April 21, 2020
When the Tax Cuts and Jobs Act (“TCJA”) was passed at the end of 2017, it provided unprecedented, although temporary, estate planning opportunities by doubling the federal gift, estate, and generation-skipping transfer tax (“GST”) exemption amounts. As a result of the TCJA, for years 2020 to 2025, these amounts are $11,580,000 per person (indexed for inflation). In 2026 and beyond, the exemption will revert back to the exemption amount prior to the TCJA, which was $5,000,000 per person (indexed for inflation). In 2017, that amount was $5,490,000. Congressional action could also result in federal estate tax increases before 2026.
Coupling these record-high federal gift and GST tax exemption amounts with the current economic conditions resulting from COVID-19 offers a significant opportunity to efficiently use these exemption amounts. If commentators’ prediction of a “V” or “U” shaped recovery comes to fruition, the gifting strategies discussed below could shift significant wealth free of federal gift, GST, and estate taxes.
Strategy 1: Gift Depreciated Assets
Due to the declines in the stock market and business valuations, now is a great time to gift stock or other business interests to family members or irrevocable trusts. The amount of gift tax exemption used for a gift is the fair market value of the asset on the date of the gift. After the gift is made, future appreciation, e.g., any rebound from the COVID-19 downturn, would be transferred to the recipient gift tax free. Gifts of depreciated assets could be made outright to children, or to irrevocable trusts that benefit a spouse, children, and future generations. Gifts in trust also provide protection from most creditor claims and is a partial defense against a former spouse seeking a division of the trust property.
Gifting minority or non-voting interests in a family-owned business can further reduce the value of gifts for federal gift tax purposes. For example, if an LLC holds undiscounted assets or a business worth $1,000,000 and the LLC’s capital structure is comprised of, for example, a 1% voting interest and 99% non-voting interests, then certain valuation discounts can be applied to reduce the value of a gift of non-voting interests. For example, a gift of a 10% non-voting interest wouldn’t be $100,000, but something closer to $65,000 to $75,000 after discounts for lack of marketability and control are applied.
Strategy 2: Take Advantage of Record Low Interest Rates
The current market conditions have led to historically low interest rates. The applicable federal rate (“AFR”) is the minimum interest rate that the IRS allows for related party loans. For May 2020, the short-term AFR is .25% (loans of up to 3 years), the mid-term AFR is .58% (loans of 3 – 9 years), and the long-term AFR is 1.15% (loans greater than 9 years).
Many estate planning tools involve the use of loans to family members or irrevocable trusts, and these techniques offer even greater opportunity for efficient wealth transfers when rates are so low. An intra-family loan itself does not result in any gift (and therefore, no use of exemption) because the funds, plus interest at the AFR, are expected to be repaid. However, as the lender, a portion of the loan could be forgiven each year up to the annual gift tax exclusion amount (currently $15,000) without using any exemption (however, forgiven interest is still taxable income). Low interest rates allow more interest and principal to be forgiven each year without the use of any exemption at all. Additionally, if the borrower is able to earn a rate of return on the principal that exceeds the interest rate, the excess passes to the borrower without the use of any exclusion or exemption. For example, assume a parent loans $1,000,000 to his or her child for a promissory note that matures in three years. If the loan is made in May 2020, the note is only required to bear interest at an annual rate of 0.25%. The child reinvests the loan proceeds in AA rated-90 day corporate commercial paper bearing interest at 2%, per annum. At the end of three years, the parent receives the principal payment of $1,000,000 and annual interest of $2,500, before income tax. The child keeps annual interest of $20,000 or a three-year total of $60,000 before income tax. No gift tax liability is incurred by the parent. This transfer is in addition to the $30,000 that the parent and his or her spouse can gift annually to the child gift tax free.
For pre-existing intra-family loans, now is a great time to refinance the loan to a lower interest rate. It is also a great time to consider intra-family sales of closely-held business interests with seller financing at these very low interest rates. These very low interest rates also make installment sales to irrevocable trusts extremely attractive in many cases.
