Preparing Clients for a Quick Estate Planning Pivot

High-net-worth clients recognize that they need to be prepared for sudden changes in tax laws and market valuations. But in the face of political uncertainty and market volatility, it may be difficult to choose which assets to transfer into trust, or determine fair market value. Attorneys and appraisers may be backlogged with similarly situated clients.

Here are some tips for setting up trusts for estate planning with flexibility to pivot quickly as possibilities turn to actualities.

1. Use “intentionally defective” irrevocable grantor trusts.

“Intentionally defective” grantor trusts that are not considered a separate income tax entity (i.e., the income of the trust is taxable to the grantor) enhance the flexibility of irrevocable trusts, because transactions between the grantor trust and the grantor are not income- taxable events.

(Related: Estate and Gift Tax Changes in the Tax Cuts and Jobs Act)

In other words, gains are not recognized when a grantor trust purchases an appreciated asset (including a life insurance policy worth more than its basis) from the grantor for fair market value or vice versa. If the grantor lends funds to their grantor trust (private finance), the interest paid by the trust back to the grantor is also not taxable.

2. Choose a jurisdiction with favorable trust modification (i.e. “decanting”) rules.

Concerned about needing to change terms of the trust in the future, such as modifying beneficiaries or responding to unanticipated tax law changes?

Trusts operate according to state laws, which vary substantially in their options for modifying or replacing an irrevocable trust. The applicable state law is generally determined by the state in which the trust is “administered” (generally, this is where the trustee is located).

So, clients can set up a trust in a different state from their usual residence with the selection of a professional trustee located in a more favorable jurisdiction.

3. Include “swap powers” (grantor right of substitution) in the trust terms.

When a trust gives any person (including the grantor), in a non-fiduciary capacity, the ability to substitute assets of equal value (without requiring the consent of any adverse party), it will automatically be classified as a grantor trust while the grantor is alive.

The “swap” power gives grantors the ability to change their minds about which assets should be inside or outside the trust, and make adjustments without needing the approval of a trustee. (However, the trustee should still have the power to determine the value of the assets being swapped to ensure they are actually equivalent.)

This can be particularly beneficial for real estate and other low basis assets that are owned by a trust: if they are swapped for high basis assets while the grantor is still alive, the low basis assets may get a substantial step-up in basis if included in the taxable estate, while assets in the irrevocable trust do not.

4. Use “Wandry” defined value clauses for transfers of hard-to-value assets.

Need to quickly make a gift of exactly $11 million dollars out of a closely-held business interest worth $50-80 million? What share of the business should be gifted?

You may not have time to get an appraisal done before making the gift, and in any case, the IRS is not bound by the findings of an appraiser.

The 2012 Tax Court decision, Wandry v. Commissioner, opened the way to making a transfer of a determinate dollar value, with the number of shares determined later according to a formula specified in the gift or transfer document as finally determined by the IRS. Be careful to follow well-tested formula language that allows a final determination of value by the IRS or court to override an appraiser’s initial value, however.

In June, the Tax Court assessed the taxpayer in Nelson v. Commissioner with costly deficiencies and penalties for a defined value clause that relied solely upon the determination of an independent appraiser, even though the appraiser was well-qualified and their values were not unreasonably lower than the final values determined by the court.

Why Not Just Wait?

Tax laws can change with little notice, even retroactively. For instance, in August 1993, the Omnibus Budget Reconciliation Act (OBRA) was made law, which included an increase in the top estate tax rate from 50% to 55%, retroactive to Jan. 1, 1993. A number of courts affirmed the constitutionality of this retroactive tax hike.

A shift in policy or control of the federal government any time in 2021 may result in tax changes effective back to Jan. 1, eliminating the possibility of “reacting quickly.”

But what if control doesn’t change in Washington, and federal tax laws stay the same, at least for the next few years? There are still several good reasons to act now rather than later:

• Future growth of an asset transferred out of the taxable estate today will not be subject to transfer tax (at least to the extent that the generation skipping transfer tax (GSTT) does not apply).
• Interest rates are at historical lows, making private financing and grantor-retained annuity trusts exceptionally attractive.
• Assets in trust, if transferred properly, enjoy greater asset protection against potential future creditors who might unexpectedly make claims on a grantor’s wealth.
• State governments have their own income and transfer tax rules, and their own political currents. States may hike transfer taxes even if the federal government doesn’t.
• Transferring interests in businesses and real estate at a time when their values are depressed by economic conditions allows wealthy clients to move a higher percentage of their assets outside the taxable estate without incurring gift taxes than if they wait for values to recover.
• Today’s tax rules and circumstances are only today’s. Politicians may resign or die suddenly. Markets move quickly. There is no guarantee that rules, such as the 2026 scheduled expiration of the doubled estate and gift tax exemption and other recent tax cuts, will survive for long.

Thank your clients may need to pivot? Now is the time to make a plan.

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Lillian Vogl, J.D., CFP, is director of advanced sales at Crump Life Insurance Services.