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Be Proactive!

August 13, 2016



Proposed Regulations Affecting Valuation of Family-Controlled Entities


Long-awaited proposed regulations were recently issued by the U.S. Treasury on August 2, 2016. These regulations would, if adopted, have a significant impact on the valuation, for gift, estate and generation-skipping transfer tax purposes, of interests in family-controlled entities.


Under current law, discounts for lack of control and minority interests are typically applied by appraisers when owners of family businesses transfer company interests to their children and loved ones.  These discounts substantially reduce the amount of gift, estate and generation-skipping transfer tax exemption an owner uses to make the transfer. 


The primary aim of these proposed regulations is to treat the lapse of voting or liquidation rights as an additional transfer, and to disregard certain restrictions on liquidation in determining the fair market value of a transferred interest.  The result would be to eliminate or substantially limit the lack of control and minority discounts for transfers of interests in a family-controlled entity.


If the proposed regulations become effective, taxpayers will have lost a highly effective estate planning technique, and the cost of transferring interest in family-owned entities will increase substantially.  Business owners who are contemplating the transfer of interest in the family business should consider making the transfers as soon as possible, as there is a small window of opportunity to take action before these proposed regulations become effective.  These rules are expected not to become effective before December of this year, making it necessary to complete any discount-related planning during the next several months.  While proactive planning is imperative in light of the proposed regulations, it is important to remain mindful of the estate tax proposals made by Hillary Clinton and Donald Trump.


Clinton and Trump Estate Tax Proposals


Whether or not you are interested in transferring interest in a family-controlled entity, it is important to ensure that estate planning serves multiple purposes and provides numerous benefits, other than the minimization of gift and estate taxes.  Given today’s environment, where the future of the gift and estate tax is uncertain, it is critical to focus on other motivations of planning, such as asset protection, divorce protection, creditor protection and others benefits. 


Hillary Clinton and Donald Trump have set forth dramatically different proposals with respect to the gift and estate tax.  Clinton proposes a $1 million gift tax exemption (a decrease from the current $5.45 million gift tax exemption); a $3.5 million estate tax exemption (a decrease from the current $5.45 million exemption); and a 45 percent estate and gift tax rate (an increase from the current 40 percent rate).  In sharp contrast, Trump proposes to completely eliminate the estate and gift tax.

If Clinton wins the election, we may experience a repeat of 2012 (when the exemption was expected to decline to $1 million) with a frenzied rush to complete complex estate planning to utilize the current $5.45 million lifetime gift and estate tax exemption before it experiences a steep drop to $3.5 million.  Those who have not used all of their exemption may favor making gifts to non-reciprocal spousal lifetime access trusts (SLATs) or domestic asset protection trusts (DAPTs).  For those who have used all of their exemption, there may be a push to implement long-term grantor-retained annuity trusts (GRATs) or sales to intentionally defective grantor trusts (IDGTs) to lock in the current historically low interest rates and to implement these techniques before proposed restrictions become effective that restrict their use.  


If Trump wins the election, an estate plan that was structured to meet multiple goals will have strong merits regardless of whether or not the gift and estate tax is repealed.  If we experience a period with no estate tax, it would present an enormous opportunity to shift as much wealth as possible to irrevocable trusts in order to attain asset protection from creditors, predators and divorcing spouses.


If individuals wait until the last minute to plan, some of the same issues that were of concern with 2012 planning will revisit once again.  If individuals procrastinate planning, they will run into legal road blocks (the reciprocal trust and step transaction doctrines), and may face difficulties transferring assets from one spouse to the other in order to allow them both to utilize their remaining gift tax exemptions.  Those who made gifts to trusts for their loves ones in 2012, rather than using spousal lifetime access trusts or domestic asset protection trusts that they could access, were extremely disappointed when they later tried unsuccessfully to unravel the planning.  Instead, there is planning that can be accomplished now to prepare for the contingency of either candidate winning the election.  Such planning will allow the full use of an individual’s exemption before it is significantly reduced, in the event Hillary wins, while offering the benefit of having achieved excellent asset protection in the event that Trump prevails.  Ideally, such a plan will also provide ultimate flexibility by allowing the individual to benefit from the assets, whether directly or indirectly. 


Thus, time is of the essence.  Proactive planning now is critical given the proposed regulations virtually eliminating discounts for transfer of interests in family-controlled entities and the dramatically different pre-election estate tax proposals.  Below is a brief overview of the aforementioned techniques, two of which I have covered in previous articles, but which merit review here.


Spousal Lifetime Access Trust (SLAT)


A spousal lifetime access trust (SLAT) constitutes a transfer planning option that balances a donor's desire to make lifetime gifts with the need to retain adequate funds to support his or her needs.  


The SLAT is a lifetime irrevocable trust created for the benefit of the donor’s spouse, which allows the donor to use his or her current $5.45 million gift tax exemption, while indirectly benefitting from the trust assets (through distributions to the spouse) should the need arise.  Additionally, in New York, where state gift taxes are not imposed but state estate taxes are, a lifetime gift to a SLAT can result in reduced state estate tax exposure.  In addition, the trust can purchase life insurance on the donor’s life, while avoiding income taxes on the growth within the policy and allowing policy death benefit proceeds to pass free of income and estate taxes.  


As an irrevocable trust, the SLAT can also protect trust assets from the beneficiaries’ creditors. Further, if the donor allocates his or her generation-skipping transfer tax exemption to the gifts to the SLAT, the donor can structure the SLAT as a dynasty trust that benefits multiple generations of his or her descendants without the imposition of additional transfer taxes. 


Domestic Asset Protection Trust (DAPT)


A properly formed and operated self-settled DAPT is generally an irrevocable trust to which an individual transfers assets, while simultaneously (i) retaining a beneficial interest in those assets and (ii) denying creditors access to them.  Asset protection trusts may also be drafted as third party asset protection trusts.  A third party asset protection trust is an irrevocable trust created for third party beneficiaries, and allows such beneficiaries to serve as their own trustees, while protecting the trust assets from creditors of the beneficiaries.  A combination of the self-settled and third party asset protection trusts is called the hybrid domestic asset protection trust (“hybrid DAPT”).  In the case of the Hybrid DAPT, the settlor is not an initial discretionary beneficiary of the trust, but can be added later.  This type of DAPT may provide increased protection over the traditional DAPT. 


Grantor Retained Annuity Trust (GRAT)


A grantor retained annuity trust (GRAT) is a highly effective estate planning tool to be used with assets likely to appreciate in value.  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 (currently at the historically low rate of 1.4%!)


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.


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.


Sale to Intentionally Defective Grantor Trust (IDGT)


Where a grantor has income producing assets (for instance, commercial real estate subject to a long-term lease) 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 includable 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 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.


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