I do not have an answer to this question, but it really doesn’t matter. With 2020 right around the corner, it is not too early to act if there is flexibility built into your client’s estate plan. There is much discussion about what might happen if the Democratic Party wins the presidential election in 2020, but I will bet just about anything that if they do, this “gift” will become the subject of much debate and the exemption may be reduced well in advance of the current sunset date of January 1, 2026. [(Click here for more information on the history of the Federal Gift and Estate Tax Exemptions from 1997 through 2019 or here for a more in-depth history dating back to 1916 from the Commerce Clearing House (CCH), A Historical Look at Estate and Gift Tax Rates). The important thing to note is how vulnerable the Federal Gift and Estate Tax Exemptions are to the economic and political cycles in the United States.]
If you are an advisor with clients who have meaningful estates and who are unaware of the doubling of the lifetime federal gift tax exemption afforded by the Tax Cut and Jobs Act of 2018, then shame on their tax advisors or maybe, shame on you! The doubling of the federal gift tax exemption, which went into effect in January of 2018, is arguably one of the most powerful planning tools available to wealthy families in the history of the gift and estate tax system. It is a political hot potato, however, and fragile at best.
Let me quantify this for you.
Assume that a family is worth well in excess of the current estate tax exemption of $22,800,000 and that they reside in a state with no current estate or inheritance tax. Every dollar over $22,800,000 is really only worth sixty cents. Why? Because the estate tax is 40% of the amount in excess of the exemption amount. So, assume that through a well thought out financial plan, an amount of $5,000,000 is deemed “not needed” for the long-term livelihood of the family and is deemed legacy capital. If left invested inside the estate, that amount, TODAY, is only worth $3,108,000 – a tax loss of $2,072,000! In 25 years, as seen in the table above, the value of the asset would have grown to almost $14,000,000, assuming a pre-tax return of 6% and a 30% combined income and capital gains tax rate. The estate tax would confiscate almost $5,600,000 leaving almost $8,400,000 to heirs.
If the VERY SAME asset were moved to an irrevocable trust TODAY, just that alone would save $5,600,000 in estate taxes in 25 years. Not only would the $5,000,000 be preserved, but ALL OF THE GROWTH would, forever, be exempt from estate taxes.
If you learned nothing more than this, I have accomplished my goal. Forget about life insurance or leveraging up the gift for a moment. This is the FIRST and ONLY decision that is in the best interest of your clients and their beneficiaries. In our example, you have saved them $5,600,000 on a gift of $5,000,000 simply by taking money out of one pocket and putting it in the other. If you can get a client to understand this and take action, you are providing meaningful advice.
Here is the big objection. Many clients, depending on their lifestyle, financial goals and legacy objectives, may have some reluctance in forever parting with the $5,000,000 in our above example. Remember, a gift to a trust must be deemed an irrevocable gift for it to be out of the taxable estate – it is no longer available, nor can it be enjoyed by or benefit the grantor(s). Careful financial planning must be conducted to show that this money will NOT be needed because most people are more afraid of running out of money in their lifetime than they are of paying taxes.
There are many options on how to structure a legacy transfer if an outright gift is not within the comfort zone of a client. I mentioned in my opening statement that “it is not too early to plan if you have flexibility built into your estate plan”. Let’s explore this further.
Option #1 – Grantor Loan to an Irrevocable Trust
Many clients might rather lend the $5,000,000 to a trust in return for an annual interest payment from the trust and potential for repayment of the $5,000,000 at some point in the future, either during life or at death. The Internal Revenue Service provides guidance on how to structure a demand note and the interest rate that should be charged for this loan arrangement. Continuing our example, if the grantor lent the assets to the trust in exchange for a demand note in the amount of $5,000,000, the trustee of the trust would invest these assets in the same manner as if a gift had been made in our prior example. We use the same assumptions in the table shown just above.
The difference is that out of the earnings from the trust, an interest payment must be made to the grantor on an annual basis. The current blended rate under IRC Section 7872 is assumed at a rate of 2.42%.
This example shows the grantor “demanding” his or her money back at the end of the 10th year, presumably because the money was needed for lifestyle or other needs. This scenario was able to remove all growth in excess of the interest paid to the grantor from the estate, leaving in excess of $1,100,000 out of the estate over a 10-year period.
