One of the benefits of the The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (The Act), to wealth managers and their clients, is that it provides opportunities to combine sophisticated estate planning techniques with the new, temporary gift and estate tax laws that are in place for the next two years. While it may seem odd to take the long-term view when the tax window is relatively short, estate tax and gift planning requires just that, arranging assets according to short-term tax laws, with a long-term view.

Of course, the fact that the estate and gift provisions are temporary makes it urgent to advise clients about how to take full advantage of higher exclusions and lower tax rates for estate planning and gift transfers, and provides wealth managers with great reasons to discuss these options with clients as soon as possible. As this is an area of wealth management that calls for specialized expertise, wealth managers often refer clients to in-house or best-of-breed outside counsel for estate planning. And the advantages strategic planning for transferring wealth are not limited to ultra-high-net-worth (UHNW) clients—estate planning and gift strategies are important for high-net-worth (HNW) clients, too.

A Two Year Timeframe to Arrange Estate and Gift Assets

“Before 2011, the estate tax was gradually reduced from a rate of 55% in 2001 to 0% in 2010,” Benjamin Ledyard, Silver Bridge Advisors’ Director of Wealth Strategies, told via e-mail. The new law “reinstates the estate tax at a flat rate of 35% on assets above $5 million for individuals and $10 million for married couples. The Act also ‘reunifies’ the gift tax rate and exclusion amount with the estate tax, which was earlier decoupled by the Bush-era tax cuts and limited to a $1 million lifetime gift credit and a $3.5 million estate tax exclusion. However, the Act will only last for two years and this whole debate will be re-opened.”

Here are three areas that clients will need to know about now, according to Ledyard:

  1. “Focus on maximizing the historic rise in the lifetime gift exclusion going from $1 million to $5 million—gift planning over estate planning.”
  2. “In making any transfers, either during life or at death, take advantage of existing planning strategies to help minimize the tax due on transfer by reducing the overall valuation of the asset being transferred.” In the example below, Ledyard demonstrates the power of   a "double discount—one at the asset level and a second at the entity level.”
  3. “In lieu of limiting the $5 million gift exclusion to simply $5 million, combine the transfer of discounted ‘Family LLC’ units with a Grantor Retained Annuity Trust (GRAT), structured such that the grantor is able to pass up to $100 million in underlying asset value over a 10-year period without triggering a significant transfer tax, which could be as high as $30 million,” or more.

Greatly Reduced Tax Liability

In this hypothetical example, Ledyard describes how taking a long-term view and maximizing the current tax law could greatly reduce the tax owed on transfer of a family business:

The Case

A family with a successful multi-generational family business, an LLC with a gross value of $202 million, is currently owned 100% by the mother and father. The parents would like to transfer 49% of the equity in the company to the next generation during their lifetime while minimizing any transfer taxes,” Ledyard notes. “Without any planning, the transfer tax on the $100 million transferred, even at today’s lower rates, would be $100 million minus the $10 million exclusion at 35%, or a tax of $31.5 million.” 

The Strategies

First, look for ways to reduce the fair market value of the asset being transferred for transfer tax valuation purposes,” Ledyard advises. “Suppose the family creates a Family, LLC naming the parents as the managers of the LLC. The parents then contribute 49% of the family company’s equity to the Family, LLC. To determine the actual value of the transfer, they obtain a business valuation of the family company. The valuation of a 49% equity stake in the family company may be discounted heavily under the ‘willing seller, willing buyer’ analysis. For planning purposes, we will assume a 30% discount. Thus, the underlying assets of the Family, LLC (49% in family company) are valued at $70 million.”    

Next, the parents obtain a business valuation of the Family, LLC that owns the 49% equity in the family company,” says Ledyard. “Generally, the valuation will assert a discount from the fair market value of the underlying assets of the Family, LLC for both ‘lack of marketability’ and ‘minority interest,’ which can range from 20%-40%. For this example, let’s assume the value of the units Family, LLC can be discounted another 30%. Thus, each unit of the $70 million LLC is valued at 70 cents on the dollar, or $49 million,”

Employing the GRAT

“The family then decides to create a Grantor Retained Annuity Trust (GRAT),” Ledyard writes. “The GRAT is a trust to which an individual (or couple) may transfer an asset and receive an annuity stream from that asset for a period of years. The transfer is considered a gift, but the value of the gift is reduced by the annuity stream received. After the period of years is over, the asset(s) of the trust pass to the beneficiaries free of any additional transfer taxes.”

“Using a carefully structured GRAT,” according to Ledyard, “the parents could gift the entire amount of the Family, LLC to the trust and retain an annuity for a period of years.” For this example, Ledyard used a 10-year term, with “an annuity rate of $3 million per year, which the trust would pay back to the parents each year for ten years. The value of the transfer for gift tax purposes is roughly $10 million, which could effectively be used against the parents’ combined current lifetime gift tax exclusion of $10 million, resulting in zero taxes on a transfer of $100 million of equity in the family company.

If the $100 million,” grows beyond “the $3 million required to pay back to the parents each year, all of the growth will pass free of taxes as well. Thus, it is important to fund this type of strategy with assets that will likely grow steadily over time,” Ledyard asserts.

The one disadvantage of a GRAT,” Ledyard cautions, “is that if both parents die during the term of the GRAT, some or all of the assets of the GRAT may be included in their taxable estates, thereby negating the effectiveness of this strategy. This concern can be mitigated by purchasing declining 10-year term life insurance policy on the joint lives of the parents, which can provide a death benefit in case of a premature death by both parents.”