Estate and Succession Planning
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Estate Planning Issues and Opportunities Under the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act, which took effect in 2018, significantly increased the gift/estate tax exemption and generation-skipping transfer (“GST”) tax exemption amounts, which currently are $11,400,000 and are scheduled to increase to $11,580,000 in 2020 (this amount is $10,000,000 indexed for cost-of-living adjustments after 2010). The temporary increase in exemption amounts is set to sunset on December 31, 2025, at which time the exemptions are scheduled to decrease to $5,000,000 (indexed for cost-of-living adjustments after 2010).
The increased exemption amounts are a political issue, so it is possible that the temporary increase in the exemptions could be terminated prior to 2026 or that the increase could be made permanent prior to 2026. The President’s Fiscal Year 2020 Budget Proposal contains a proposal to make the increased exemption amounts permanent.
This Article will address some estate planning opportunities presented by and methods of taking advantage of the temporary increase in exemption amounts.
Review of Current Documents
It is important for individuals to review their current estate planning documents. If their documents were executed, or last updated, prior to 2018 and contain formula gifts at death based on their unused gift/estate tax exemption, then the increase in exemptions could result in an unintended or unfavorable distribution of assets. Below is an example that illustrates the importance of having one’s current estate planning documents reviewed.
Assume that an individual had their current estate planning documents executed in 2001 when the gift/estate tax exemption was $675,000. Assume further that this individual provided a formula amount equal to their remaining gift/estate tax exemption to be distributed to their children and the balance of their assets to be held in a marital trust for their spouse. If the individual were to die in 2019, then $11,400,000, reduced by any prior gift/estate tax exemption used in respect to lifetime gifts, would be distributed to the children potentially leaving no assets for the marital trust for their spouse. This result can easily be avoided by reviewing current documents and making necessary revisions.
Planning Opportunities
One way of utilizing the increased exemption amounts is to make gifts prior to their scheduled decrease in 2026. Making large gifts is more attractive now than it was before 2018 due to the increased exemption amounts. Individuals have an incentive to make gifts large enough to use most or all of their exemption amounts before 2026 in order to ensure that none of the increased gift/estate tax and GST tax exemption amounts are forfeited.
Below are two examples that illustrate the benefits of making gifts prior to 2026 using the unindexed exemption amounts of $5,000,000 and $10,000,000 for simplicity. If an individual made a gift before 2026 that brought the total amount of their gifts up to $5,000,000, then the individual would pay no gift tax on the gifts. In 2026, when the gift/estate tax exemption is scheduled to decrease to $5,000,000, the individual would have no exemption left to offset estate tax at their death (i.e., the benefit of the additional $5,000,000 of exemption that existed through 2025 would be lost).
However, if the individual made gifts before 2026 that brought the total amount of their gifts up to $10,000,000, then the individual would pay no gift tax on the gifts. In 2026, when the gift/estate tax exemption is scheduled to decrease to $5,000,000, the individual would have no exemption left to offset estate tax at their death, but there would be no penalty for using the extra $5,000,000 of exemption prior to 2026.
Keep in mind that an individual’s gift/estate tax exemption and GST tax exemption are reduced by the amounts previously used in respect to prior gifts, if any.
There are dozens of different planning initiatives to potentially utilize the increased exemptions and reduce one’s estate tax burden. Each of them works best, or works at all, under specific circumstances. Some of the more common initiatives that are likely to reduce the estate tax and GST tax that will be due after death are discussed briefly below. These include (i) a gift to an irrevocable trust, (ii) a sale to an irrevocable, grantor trust, (iii) the transfer of assets to a grantor retained annuity trust (“GRAT”), (iv) forgiving outstanding loans to family members, (v) the allocation of GST tax to an existing irrevocable trust that is not wholly exempt from GST tax, and (vi) a gift to a spousal lifetime access trust (“SLAT”), if applicable.
Gift to an Irrevocable Trust
An individual could utilize the increased gift/estate tax exemption by making a lifetime gift of assets, such as marketable securities or an interest in an entity (e.g., corporation, limited liability company (“LLC”) or partnership) to an irrevocable trust for the benefit of their spouse, children and grandchildren or only their children or grandchildren (their “descendants”). The individual could then allocate GST tax exemption to the gift, which would allow the trust to continue for multiple generations without the imposition of any type of transfer tax (a “dynasty trust”). The use of an irrevocable trust also would provide protection from potential future creditors of the beneficiaries.
The gift would have to be reported on a gift tax return and, if an interest in an entity was involved, then the value of the interest in the entity must be supported by a business valuation report.
