There are a number of estate planning techniques that work more effectively in a low interest rate environment. Accordingly, our current economic environment presents unique wealth transfer opportunities, including Grantor Retained Annuity Trusts (GRATs), Sales to Intentionally Defective Grantor Trusts and Charitable Lead Trusts (CLTs). GRATs, Sales to Grantor Trusts and CLTs allow entrepreneurs, private equity investors and high net worth individuals the opportunity to pass large amounts of wealth to children, grandchildren and charities, with little or no gift and estate tax cost.
In 2016, an individual may gift during his or her lifetime the total sum of $5,450,000. Any gifts in excess of that amount are subject to a 40% maximum federal gift tax. At death, an individual may leave the total sum of $5,450,000 federal estate tax free. This estate tax exemption amount is inter-related to the lifetime gift tax exemption. For instance, to the extent the person made a gift of $2,000,000 during his or her life, then that person may only leave $3,545,000 at death without incurring a federal estate tax. The maximum federal estate tax on assets passed at death over $5,450,000 is currently 40%.
As of April 1, 2016, the New York State estate tax exemption will increase to $4,187,500 from $3,125,000. The size of the New York State estate tax exemption can be misleading, however, because if the value of the estate exceeds the exemption by 5% or more, the New York State estate tax exemption is completely eliminated. In that event, the estate will be taxed by New York State on dollar one. This is referred to as the “exemption cliff”. The New York State maximum marginal estate tax is 16%.
Because of this high rate of gift and estate tax, individuals seek to transfer wealth during their lives to their children, grandchildren and charities gift and estate tax free. The current environment of low interest rates presents unique opportunities for clients to make these gift and estate tax free transfers. These estate planning strategies rely on the Internal Revenue Service’s section 7520 interest rate, calculated by multiplying the average market yield — known as the applicable federal rate, or AFR — of certain U.S. obligations by 120%. Accordingly, when interest rates rise, so do the AFR and the 7520 rate. Because of the uncertainty as to how long these low interest rates will last and the unknown tax environment after the 2016 election, individuals should consider the tax advantages of entering into one of the three transactions described below.
A grantor retained annuity trust (GRAT) is a highly effective estate planning tool to be used with assets likely to appreciate in value (e.g., stock, partnership interests, closely held business interests). A GRAT is an irrevocable trust from which the grantor retains the right to receive annuity payments for a specified term of years. At the end of this retained term, assets contained in the trust pass to other remainder beneficiaries. The annuity payments made to the grantor during the term dramatically reduce the value of the gift of the remainder interest when the GRAT is established, so that only the net present value of the remainder interest is subject to gift tax. A GRAT produces estate and gift tax savings if the assets placed in the GRAT produce a total net return (net income and appreciation) in excess of the assumed discount rate under the Internal Revenue Code (2.2% for February 2016).
The annuity payments may be set sufficiently high so as to create a "zeroed-out" GRAT. With a zeroed-out GRAT, the net present value of the retained annuity payment stream equals 100% of the value of the assets placed in the trust. If the assets in the GRAT appreciate in value beyond the amount necessary to produce the retained annuity payments, then the value of the trust remaining at the end of the term of the trust will pass to the designated beneficiaries free of gift and estate taxes. A zeroed-out GRAT, in particular, is an excellent estate planning tool for an individual who has exhausted his or her lifetime gift tax exemption and who is already maximizing annual exclusion gifts (the annual exclusion allows an individual to give away up to $14,000 in 2016 to as many people as he or she wishes without those gifts counting against his or her lifetime gift tax exemption.)
There is virtually no downside to creating a GRAT. If the grantor dies before the expiration of the term of the GRAT, the assets remaining in the trust will be included in the grantor's taxable estate, with an appropriate credit being given for any gift tax paid when the trust was created. Similarly, if the trust assets decrease in value, so that there is nothing remaining in the trust at the expiration of the term, the grantor is returned to the same position as he or she was in prior to creation of the GRAT, with no tax costs having been incurred. In both instances, the grantor's loss is limited solely to the costs associated with establishing the GRAT.
