As the year 2019 was winding down, we, along with our clients, were optimistic about 2020. The stock market was hovering around its all time high and the U.S. economy was continuing to ascend. Many clients who owned closely-held businesses were operating in a sellers’ market and were beginning to take the necessary steps to bring their business to market. That was then. This is now. Life as we knew it has changed in only a matter of a few short months. So where do we go from here?
At Gunster, the health and safety of our clients, employees, and each of their families has remained as our top priority. We have encouraged our clients to meet with us virtually and we continue to serve our clients from wherever they, or we, may be working. We have spoken with many clients who have wished to revisit, discuss, or alter their estate plans in light of the changing world around us.
In addition, a number of clients have wanted to explore additional opportunities with respect to wealth transfer planning. A low interest rate environment combined with depressed asset values (for example, closely held businesses and publicly traded stock), is generally a potent combination conducive to many estate planning techniques. While the way we conduct business is evolving as we practice “social distancing,” many of our tried and true estate planning techniques remain as effective as ever. As such, below are some wealth transfer planning opportunities that our clients are considering in this new normal:
Gifting to Utilize Gift Tax Exemption
Grantor Retained Annuity Trust (“GRAT”)
Charitable Lead Annuity Trust (“CLAT”)
Gifting to Utilize Gift Tax Exemption
Each U.S. citizen has a combined exemption against gift and estate taxes that exempts a certain amount of his or her assets from those taxes. For 2020, that exemption amount is $11,580,000 (which amount is adjusted annually for inflation by the U.S. Department of the Treasury). Note, however, that under current law, the gift and estate tax exemption will be lowered to $5,000,000 (indexed for inflation after 2011) effective January 1, 2026 and thereafter. The primary advantage of lifetime gifting is that any appreciation in the gifted property between the date of gift and the date of the donor’s death generally will not be subject to federal or state estate tax. Gifting can be especially powerful when the assets being gifted have a depressed value (e., due to market turndown or other economic factors).
Grantor Retained Annuity Trust (“GRAT”)
The GRAT is a wealth transfer technique whereby a grantor makes a gift of assets to an irrevocable trust for certain named beneficiaries and retains the right to certain payments for a specified number of years chosen by the grantor (the “Retention Term”). Statistically speaking, the shorter the Retention Term of the GRAT, the more likely the GRAT will be successful. The minimum Retention Term must be two years. The grantor typically receives the same payment from the GRAT on an annual basis. At the end of the Retention Term, the property in the GRAT passes to the trust beneficiaries. The GRAT is “successful” if the assets held by the GRAT appreciate greater than the 7520 rate promulgated by the IRS. For April 2020, the 7520 is 1.2%, which like most other interest rates is historically low.
If the grantor survives the Retention Term, any appreciation on the GRAT assets after the date the GRAT is funded will pass to the grantor’s remainder beneficiaries free of gift or estate tax. If the grantor does not survive the Retention Term, then part or all (depending upon the terms of the GRAT) of the value of the assets as of the grantor’s date of death will be included in the grantor’s taxable estate (which is the same position the Grantor would have been in if the GRAT was not created). In addition, many GRATs are structured as “zeroed out” GRATs such that the gift tax consequences upon creation are nominal.
In a sale to an intentionally defective grantor trust (“IDGT”), the grantor sells assets to the IDGT in exchange for a promissory note bearing interest at a rate at least equal to the AFR, which rates for April 2020 are again, historically low, and may continue to drop in the coming months. The short-term AFR for April 2020 is 0.91%, the mid-term AFR is 0.99%, and the long-term AFR is 1.44%. Provided the assets in the IDGT appreciate greater than the AFR, the sale technique will be effective from a wealth transfer tax perspective. The value of the assets sold are “frozen” in value at the time of the sale such that all appreciation subsequent to the sale would pass to the trust beneficiaries free from any transfer taxes. Because the IDGT is a grantor trust for income tax purposes, the sale is ignored for income tax purposes and there is no gain or loss to report on the sale. Furthermore, when the IDGT pays interest to the grantor pursuant to the terms of the promissory note, the grantor does not have to recognize any interest income because the IDGT is a grantor trust for income tax purposes.
In addition, the IDGT should be “seeded” with sufficient assets to justify the issuance of the promissory note in connection with the purchase of the assets. Although there is no standard amount with which the IDGT should be funded, as a guideline, approximately 10% of the purchase price should be sufficient. Unless an individual already has an IDGT with sufficient assets to enter into the transaction, they would need to create a new IDGT and make a taxable gift to the IDGT to properly seed the IDGT. The grantor’s available gift tax exemption could be used to shield any such gift from the imposition of gift taxes.
Under this technique, an individual can lend assets to a family member in a younger generation, or to a trust for the benefit of younger generations, in exchange for a promissory note bearing interest at the AFR rate (described above). The loan will have no gift tax cost if (i) the value of the promissory note equals the value of the loaned assets and (ii) the promissory note bears an interest rate sufficient to avoid an imputed gift. Any appreciation of the loaned assets exceeding the interest rate passes to the borrower free of gift or estate tax. Further, an intra-family loan currently in existence may be re-financed using current rates.
Charitable Lead Annuity Trust (“CLAT”)
A CLAT is a “split interest” trust with both non-charitable and charitable beneficiaries. The CLAT’s charitable beneficiaries are entitled to begin receiving distributions upon the creation (and funding) of the trust. The charities will continue to receive payments from the trust for a term of years or during the life or lives of one or more individuals who are living when the trust is created. Upon the termination of the charitable interest in the CLAT, the remaining assets are distributed to the donor’s non-charitable beneficiaries. Because the non-charitable beneficiaries must wait to receive assets from the CLAT, the value of the gift to them is discounted (i.e., it is reduced) for estate and gift tax purposes. Depending on how the CLAT is structured, the benefits of a CLAT may include the ability to accelerate a current income tax deduction in the year the CLAT is created and a reduction in the donor’s estate and gift taxes. Similar to GRATs, the CLAT can be a “zeroed out” CLAT such that the gift upon creation is nominal. In addition, as with a GRAT, a CLAT is successful for wealth transfer tax purposes if the assets held by the CLAT appreciate greater than the 7520 rate promulgated by the IRS.
We hope our clients and their families stay safe during these unprecedented times. The Gunster Private Wealth Services Team is committed to providing our clients the first class service they have come to expect and we are here to help in any way we can. We ask that you do not hesitate to contact us if you would like to discuss your current estate plan or to explore if any of the foregoing planning options is right for you.