The benefits of a gift described above to an irrevocable trust would be that (i) the individual could utilize a portion of both their increased gift/estate tax exemption and GST tax exemption before they are scheduled to decrease in 2026, (ii) any future appreciation on, and income generated by, the assets held in the irrevocable trust would avoid estate tax at the individual’s death, (iii) the assets would not be subject to any type of transfer tax for multiple generations, and (iv) the assets would be protected from most of the beneficiaries’ creditors.
Sale to an Irrevocable, Grantor Trust
An individual could sell assets to an irrevocable, grantor trust for the benefit of their descendants. If the trust is a grantor trust for income tax purposes, then all of the items of income, gain, deduction and credit would be treated as if realized by the grantor and reported on the grantor’s individual income tax return (i.e., the trust would be ignored for income tax purposes). More importantly, because the individual and the grantor trust are treated as the same taxpayer for income tax purposes, the individual would not realize a taxable gain on the sale of assets to the trust.
After establishing the irrevocable, grantor trust, the individual would make a “seed” gift of cash to the trust in an amount approximating 10% of the value of the interests they were going to sell to the trust. For example, if the individual intended to sell interests in an entity with a total value of $4,000,000 to the trust, then they would make an initial cash gift of $400,000 to the trust. They would allocate $400,000 of GST tax exemption to the initial transfer, making the trust wholly exempt from GST tax.
The trust would purchase the interests from the individual and provide a promissory note (the “Note”) for $4,000,000. The interest rate on the Note would have to be at least equal to the applicable federal rate (“AFR”) determined by the IRS for the month of the sale in order to avoid adverse tax consequences. The Note would have a maturity date in nine years in order to use the mid-term AFR. The Note could be renegotiated and extended prior to the maturity date if the entire principal amount could not be repaid at that time.
The accrued interest on the Note should be paid annually in order to avoid adverse tax consequences. It would be preferable, but not necessary, if some principal could be repaid each year. The source of the interest payments and principal payments, if any, would be the initial “seed” gift and cash flow from the entity sold to the trust, if any.
The benefits of the sale would be that (i) any future appreciation of the assets and cash flow from the assets in excess of payments on the Note, would avoid estate tax at the individual’s death, (ii) the assets would not be subject to any type of transfer tax for multiple generations, and (iii) the assets would be protected from most creditors of the beneficiaries. The unpaid principal and accrued interest on the Note at death would be subject to estate tax, however. Moreover, the sale would not utilize any portion of the increased gift/estate tax exemption and GST tax exemption, although some would be utilized by the “seed” gift of cash.
Gift to a GRAT
A GRAT also may be used to transfer assets. A GRAT is an irrevocable trust in which the grantor retains the right to receive a series of annuity payments for a period of years. When the annuity payments end, the assets could pass to an irrevocable trust for the benefit of the grantor’s descendants.
A GRAT will be successful in transferring wealth to an individual’s descendants only if the return (income and appreciation) on the assets transferred to the GRAT exceeds the interest rate used to determine the value of the series of annuity payments to the grantor (the “Section 7520 Rate”). The Section 7520 Rate is determined by the IRS each month.
If the grantor were to die during the term of a GRAT, then most, if not all, of the value of the assets in the GRAT at the grantor’s death would be subject to estate tax. In order to mitigate the risk of the grantor’s death during the term of a GRAT, the term usually is limited to two years or life insurance is purchased to provide liquidity to pay potential estate tax.
In many cases, the grantor will contribute the assets coming back to them each year in the form of the annuity payments, or substitute different assets with a greater appreciation potential, to a new 2-year GRAT and continue the process until the desired amount has been transferred. This type of planning is referred to as a series of “rolling GRATs.”
There are multiple methods of structuring the annuity payments from a GRAT, including (i) a percentage of the value of the assets contributed to the GRAT that would provide a reasonable return (i.e., 5%), (ii) a large percentage (i.e., 50% or greater), which reduces the amount of the gift at the time the GRAT is funded to nearly zero, (iii) a percentage that increases each year, and (iv) a percentage that decreases each year. The choice of the structure of the annuity depends on the nature of the assets transferred to the GRAT, the anticipated return on the assets, the individual’s goals and other factors.
As an example, using the section 7520 rate for November of 2019, if an individual transferred assets with a value of $1,000,000 to a 2-year GRAT paying an annual annuity of 5.0%, then the initial gift would be $902,920. Assuming the assets returned 10% a year, then $1,105,000 could pass to an irrevocable trust for the individual’s descendants at the end of the 2-year term of the GRAT.
Alternatively, using the section 7520 rate for November of 2019, if an individual transferred the same assets to a 2-year GRAT paying an annuity of 51.0%, then the initial gift would be $9,784 and $139,000 could pass to an irrevocable trust for the individual’s descendants at the end of the 2-year term of the GRAT.