The GRAT presents a way to pass excess growth and appreciation in assets to children without incurring gift or estate tax. While such a technique works only if the assets placed in trust appreciate beyond the applicable federal discount rate, the grantor is generally able to identify which assets are likely to do so. A GRAT generates the greatest transfer tax benefit in a low interest rate climate because it is more likely that the return on assets held by the GRAT will exceed the low interest rate.
SALE TO INTENTIONALLY DEFECTIVE GRANTOR TRUST
Where a grantor has income producing assets (for instance, commercial real estate subject to a long-term lease or a closely held business) that the grantor expects to appreciate significantly in value, a sale of that property to an income tax defective grantor trust is an attractive estate planning technique. Such a trust is deemed defective for income tax purposes because the grantor is considered to be the owner of the trust for income tax purposes, such that the grantor and the trust are deemed to be the same person with respect to income tax issues. Consequently, the sale of assets to the trust by the grantor does not result in any taxable capital gain. While the grantor is deemed the owner of the trust for income tax purposes, the trust is designed so that the trust assets are not includible in the grantor's taxable estate for estate tax purposes.
Typically, such a transaction takes the form of an installment sale over an extended term, with the trust's payment obligation to the grantor being evidenced by a promissory note. For tax reasons, the term of the note should not exceed the grantor's actuarial life expectancy. However, the note may contain a provision providing for the termination of the repayment obligation in the event the grantor dies prematurely. This provision presents the opportunity for a windfall to the grantor's beneficiaries in the event of an untimely death. However, the use of this provision requires that a premium be attached to the promissory note, either in the form of an increased principal amount or above-market interest rate.
This estate planning technique is useful where the property being sold will generate enough income to offset the promissory note payments. It is often wise to combine such a sale with a concurrent gift of other assets to the trust, in order to give the trust other means of repaying the note.
The benefit of this technique is that it presents the opportunity to transfer property at little or no gift or estate tax cost to the beneficiaries, while having the asset pay for its own transfer by applying the income stream to the promissory note payments. Moreover, since all of the income produced by the asset is taxed to the grantor, the grantor's payment of that income tax liability is, essentially, an additional tax-free gift to the beneficiaries of the trust.
CHARITABLE LEAD TRUST
A Charitable Lead Trust (CLT) is used to pass assets to family members at a reduced gift tax cost, while benefitting a charity. A CLT is a trust that gives a charity the right to receive funds for a fixed number of years, after which the funds pass to the grantor’s family members. The charity can be a private family foundation. The amount payable to charity can be either a fixed dollar amount each year (charitable lead annuity trust or CLAT), or a percentage of the value of the assets as redetermined each year (charitable lead unitrust or CLUT).
A CLT can be set up during the donor's lifetime, or on the donor's death. If the CLT is set up during the donor's life as a grantor trust for income tax purposes (so the donor is taxed on the income earned by the trust each year), then the donor can claim an income tax deduction when the trust is funded, but the donor will not get an income tax deduction as distributions are made to charity. If the trust is not set up as a grantor trust for income tax purposes, then the donor gets no income tax deduction when the trust is funded, but distributions to charity from the trust will be deductible against the trust's income.
Frequently, a CLT is set up under a revocable living trust or Will. The decedent's estate gets an estate tax deduction for a portion of the assets going into the trust. The amount of the deduction will depend on what kind of CLT (unitrust or annuity trust) is used, the payout rate, interest rates when the trust is funded and the length of the charitable term. A CLT works well if the donor has assets which are likely to increase in value far faster than the IRS assumed rate of interest, or if valuation discounts can be claimed to reduce the value of the assets going into the CLT.
It is important to note that the President’s budget proposal for Fiscal Year 2016 proposes adverse changes in how GRATs may be structured. In addition, the President’s budget proposal calls for eliminating the benefits of sales to grantor trusts. The United States Treasury Department is expected to issue proposed regulations, in the near future, which may limit valuation discounts that apply to some or possibly all family owned businesses, such as family limited partnerships and limited liability companies. These regulations may have a significant impact on the estate planning techniques described herein. As a result of these proposed changes and possible rising interest rates, the time to act is now.
LARA SASS is the Managing Attorney at Lara M. Sass, PLLC,
a boutique firm, located in Roslyn and Manhattan, New York,
dedicated exclusively to the practice of trusts and estates law.