The 2010 Tax Relief Act gives you a chance to transfer substantial wealth free of tax, but you must act quickly.
The 2010 Tax Relief Act provides you with an extraordinary opportunity to significantly reduce gift, estate and generation-skipping transfer taxes and allow wealth of a magnitude unimagined by Congress to pass to family and friends tax-free.
The reunification of gift, estate and generation-skipping tax exemptions at $5 million and a reduction in all three rates to 35% until the end of this year should result in an avalanche of wealth transfering to younger generations. This is an unprecedented opportunity to escape transfer taxes and direct the tax savings to loved ones and charities. High exemptions and historically lower rates create a unique planning opportunity during 2012.
One reason to act quickly is that nobody knows if the $5 million exemption will be extended beyond 2012. Under the law, the estate, gift and generation-skipping exemptions will return to $1 million dollars in 2013 unless Congress passes a new tax bill. Given the federal deficit, you should not expect Congress to extend this benefit.
Another reason to act quickly is to transfer assets before they grow in value through a sale or appreciation over time. This values assets at their current, presumably low, fair market values for transfer tax purposes, and lets you gift future appreciation out of your estate. This is particularly important when an older family member wishes to transfer a family enterprise to younger family members at the lowest possible transfer cost. This type of planning is very effective if you are interested in preserving and maximizing wealth for the family for generations to come.
The following is a brief explanation of two popular techniques and the specific benefit of implementing them before the end of this year.
The Grantor Retained Annuity Trust (GRAT)
A GRAT is a trust into which the grantor gifts property and retains the right to receive an annuity payment for a period of years. The value of the gift is the actuarial value of the remainder interest after all of the annuity payments have been paid to the grantor. In recent years, a popular strategy has been to “zero out” GRATs so that, at the end of the trust’s term, the sum of the annuity payments is about equal to the principal plus accumulated interest, at a rate set by the IRS. This results in a gift with zero value at the end of the term.
The transfer benefits come into play when the trust’s assets appreciate at a higher rate than the presumed IRS interest rate. At the end of the trust’s term, this excess growth can be passed on to beneficiaries free of tax.
This strategy has become so popular that it was widely presumed it would be severely curtailed in any tax reform legislation last year. That did not happen. However there is no guarantee that Congress will not cut off this benefit at the end of the year.
This technique works best at times like now when interest rates are low. The lower the interest rate, the easier it is for the transferred asset to outperform the IRS hurdle rate. As of December 2011, a GRAT would only need to earn more than 2.8% annually for the planning to be successful. This rate is at historic lows.
Selecting the correct payout rate and term is vital. The risk that the grantor does not survive the term of the GRAT is a serious one because if the grantor dies before the trust expires some or all of the trust assets, including appreciation, will be included in the grantor’s estate.
Because the GRAT is a grantor trust, the individual who creates the GRAT pays any income tax due on the trust’s investments. This is actually advantageous, because the payment of the trust’s taxes by the grantor is not a gift for tax purposes. The assets of the GRAT will grow on a pretax basis, and the payment of taxes by the grantor serves as additional tax-free gifts to the trust.
For technical reasons, beneficiaries of GRATs should only be one generation younger than the grantor, meaning the GRAT is not a good multi-generational or dynastic planning vehicle. Certain types of investments, especially illiquid assets, present difficulties when placed in GRATs because the assets may not earn enough income to pay the annual annuity. It is also not uncommon to create a GRAT with a relatively small initial annuity payment that is increased up to 20% per year for the GRAT term. That is particularly helpful if the early years of an investment are expected to be less profitable.
Selling an asset to a grantor trust (IDGT) is similar to establishing a GRAT, but with a number of extra advantages. The transaction is an initial gift to the trust, followed by a sale of assets by the grantor to the trust in return for an installment note.
In the typical structure, an IDGT is a trust in which a grantor retains no beneficial interest and no right to distributions. As a result, the trust can be outside of the grantor’s taxable estate immediately. The grantor is responsible for payment of all of the trust’s income taxes. This allows the trust assets to effectively grow free of income taxes. Payment of the income taxes is a tax-free gift to the trust. There is a second income tax advantage to grantor trust status. In a grantor trust, all assets are considered owned by the grantor. For income tax purposes, it is synonymous with the grantor. Consequently, the grantor can sell assets to the trust without triggering immediate capital gains.
To use this strategy, the client forms the grantor trust and funds it with a gift of 10% of the assets ultimately to be transferred to the trust. The client then sells assets to the trust in exchange for a promissory note. A $10 million gift is now possible for married couples, which would allow a sale of towards $90 million of additional undiscounted assets for the promissory note. The grantor does not recognize any gain on the sale, but for gift and estate tax purposes, the trust is separate and apart from the grantor and is not included in his or her estate. If structured as a multi-generational trust, all future appreciation escapes transfer taxes.
The trust will repay the note using either the income generated by the asset transferred to it, or by cannibalizing the trust assets. The note will generally impose interest at the lowest permitted interest rate. In December 2011, the rate on a transfer of nine years could be as low as 2.8%. As long as the trust earns more than 2.8%, the transfer will be successful.
The sale to an IDGT trust has a hurdle rate that is below the rate set in a GRAT, does not have survivorship risk and can be used for multi-generational planning. The cash flows are flexible; notes are often partially amortizing or interest-only with a balloon at the end of the term. This flexibility is not possible with a GRAT. IDGTs are also often structured as dynasty trusts and, depending on the jurisdiction in which they are formed, can exist in perpetuity.