By Daniel R. Bernard, Associate
There is a Chinese curse which says ‘May he live in interesting times.’ Like it or not we live in interesting times. They are times of danger and uncertainty; but they are also more open to the creative energy of men than any other time in history.”- Robert Kennedy, Day of Affirmation Address, University of Capetown, Capetown, South Africa, June 6, 1966.
Once again, I hope as you are reading this you and your family are well. It is not breaking news that the novel coronavirus pandemic has wreaked havoc on the global economy. Although some of the losses have been recovered, the stock market as a whole is down approximately 25% from the record peaks of February. In an effort to soften the blow, the Federal Reserve has lowered interest rates to near historic lows. The stock market decline and the low interest rate environment due to the novel coronavirus pandemic offer unique estate tax planning opportunities for higher net worth individuals, including intra family loans, grantor retained annuity trusts, sales to intentionally defective grantor trusts and gifts.
Federal and New York State Estate Tax Exemption
In December 2017 President Donald J. Trump signed into law the Tax Cuts and Jobs Act (the “TCJA”). Among other provisions, the TCJA doubled the federal estate and gift tax exemption amount from $5 million to $10 million, adjusted for inflation. For example, for 2020 the federal estate and gift tax exemption is $11,580,000. However, the doubling of the federal estate and gift tax exemption is scheduled to sunset on December 31, 2025, and revert back to the previous $5 million exemption, adjusted for inflation. The estate and gift tax exemption is a unified credit, meaning the more of the gift tax exemption you use during your life the less estate tax exemption you will have remaining at your death.
New York State has an estate tax exemption for 2020 of $5,850,000. New York State does not impose a gift tax, but New York State does “claw bac” the value of any gifts made within three years of death. So, unlike the federal estate tax, all of the strategies discussed below will not cause you to have less New York State estate tax exemption at your death, as long as you survive three years from the date of the gift.
Sale to an Intentionally Defective Grantor Trust (“IDGT sale”)
In an IDGT you would sell an asset to an intentionally defective grantor trust, (the intentional defect makes the trust income taxable to you, as the person establishing the trust, but removes the trust property from your estate for estate tax purposes), in exchange for a promissory note. This acts as an “estate tax freeze” by locking in the value of the asset at the time of the sale and allowing the asset to continue to appreciate in the trust, outside your estate. The standard practice in initiating an IDGT sale is for the seller to make a gift to the trust of 10% of the asset value, so that the trust has adequate initial capital to make note payments. This is where the first benefit comes in, with the market downturn the valuation of assets you may wish to sell in an IDGT sale has decreased, therefore the amount of estate and gift tax credit needed to fund the trust with 10% of the sale assets has decreased as well.
The second benefit is that the assets are sold in exchange for a promissory note, which must at a minimum bear interest at the Applicable Federal Rate (“AFR”). The AFR rates for April are: .91% for any loan with a term less than three years, .99% for any loan with a term greater than three years and shorter than nine years, and 1.44% for any loan with a term greater than nine years. The interest rates having decreased to near record lows, means that the minimum interest on the promissory note is lower, making the note payments lower. The benefit of lower note payments is twofold, one, the ability to keep more of assets in the trust and out of your estate, and two the ability to transfer more assets for the same payment than when interest rates were higher.
Grantor Retained Annuity Trust (“GRATs”)
Similar to an IDGT sale, a GRAT is a transfer of assets to an irrevocable trust, except instead of receiving back a promissory note, you would reserve the right to an annuity for a set period of time. The annuity payment is a combination of: 1. a partial return of the principal; and 2. interest calculated at the AFR rate. At the end of the GRAT’s term the trust beneficiaries receive the remaining trust assets. The amount of estate and gift tax exemption used in a GRAT is the value of the property transferred to the trust reduced by the retained annuity payments. In a “zeroed out GRAT” the GRAT pays back the full value of the assets transferred plus the minimum required interest, therefore, using zero estate and gift tax exemption.
GRATs work best in low interest rate environments because for a GRAT to be successful the trust assets must appreciate more than the value of the interest payments. Therefore, in a low interest rate environment the trust assets have a lower bar to outperform in order to make the GRAT successful. The best assets for a GRAT are those where you expect to see a lot of appreciation, because any growth in the assets beyond the AFR rate is essentially a tax free gift to the trust beneficiaries. Current market conditions are ideal for GRATs because interest rates are low and asset values are depressed.
Intra Family Loans
Another use of the low interest rate environment is to make low interest loans to family members, such as your children and grandchildren. If you make a loan and do not charge any interest, the IRS will impute the interest they feel should have been charged. In order to avoid imputed interest treatment, you can charge the AFR rate for the loan. The loan can be structured to be an interest only loan for a set period of time, with a balloon payment at the end of the loan term. The benefit to low interest loans is that the debtor can have access to the loan principal for investment and any appreciation on the invested assets over the interest payments is additional estate and gift tax free assets transferred to your child or grandchild, because if you invested the loan principal yourself any appreciation on the assets would remain in your estate for estate tax purposes.
For example, using the April AFR rates, if you were to make a loan to your son of $100,000 for ten years, he would owe you annual interest payments of approximately $1,400. So over the ten year term would pay a total of approximately $14,000 of interest. If the trust assets grew by 5% per year for the ten year term, at the end of ten years there would be a gain of approximately $62,000. Subtracting the total interest payments would leave a gain of approximately $48,000, that would belong to your son estate and gift tax free.
Lastly, with the market downturn and the decreased value of assets, another option to consider would be the gifting of assets to children or grandchildren, either outright or in trust. Any assets gifted now would use a portion of your lifetime estate and gift tax exemption, and any appreciation on those assets would be outside of your estate for estate tax purposes.
One caveat with gifting is basis. When a property is purchased the purchaser has a tax basis in the property equal to the purchase price. If depreciation deductions are taken on the property, the basis in the property decreases. If improvements are made to the property, the basis increases. If the property is transferred to another party as a gift, the other party has the same basis in the property as the person who made the gift. Upon the sale of the property, a capital gain tax is assessed for the difference between the basis in the property and the purchase price. The capital gains rates are approximately 15-20% for federal and 4% to 8.82% for New York state (New York treats capital gains as ordinary income). However, upon your death, most assets in your estate receive a “basis step-up” to their fair market value on the date of your death. If your heirs decided to immediately sell the property, no capital gains tax should be due. Therefore, if considering gifting, the best assets to gift are those that have a higher basis. Also, since the estate tax rates are higher than the capital gains rates, it is better to plan to avoid the estate tax than the capital gains tax.
The Robert Kennedy quote at the beginning of this article, spoken almost 54 years ago, feels as relevant today as the day he uttered these now famous words. Of course, Kennedy’s speech was about civil rights, not a worldwide pandemic, but I believe the sentiment is the same, like it or not, we live in interesting times, and those interesting times have brought with them a unique opportunity for estate tax planning. The estate planning attorneys at Twomey, Latham, Shea, Kelley, Dubin & Quartararo are available at your convenience to answer your questions, review your current estate plan to ensure it continues to meet your needs or to discuss the implementation of an estate and succession plan.
Please stay safe and be well.