Grantor Retained Annuity Trust
Another estate planning tool that works most efficiently in low interest rate environments is a grantor retained annuity trust (“GRAT”). A GRAT is a trust in which the grantor (the person making the gift to a trust) transfers assets that are anticipated to appreciate, but the grantor retains a right to receive an annuity payment from the trust each year for a fixed number of years. If properly structured, the taxable gift upon creation of the GRAT should be zero. This can be accomplished when the value of the annuity stream is equal to the value of the gift plus a rate of return (which is determined by the IRS). The rate of return set by the IRS is based on the current AFR (discussed above) and is known as the 7520 rate. After the annuity is paid, the leftover assets, i.e., the appreciation over the IRS-determined rate of return, are given to the GRAT’s beneficiaries (either outright or in a continuing trust for their benefit) gift tax free. The 7520 rate for May 2020 is .8%. This means that if publicly traded stock is gifted to a GRAT, and it fully recovers to pre-COVID-19 values during the GRAT term, all of that appreciation over the historically low 7520 rate will pass free of any gift tax or use of any exemption. That’s why a combination of publicly traded stock expected to recover, with a low 7520 rate, makes GRATs a potentially very successful estate planning tool. This tool also may be applied to make tax efficient transfers of interests in closely-held businesses.
As an example, if you transfer $2,500,000 to a zeroed out GRAT with a two-year term in May of 2020 and the stock appreciates 5%, roughly $160,000 would pass to the GRAT beneficiaries gift tax free at the end of the term. If the stock appreciated 10%, approximately $370,000 would pass to the GRAT beneficiaries gift tax free. If the market makes a full recovery post COVID-19 and the stock appreciates 25%, over $1,000,000 would pass to the GRAT beneficiaries gift tax free. With the current gift tax rate of 40%, that would be a $400,000 savings!
Strategy 3: Use Record High Gift Tax and GST Exemption Amounts Before They Expire
Although the incredibly low interest rates offer a great opportunity to pass wealth without using any gift tax exemption, the current record-high exemptions are likely “use it or lose it.” Thus, gifting strategies that do use exemptions should be considered, as these exemptions are already set to reduce in 2026. The exemption amount may reduce sooner and/or reduce to less than $5,000,000 depending on the results of the federal election this November.
The presumptive Democratic nominee, Joe Biden, has expressed plans to dramatically alter the current gift and estate tax law. Under current law, if you purchased stock for $100,000 and upon your death, the stock was worth $200,000, the beneficiary would receive the stock with a basis of $200,000. The beneficiary could then sell the stock the next day for $200,000 and realize no capital gain, even if no estate tax was paid at death. Joe Biden’s plan would eliminate this step-up in basis at death, and tax any unrealized appreciation in the decedent’s assets upon his or her death. Under Biden’s proposal, lifetime gifts would also trigger the income tax on any unrealized appreciation of the gifted asset. The exact details of how this would work still need to be addressed, and, of course, would also require congressional approval. We don’t know much about Biden’s plans for the estate and gift tax exemption amount, but it is anticipated it would return at least to the pre-TCJA amount, and perhaps sooner than 2026. Others have suggested a reduction of the exemptions amount to $3.5 million per decedent / donor.
Strategy 4: Optimize Charitable Giving
A charitable lead annuity trust (“CLAT”) offers an opportunity for an individual to both provide to charitable organizations and still pass on wealth to family members. A CLAT is a trust to which a person contributes assets and the trust pays a charity a fixed amount for a fixed number of years (or over a specified individual’s lifetime), and the assets remaining in the trust at the end of the term return to the non-charitable trust beneficiaries (often children or grandchildren). A CLAT is beneficial because on the transfer of assets to the trust, the gift is the difference between the value of the assets and the value of the charity’s interest. Current economic conditions make CLATs an efficient use of gift tax exemption because due to the substantial decrease in the interest rate used to determine the value of the charity’s interest, the value of the charity’s interest is now greater, which results in a significantly lower gift for gift tax purposes.
If you would like to discuss these and additional gifting opportunities during this unprecedented time, please contact any member of the McGrath North Tax & Estate Planning Group.
If you have any questions about this alert, please contact the Tax members of our COVID-19 Response Team indentified below.
Contact information for the complete McGrath North’s COVID-19 Response Team can be found here.
For information regarding additional business-related concerns centered around COVID-19, please visit our COVID-19 Resource Guide here.