What do low interest rates, US tax policy and a depressed economy have in common? They have all aligned perfectly to create the most efficient wealth transfer planning environment possible. Every insurance advisor, wealth management firm, family office, trust and estate attorney, and CPA will tell you the same thing, assuming they are paying attention and understand estate planning. Let’s walk through the facts.
US Tax Policy – The Tax Cut & Jobs Act
In January of 2018 the Tax Cut and Jobs Act (TCJA) included a provision that doubled the federal gift, estate and generation skipping transfer tax exemption, raising the limit from $5.49 million in 2017 to $11.18 million in 2018, and keeping in place the indexing of this limit for future years. This is the amount of assets that an individual can gift, or otherwise transfer to another, without having to pay a tax on the transfer although a disclosure of the gift must be made to the IRS using Form 709
In 2020, the limit increased to $11.58 million per individual through inflation adjustments. This amount is announced annually by the Treasury Department. These amounts double for married couples, allowing them to transfer $23.16 million in 2020 without any transfer tax whatsoever. Due to a variety of political reasons that I won’t get into, this amount drops back to the previous $5 million limit (plus inflation adjustments) on January 1, 2026 due to a “sunset” provision in the TCJA. If we project that number out to 2026 assuming a 2% inflation factor, the exemption will drop to approximately $6.52 million per individual or $13.04 million per couple.
With proper forecasting and financial modelling, the right profile client should consider taking advantage of this doubling of the gift and generation skipping transfer tax exemption prior to 2026 because, as the law stands today, we know it will significantly decrease on January 1, 2026. In fact, there are already proposals in Congress that the exemption may drop further due to the need for revenue because of the burgeoning national debt. If the Democrats take over, you can almost be assured that the exemption will be reduced and likely sooner than 2026.
Many clients who are not in the ultra high net worth class may tend to hesitate when being asked to make a $5 or $10 million gift or transfer either to a trust or outright to children mostly because they fear that they might need the money in the future. So how can they take advantage of this unique wealth transfer opportunity? We will get to that in a minute.
Low Interest Rates
Due to the COVID pandemic, the Federal Reserve reduced interest rates dramatically, essentially to zero, in order to keep the economy afloat. The Treasury Department provides guidance via
Revenue Rulings on interest rates to be used for loans made between family members (intra-family loans), certain corporate arrangements, or trusts – it is called the Applicable Federal Rate. These revenue rulings provide various prescribed rates for federal income tax purposes for each month of the year, the most recent of which is Revenue Ruling 2020-14. Table 1 of RR 2020-14 contains the short-term, mid-term, and long-term applicable federal rates (AFR) for the current month for purposes of section 1274(d) of the Internal Revenue Code. Under section 1274(d)(1), the AFR is:
(i) in the case of a debt instrument with a term not over three years, the Federal short-term rate;
(ii) in the case of a debt instrument with a term over three years but not over nine years, the Federal mid-term rate; and
(iii) in the case of a debt instrument with a term over nine years, the Federal long-term rate.
Due to the Federal Reserve’s actions in light of the economic challenges in today’s economy, the current rates are historically low. In fact, a grantor can lend money to a trust or sell property to said trust in exchange for a lifetime note at 1.01% during the month of June. Again, more on this later, as we bring all three “stars” into alignment.
Depressed Economy – Equity, Property & Business Valuations
While equity markets have enjoyed a recent rebound since the precipitous drop in March of this year, there are still many assets that are in substantial decline that may be part of a taxpayer’s balance sheet. Some stock positions, privately held businesses, or commercial or residential real estate may still be suffering from the economic devastation caused by COVID-19 and may remain that way for some time.
Gifts, transfers or sales of depreciated assets that are expected to rebound in value provide an excellent opportunity to discount the valuation of the gift today if one would expect it to appreciate outside of the taxable estate of the grantor in the future. Furthermore, most owners of closely held businesses or income producing real estate own those properties in Limited Liability Companies or Partnerships which could afford an additional discount due to lack of control and marketability, so called valuation discounts. So, for example, the grantor would gift or sell LLC shares of an LLC that holds a commercial property at a discount versus selling the property itself. It is an ideal time to transfer or sell assets to trusts as part of an estate freeze or reduction strategy due to lower market valuations.
To summarize, a doubling of the gift and generation skipping transfer tax exemption, historically low interest rates and reduced asset valuations provide an incredible opportunity to execute a sound wealth transfer strategy that includes a huge amount of flexibility.
Consider a married couple (ages 65 and 60) who have 2 children and are worth $20,000,000, much of it comprised in illiquid assets or “tax-inefficient” to transfer assets, such as a closely held business, commercial real estate and qualified plan money. The attached diagram shows the proposed planning transaction.
As you review the numbers and the diagram, you will notice that the trust that is created can include spousal access provisions to allow the grantor and his spouse to access trust income if needed. This allows us to overcome the concern mentioned previously about having access to the amount transferred to a trust. Furthermore, generation skipping provisions could be elected to provide for future generations without having to distribute the trust corpus at the death of the 2 children .
The transaction provides a discounted sale of LLC interests in commercial real estate (which may or may not have lost value during the current recession) in exchange for a note using the long term AFR rate (currently at 1.01% for June 2020), plus a transfer of liquid assets (which may or may not have lost value in the current recession) of approximately 10% of the value of the note to provide economic substance to the transaction (the so called 9:1 Rule). The LLC interests are further discounted by 25% for lack of marketability and control (valuation discount). The commercial real estate is assumed to generate a 3% free cash flow after expenses such as mortgage principal and interest, repairs and maintenance, taxes, etc.
The trustee uses the free cash flow generated in the trust to pay interest on the note to the grantor and, in addition, to pay premiums for a 2nd to die life insurance policy. The trust will have additional cash flow for other needs or investments.
As the transfer is primarily in the form of a note, the grantor has the option to forgive the note and complete the gift should the gift and estate tax exemption be decreased. This would be done prior to the actual date of the proposed reduction by Congress thereby allowing the grantor to take advantage of the higher exemption amount. This provides extraordinary flexibility in planning.
To summarize the impact and benefits of this transaction:
- A $10MM transfer to the trust in exchange for a note due back to the grantor’s estate of only $7.5MM – an immediate $2.5MM gift tax free transfer for the benefit of the trust and its beneficiaries.
- A loan at 1.01% for the life of the grantor.
- A gift of $750,000 in liquid assets to the trust, thereby eliminating any possible estate taxes on its current value and any appreciation in the future. The taxpayer would need to file Form 709 and report the gift in excess of the annual exclusion amount available.
- The purchase of $10MM income and estate tax free proceeds though life insurance for the benefit of the trust and its beneficiaries.
- Trust cashflow greater than the interest and premium payments due by almost $110,000 which can be used for other purposes.
- No current gift tax or use of the lifetime exemption amount, other than the $750,000 gift for which Form 709 would need to be filed to report the gift.
- No current annual exclusion gifting required, allowing it to be used for other purposes such as outright gifts to the children in cash.
- Provisions for the non-grantor spouse to take income from trust assets if needed.
- Provisions to create a trust that could last for generations without transfer taxes.
- The ability to forgive the loan prior to any adverse action by Congress relative to the estate and gift tax exemption.
Please contact AgencyONE’s Marketing Department at 301.803.7500 for more information about this planning scenario or to discuss a case.
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