The primary benefit of a gift to a GRAT is to leverage the use of the exemptions (i.e., transferring assets with a value greater than the amount of gift/estate tax exemption used).
Forgiving Existing Loans
An individual could consider forgiving outstanding loans to their children or other descendants. The outstanding principal and interest on a note that is forgiven would be considered a gift.
For example, assume an individual loaned $500,000 to their child and received a promissory note in return. Later, after the child has paid back $200,000 of the original amount, the individual forgives the debt. The $300,000 principal balance plus any accrued interest would be a gift to the child.
The discharge of a debt generally results in income to the debtor. In circumstances involving family members, however, the discharge of a debt generally will be treated as a gift and there would be no adverse income tax consequences to the debtor.
If the individual does not want to forgive the loan outright but would like to trigger a gift and utilize the increased exemption amount, then they could transfer a promissory note from a child to a trust for the benefit of their spouse or other descendants. This strategy allows the individual to provide a source of income to their spouse or descendants while using up a portion of the increased exemption amounts and maintaining the debt owed by the child.
For example, if an individual transferred a promissory note from a child into an irrevocable trust for the benefit of their grandchildren, then the child would still be obligated to make payments in accordance with the terms of the note. The individual would have made a completed gift of the outstanding principal and accrued interest to the trust, utilizing a portion of their gift/estate tax exemption and GST tax exemption, reduced the amount of their estate, and provided a benefit to their grandchildren.
The primary benefit of forgiving existing loans is that it allows for the utilization of a portion of the increased gift/estate tax exemption, and possibly GST tax exemption if the gift is made to a skip person (i.e. grandchild), without having to transfer any investment assets or interests in entities.
Late Allocation of GST Tax Exemption
If an individual wants to take advantage of the increased GST tax exemption but does not want to make additional gifts, then they could consider making a late allocation of GST tax exemption to prior gifts.
There are two types of GST skips: direct skips and indirect skips. Direct skips occur when a gift is made directly to a skip person (i.e., a person two or more generations younger than the individual making the gift or a trust with only skip persons as beneficiaries). An indirect skip occurs when an event occurs that leaves only skip persons as beneficiaries of an existing trust (i.e., the death of a child who is a beneficiary of the trust leaving only the child’s descendants or beneficiaries of the trust).
Direct skips always have received an automatic allocation of GST tax exemption. After December 31, 2000, all indirect skips also received an automatic allocation. However, prior to that date, the allocation for indirect skips was not automatic. In addition, after 2000 it was possible to opt out of the automatic allocation rules on gift tax returns.
The individual would need to review their gift tax returns to determine if GST tax exemption was properly allocated and, if not, whether they could make a late allocation.
The benefit of making a late allocation to an existing trust is that the individual could utilize a portion of their increased GST tax exemption before it is scheduled to decrease in 2026 without making an additional gift and the trust could continue for multiple generations without the imposition of any type of transfer tax.
The drawback of a late allocation is that the amount of GST tax exemption that must be allocated is based on the value of the property on the date of the late allocation. Therefore, the individual could be allocating GST tax exemption to appreciation that already has occurred.
Gift to a SLAT
The final alternative discussed in this Article is the possibility of a creating a “spousal lifetime access trust” (“SLAT”). A SLAT is an irrevocable, discretionary trust for the benefit of one’s spouse, or one’s spouse and other descendants.
A SLAT is a form of grantor trust, which means that the trust would be ignored for income tax purposes and all of the items of income, gain, deduction and credit would be treated as if realized by the grantor and reported on the grantor’s individual income tax return. The gift would be reported on the grantor’s gift tax return.
The benefits of a SLAT would be that (i) the grantor would utilize a portion of their increased gift/estate tax exemption, and possibly GST tax exemption if skip persons also were potential beneficiaries of the trust, (ii) any future appreciation on, and income generated by, the assets transferred to the trust would avoid estate tax at the individual’s death, (iii) if GST tax exemption was allocated to the SLAT, then the assets would not be subject to any type of transfer tax for multiple generations, and (iv) the assets would be protected from most creditors of the beneficiaries.
The grantor’s spouse also could create a SLAT for the grantor’s benefit and utilize their exclusion as well. If both the grantor and their spouse create a SLAT, then it is essential that the terms of the trusts be sufficiently different to avoid the application of the reciprocal trust doctrine. This doctrine is used by the IRS as a way of “uncrossing” identical trusts, which would eliminate the tax benefits by causing inclusion of the assets in the SLATs created by the grantor and the grantor’s spouse in their respective estates at their deaths.
