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What are Wealth Transfer Strategies in an Election Year?

by | Oct 12, 2020 | Estate Planning

Have you considered what impact the election has on your wealth planning and the transfer of wealth to your children? There is a new focus by the Democratic party to reduce federal estate taxes to their historic norms if Joe Biden is elected President. Those of us with less than a million dollars probably don’t have too much to worry about. Those with more than a million, however, should start being cautious. Taxpayers should act now before Congress passes legislation that could adversely impact their estates. Currently, the federal estate and gift tax exemption is set at $11.58 million per taxpayer. Estate Assets that exceed the exemption available at death are taxed at a federal rate of 40 percent (with Pennsylvania also have an inheritance tax paid to the state starting at the first dollar of the decedent’s assets). Each asset included in the decedent’s estate receives an income tax basis adjustment so that the asset’s basis equals its fair market value on the date of the decedent’s death. Thus, beneficiaries realize capital gain upon the subsequent sale of an asset only to the extent of the asset’s appreciation since the decedent’s death. At least that’s how it is for now…

This election could have a great impact on the current wealth transfer rules. It is being discussed that if former Vice President Joe Biden wins the election, it could mean not only lower estate and gift tax exemption amounts but also the end of the longtime taxpayer benefit of a stepped-up basis at death. To avoid the negative impact of these potential changes, there are a few wealth transfer strategies it would be prudent to consider before the year-end.

Notes and Sales Within Your Family

The Federal Reserve lowered the federal interest rates to stimulate the economy in response to the Coronavirus Pandemic. Individuals should consider loaning funds or selling one or more income-producing assets, such as an interest in a family business or a rental property, to a family member in exchange for a promissory note that charges interest at the federal rate. This allows an individual to provide money to a family member on more flexible terms than a commercial loan. If the investment of the loaned funds or income resulting from the sold assets produces a return greater than the applicable interest rate, the individual transfers wealth to a family member without using that individual’s estate or gift tax exemption. Pretty cool right?

Swap Power for Basis Management

Property or accounts transferred to an irrevocable trust do not receive a step-up in income tax basis at the individual’s death. It is important to know that gifted assets instead retain the carryover basis, potentially resulting in significant capital gains realized upon the subsequent sale of any appreciated assets. 

This is why we often advise people to think twice before “gifting” their house to their children while they are alive and well. The step-up basis is significant. 

Exercising a “swap” power allows an individual to exchange one or more low-basis assets in an existing irrevocable trust for one or more high-basis assets currently owned by and includible in the individual’s estate for estate tax purposes. In this way, low-basis assets are positioned to receive a basis adjustment upon the donor’s death, and the capital gains realized upon the sale of any high-basis assets, whether by the trustee of the irrevocable trust or any trust beneficiary who received an asset-in-kind, may be reduced or eliminated.

Example: Donnie purchased real estate in 2008 for $3 million and gifted the property to his irrevocable trust in 2011 when the property had a fair market value of $6 million. Donnie dies in 2020, and the property has a date-of-death value of $13 million. If the trust sells the property soon after Donnie’s death for $17 million, the trust would be required to pay capital gains tax on $14 million, the difference between the sale price and the purchase price. Let us say that before Donnie died, he utilized the swap power in his irrevocable trust and exchanged the real estate in the irrevocable trust for stocks and cash having a value equivalent to the fair market value of the real estate on the date of the swap. At Donnie’s death, because the property is part of his gross estate, the property receives an adjusted basis of $13 million. If his estate or beneficiaries sell the property for $17 million, they will only pay capital gains tax on $4 million, the difference between the adjusted date-of-death basis and the sale price. Donnie’s estate and beneficiaries avoid paying capital gains tax on $10 million by taking advantage of the “swap” power. 

What do you think?

Grantor Retained Annuity Trust (GRAT)

A grantor retained annuity trust (GRAT) is an efficient way for someone to transfer the increase in the value of an asset to beneficiaries without using, or using a minimal amount, of the individual’s gift tax exemption. After the individual transfers property to the GRAT and until the expiration of the initial term, the trustee of the GRAT (often the individual themselves for the initial term) will pay the individual who set up the GRAT an annual annuity amount. The annuity amount is calculated using the applicable federal rate as a specified percentage of the initial fair market value of the property transferred to the GRAT. A zeroed-out or Walton GRAT is intended to result in a remainder interest (the interest that is considered a gift) valued at zero or as close to zero as possible. The individual’s retained interest terminates after the initial term, and any appreciation on the assets in excess of the annuity amounts passes to the beneficiaries. If the transferred assets grow at a rate greater than the federal rate, the GRAT will succeed in transferring wealth.