What is critical in this example is that the investments in all probability should earn in excess of the Applicable Federal Rate (AFR), which is currently at 2.42%. The 7872 rate, as it is called, is restated every July, but alternatively the short-term AFR could be used and interest calculated monthly, as explained in the Evans Estate Law Resource article. The short term AFR is 1.85% for September 2019. Interest rates are historically low, so grantor loans to trust arrangements are particularly attractive.
Option 1.1 – Grantor Loan to an Irrevocable Trust with Loan Forgiveness and Gift Completion
This option is called 1.1 because it starts the same way as Option 1 but ends differently. Instead of calling the note, the grantor forgives the loan. This creates an interesting “off-ramp” of the loan arrangement in the current uncertain political and tax environment.
Continuing our example, the grantor loans $5,000,000 to his or her trust. It is invested and managed just like Option 1.
Nothing has happened politically, and the doubling of the estate and gift tax exemption is scheduled to “sunset” on January 1, 2026 (at the end of the 7th year). The grantor of the trust has the flexibility to forgive the loan prior to the sunset date and complete the gift. Until that time, he or she had the option to demand payment or forgive the loan, thereby completing the gift. Again, this should only be done in an environment where the grantor is confident that other assets will be enough to satisfy his or her lifetime spending needs.
This scenario creates a “having your cake and eating it too” option between now and January 1, 2026 when the doubling of the estate and gift tax exemption will sunset, allowing a family to act now instead of waiting. For an explanation of why this should be done now, please read Option 2 below.
Option 2 – Leverage Trust Assets with Survivorship (2nd-to-Die) Life Insurance
Until now, I have discussed investing the proceeds gifted or lent to the trust at a 6% taxable return. But a grantor may instead choose to leverage these assets by placing the proceeds either systematically or as a lump sum into a second-to-die life insurance product. There are many products in the market, with and without guarantees and with or without early cash value riders, which will allow similar exit strategies as discussed in the outright gifting scenario as well as Options 1 and 1.1 above.
Assuming a healthy 60-year-old couple (male and female age 60), a $5,000,000 single premium can purchase $24,500,000 GUARANTEED DEATH BENEFIT FOR LIFE with a high early cash value rider. The trust would have to earn a 9.4% pre-tax return to grow to $24,500,000 over a 25-year period. This policy would be a modified endowment contract (MEC), and this must be taken into consideration in the planning.
Now for the explanation of why this should be done now. The younger and healthier your clients are, the more attractive the insurance solution will be. Don’t wait until a client has been diagnosed with diabetes, cancer or a heart condition.
There are a myriad of ways to fund second to die life insurance that go beyond the scope of this discussion, including paying premiums from invested assets over time, so as to not create a MEC contract, but this will give you a flavor for the efficiency of this product in this scenario.
Option 2.1 – Leverage Trust Assets with Survivorship (2nd-to-Die) Life Insurance with Spousal Access Provisions
Adding spousal access provisions to a trust is another way to access assets from a trust during the grantor’s lifetime. The important distinction here is that only the husband OR wife can be the grantor, while the other would be a trust beneficiary.
If this option is pursued, the life insurance would be designed to not be a MEC, thereby allowing tax favored distributions from a policy in the event that cash was needed for the reasonable health, education, maintenance and support of the trust beneficiary, which in our scenario would be the non-grantor spouse.
Option 3 – Gift or Lend Assets and Use Premium Financing
This is a sophisticated and complex arrangement whereby commercial premium financing could be deployed to pay for life insurance premiums, while investing the assets as part of the collateral for the premium finance loan, in addition to the policy’s cash value.
I could continue to provide you with options because the alternatives are endless. The important point is that the sun will set eventually (or not) but the January 1, 2026 date is written into the law, until changed. The political environment is equally uncertain, for the 2020 election and future elections as well. Regardless of what you think is going to happen, our client’s gift and estate planning should NOT be subjected to the whims of the political process. Flexibility in planning is key.
With the favorable gift tax exemption, the low interest rate environment and a generally healthy economy, there is no better time to engage in estate planning and taking advantage of the current gift tax exemption limit. And it should not be overlooked that all these scenarios work for someone whose net worth is under the current exemption amount as well.
AgencyONE has built a variety of analytical tools and has the capability to customize presentations on these ideas. Please call AgencyONE\’s Marketing Department at 301.803.7500 for more information or to discuss a case.