicable educational institutions. If the tuition is paid directly to the educational institutions, the tuition should not constitute a gift under current law and should reduce your estate.
You may also pay premiums for health/dental insurance and uncovered medical/dental bills for your children, grandchildren and/or others directly to the hospitals or applicable service providers. If the premiums and medical payments are made directly to the hospitals or applicable service providers, the payments should not constitute gifts under current law and should reduce your estate.
Because these types of payments are not gifts, they do not reduce your Federal Exemption Amount or your annual exclusion amount (discussed below).
5. Annual Exclusion Gifts to Family or Others. You may make annual exclusion gifts each year (i.e., $14,000 per person for 2014) to your children, grandchildren and/or others to help reduce your estate. These non-taxable gifts may be made every year to your desired beneficiaries and do not reduce your Federal Exemption Amount.
Instead of making an annual exclusion gift to a beneficiary directly, you could make this gift to a 529 educational account for the beneficiary or a trust for the beneficiary. These gifts are not income to the recipient.
6. Charitable Lead Annuity Trust or Outright Charitable Bequests. To the extent you want some of your assets to pass to charity during your life or at death, under current law, you may establish a zeroed-out charitable lead annuity trust (“CLAT”). A zeroed-out CLAT is a trust to which you may contribute assets and the CLAT would pay a qualified charity (selected by you) an annuity amount for the term of the CLAT (also selected by you, but the duration of which is sufficiently long to reduce the taxable remainder to zero). The assets remaining in the CLAT at the end of the term would pass to your designated beneficiaries free of estate and gift taxes. This idea is similar to the GRAT only a charity (instead of you) receives the annual annuity payment.
For example, assume that you establish a $2,000,000 zeroed-out CLAT with a term of 15 years and a back-loaded annuity amount (with each annuity payment increasing 20% over the previous annuity payment), the amount passing to your designated beneficiaries at the end of the 15-year term (assuming a 6% growth rate of the CLAT assets) would be approximately $1,522,000 while an estimated $2,536,000 would pass to charity.
If a CLAT is established at death, your estate should receive an estate tax charitable deduction for the full fair market value of the assets passing to the CLAT, which should minimize federal estate taxes. If you are married, this type of planning is often structured in the survivor’s estate.
Of course, for simplicity, you may also make outright bequests directly to qualified charities at death to help minimize your federal estate taxes. However, with an outright bequest to charity, no additional assets pass to your designated beneficiaries free of estate and gift taxes. During life, you may also make gifts to qualified charities, which should result in an income tax deduction on your income tax return (subject to certain limitations), and helps reduce your estate.
7. Loans to Family or Others at Favorable Interest Rates. You may also use intra-family loans as a simple method to transfer assets to your family members or others without gift tax and with minimal legal fees. With an intra-family loan, you may lend funds to a family member or other person in exchange for a Promissory Note bearing interest at the required rate set by the IRS. For example, the required annual interest rate for a 9-year term Promissory Note signed in April 2014 is only 1.81%.
In the current environment, you may take advantage of these low interest rates by using available cash resources (including borrowing capacity) to lend cash to your family members or others (or their respective businesses) to help them (a) make investments or purchases, (b) grow their business, and/or (c) pay off higher-interest debt to commercial lenders.
For loans made in April 2014, the following interest rates are required for the following loan terms: (a) 0.28% for a 1-3 year loan, (b) 1.81% for a 4-9 year loan, and (c) 3.32% for a 10 year+ loan. If a borrower realizes a rate of return greater than these rates, the excess appreciation results in a tax-free gift to the borrower.
Please consult with a member of McGrath North’s Tax Group to discuss these techniques in more detail and other planning techniques.