Example: Bryan executes a GRAT with a three-year term when the applicable federal rate is 0.8 percent. He funds the trust with $1 million and receives annuity payments of $279,400 at the end of the first year, $335,280 at the end of the second year, and $402,336 at the end of the third year. Assume that during the three-year term, the GRAT invested the $1 million and realized a return on investment of 5 percent, or approximately $95,000. Over the term of the GRAT, Kevin received a total of $1,017,016 in principal and interest payments. This also accomplished transferring approximately $95,000 to Bryan’s beneficiaries with minimal or no impact on his gift tax exemption. 

Installment Sale to an Irrevocable Trust

This strategy is similar to the family sale I mentioned above, however, the income-producing assets are sold to an existing irrevocable trust instead of directly to a family member. In addition to selling the assets, the individual also seeds the irrevocable trust with assets worth at least 10 percent of the assets being sold to the trust. The seed money is used to demonstrate to the Internal Revenue Service (IRS) that the trust has assets of its own and that the installment sale is a bona fide sale. Without the seed money, the IRS could recharacterize the transaction as a transfer of the assets with a retained interest instead of a bona fide sale, which would result in the very negative outcome of the entire interest in the assets being includible in the individual’s taxable estate. This strategy not only allows individuals to pass the asset growth to their beneficiaries with limited estate and gift tax implications but also gives individuals the opportunity to maximize their remaining gift and generation-skipping transfer tax exemptions if the assets sold to the trust warrant a valuation discount.

Example: Robert owns 100 percent of a family business worth $1 million. He gifts $8,000 to his irrevocable trust as seed money. The trustee of the irrevocable trust purchases a $100,000 dollar interest in the family business from Robert for $80,000 in return for an installment note with interest calculated using the applicable federal rate. It can be argued that the trustee paid $80,000 for a $100,000 interest because the interest is a minority interest in a family business and therefore only worth $80,000. A discount is justified because a minority interest does not give the owner much if any, control over the family business, and a prudent investor would not pay full price for the minority interest. Under this scenario, Robert has removed $20,000 from his taxable gross estate while only using $8,000 of his federal estate and gift tax exemption.

Spousal Lifetime Access Trust (SLAT)

With the threat of a lowered estate and gift tax exemption amounts looming based on this election, a spousal lifetime access trust (SLAT) allows educated people to lock in the current, historic high exemption amounts to avoid adverse estate tax consequences at death. The individual transfers an amount up to that individual’s available gift tax exemption into the SLAT. Because the gift tax exemption is used, the value of the SLAT’s assets is excluded from the gross estates of both the individual and their spouse. An independent trustee administers the SLAT for the benefit of the individual’s beneficiaries. In addition to the individual’s spouse, the beneficiaries can be any person or entity including children, friends, and charities. The donor’s spouse may also execute a similar but not identical SLAT for the individual’s benefit. The SLAT allows the appreciation of the assets to escape federal estate taxation and, in most cases, the assets in the SLAT are generally protected against creditor claims. Because the SLAT provides protection against both federal estate taxation and creditor claims, it is a great transfer option that can be used to transfer wealth to multiple generations of beneficiaries.

Example: Kylie and Chase are married, and they are concerned about a potential decrease in the estate and gift tax exemption amount in the upcoming years. Kylie executes a SLAT and funds it with $11.58 million in assets. Kylie’s SLAT names Chase and their three children as beneficiaries and designates their friend Greg as a trustee. Chase creates and funds a similar trust with $11.58 million that names Kylie, their three children, and his nephew as beneficiaries and designates Fulton Bank as a corporate trustee (among other differences between the trust structures). Kylie and Chase pass away in the same year when the estate and gift tax exemption is only $5 million per person. Even though they have gifted more than the $5 million exemption in place at their deaths, the IRS has taken the position that it will not punish taxpayers with a clawback provision that pulls transferred assets back into the taxpayer’s taxable estate. As a result, Kylie and Chase have saved over $2.6 million each in estate taxes assuming a 40 percent estate tax rate at the time of their deaths. 

Irrevocable Life Insurance Trust (ILIT)

An existing insurance policy can be transferred into an irrevocable life insurance trust (ILIT), or the trustee of the ILIT can purchase an insurance policy in the name of the trust. The individual can make gifts to the ILIT that qualify for the annual gift tax exclusion, and the trustee will use those gifts to pay the policy premiums. Since the insurance policy is held by the ILIT, the premium payments and the full death benefit are not included in the donor’s taxable estate. Furthermore, the insurance proceeds at the donor’s death will be exempt from income taxes. This couldn’t be better, could it?

When Should I Talk to an Estate Attorney?

If you are just now asking yourself first town, the answer is now. If any of these ideas interest you, or you feel that the election may negatively impact your wealth, we strongly encourage you to schedule a meeting with us at your earliest convenience and definitely before the end of the year. We can review your estate plan and recommend changes and improvements to protect you and your loved ones.  

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