Today’s economic environment presents unique estate planning opportunities for high-net-worth clients to consider with their trusted tax and legal advisors. Assuming your clients are comfortable that they have more than sufficient assets to support their lifestyle, today’s lower valuation of “excess assets” (including marketable securities and real estate) may make them excellent candidates for lifetime gifts.
Lower valuations potentially mean less gift tax exposure on both the federal and the state level. As always, family dynamics and other tax considerations should be evaluated before making these transfers. The graph on this page shows the IRC Section 7520 rate, a “key” estate planning interest rate, during the month of September from 1989 to the present.
Note that while the trend is down on a historical basis, the 7520 rate has been moving up this year: from a low of 2.0% in February to 3.4% today. While the 7520 rate is used when contemplating an estate plan, it is also representative of other rates used, including the short-term, mid-term and long-term applicable federal rates (AFR). While it’s not too late to leverage planning strategies that benefit from low interest rates, time may be of the essence.
The following is a list of the key considerations associated with various strategies that may also involve the purchase of life insurance.
Grantor-Retained Annuity Trusts
A GRAT is an estate-freezing strategy that enables clients to transfer the future appreciation on stock or other property to heirs at no or minimal gift tax cost. GRATs are particularly attractive when asset values are depressed and interest rates are low.
Clients transfer property they expect to appreciate to an irrevocable trust for a fixed term of years. During the GRAT term, they receive a stream of annuity payments, payable with cash or property. When the GRAT term expires, any property remaining in the trust after payment of their annuity passes to their children or another named beneficiary.
Transfer-tax benefits of a GRAT are realized when the transferred property produces a return in excess of the IRS assumed rate of return (IRS Section 7520 rate). If a client dies during the trust term, some portion of the trust property may be included in his or her estate and the beneficiaries receive nothing from the trust. In that circumstance, the client would end up in about the same position as if he or she had not created the GRAT.
Fortunately, this risk can be insured. The grantor can use the GRAT income to purchase life insurance to cover the inclusion of the asset that could potentially revert back into the estate or to increase the inheritance of the beneficiaries.
Installment sale to an Intentionally Defective Grantor Trust
An installment sale to an intentionally defective grantor trust (IDGT) is an alternative estate-freezing strategy that is often compared to a GRAT. This trust is so named because transfers to it can be removed from the client’s estate but are still considered owned by them for income tax purposes. After creating the “defective” trust with an initial gift (typically 10% of the sale price), assets that they expect to appreciate are sold to the trust in exchange for an installment note equal to the property’s fair market value.
During the term of the note, the grantor receives interest payments from the trust and a balloon payment of principal at the end of the note term. As the trust is a grantor trust, no gain or loss is reportable on the sale; and the interest payments are not reportable as income. All future appreciation of the trust assets in excess of the note’s AFR passes to children or another named beneficiary free of estate or gift tax.
In addition, if the IDGT is drafted to allow for the purchase of life insurance on the grantor’s life, the trustee can use the income generated by the transferred asset (after the interest payment on the note) to purchase life insurance. Low AFRs and, therefore, note payments mean that more income is available to purchase life insurance. Also, buying the policy inside of the IDGT assists the trustee in paying the grantor’s estate tax burden without having to worry about gift taxes.
Qualified Personal Residence Trust
A QPRT is an irrevocable trust to which an individual transfers his or her residence, reserving the right to live in the residence rent-free for a term of years, with the remainder interest passing to specified beneficiaries. The beauty of the QPRT is that it freezes the home at its current value and allows the client to transfer future appreciation to heirs free of gift and estate taxes.
A high interest rate environment is generally the time to put a QPRT into place, as high rates reduce the value of the gift to the client’s heirs, thus reducing the amount of gift tax. However, the depressed housing market may more than offset the current low interest rate market and still provide the gift tax leverage necessary to make the QPRT a viable strategy.
The disadvantage of a QPRT is that the full market value of the property will be “pulled back” into the estate if the grantor does not survive the specified term for years. Therefore, life insurance in an irrevocable trust can be a useful complement to the QPRT design. The death proceeds can be used to offset additional estate taxes generated by the inclusion of the QPRT in the taxable estate.
Family Limited Partnerships
An FLP may enable the client to make gifts to heirs on a potentially discounted basis while retaining some control over the gifted property. The client transfers property to the partnership in exchange for a limited partnership interest. The client may then gift all or a portion of the limited partnership interest to the children.
The client maintains management control of the partnership through the general partnership interest. The gift tax value of the limited partnership interest may be discounted due to factors such as lack of marketability and lack of control. If the FLP is the owner of a life insurance policy, it can use the income received by the partnership to pay the premiums and can isolate most of the proceeds from the estate of the deceased. In fact, an FLP can serve as an alternative to–one that may also offer greater flexibility than–an irrevocable life insurance trust or ILIT.
Selling depreciated assets and gifting net proceeds
While stock values have been rising lately, many clients still might find themselves owning stock or other property with a current fair market value less than their adjusted basis. It may be advisable to sell the stock and recognize the loss. This would avoid the possible “step-down” in basis that would otherwise occur if the property were still held at death.
In other words, the income tax basis of securities inherited from a decedent is the fair market value at death, even if the decedent’s basis was higher. Not selling depreciated assets before death allows losses to go permanently unrecognized. The proceeds of the sale may be used to purchase life insurance and increase the size of the inheritance to the beneficiaries.
Effective estate planning often involves making transfers designed to shift future appreciation on assets to children and grandchildren at a minimal gift tax cost. If your clients are looking to limit growth in the size of their taxable estate and they believe that asset values in the taxable estate will appreciate in coming years, they may wish to employ some of these techniques.
Regardless of the interest rate environment, life insurance can be important for estate liquidity purposes and may be a complement for any of these five strategies.
Ronald Herrmann, CFP, is regional vice president, and Scott Butterworth is an advanced sales consultant at Hartford Financial Services Group, Hartford, Conn. Their e-mail addresses are, respectively, [email protected] and [email protected].