Over the past 20 years, I have specialized in working with wealthy people who have estates of $15 million or more. Most own closely-held businesses. Almost all have done basic estate planning with tax wise wills, made annual exclusion gifts, and have a life insurance trust. Most have reduced estate tax, but still have significant estate taxes to pay.
Our wealthy clients and prospects have four choices to address their remaining estate tax problem. They can ignore, reduce, leverage, or eliminate the tax. There are some who will ignore the problem because they believe that the estate tax will be completely repealed. However, most understand that the tax is here to stay, perhaps with higher exemptions and lower rates. For these folks, one way to reduce taxes tomorrow is to 'freeze' assets today. In this article, I will explain two ways to freeze assets that have interested my key clients. In addition, these techniques allow for the sale of large amounts of needed additional life insurance.
Effective strategies to freeze assets include the gifting or selling of assets to "grantor trusts." Both techniques freeze assets at today's values, but they take different forms and lead to different consequences.
With a grantor-retained annuity trust (GRAT), our clients can gift and transfer income-producing assets to an irrevocable trust, receiving a stream of income from the annuity for the term of the trust. At the end of the term, the remaining principal is paid to their beneficiaries. A GRAT is a grantor trust during the annuity term because the grantor retains an annuity interest. The expected value of the remainder at the end of the annuity term is a taxable gift upon creation of the GRAT. One computes the amount of the taxable gift according to actuarial tables issued by the IRS pursuant to Section 7520 of the Internal Revenue Code. The amount of the gift depends on the length of the annuity term, the amount of the annuity, and the Section 7520 interest rate at the date of transfer. The IRS issues the Section 7520 rate monthly.
GRATs have little downside. If the assets appreciate as expected, the appreciation goes to the beneficiaries. If the assets underperform, the client has accomplished nothing but also loses nothing. If the grantor dies during the term of the trust, the assets return to his or her taxable estate. This is a good reason for keeping the term of the GRAT short. GRATs are spelled out and specifically sanctioned in the Internal Revenue Code. As a result, they carry a low risk of challenge by the IRS and may be more "emotionally comfortable."
If clients and their advisors are willing to be more aggressive, they might consider a tactic not specifically spelled out in the code: the sale of assets to a "defective" grantor trust with a promissory note secured by the property. The face amount of the note should be equal to the fair market value of the property. That value, depending on the property, may be discounted to yield greater benefits. The concept behind these intentionally defective grantor trusts (IDGTs), also known as intentionally defective irrevocable trusts (IDITs), is that the asset must appreciate at a rate higher than the interest rate paid on the note. That interest is based on an applicable federal rate (AFR) set each month. The AFR rate for July this year was 3.45% on mid-term notes of three to nine years. This is lower than the interest rate for a GRAT, which is based on the section 7520 rate of 4.2%.
An IDIT is "defective" only in the sense that it is a grantor trust for income tax purposes. This means that the grantor is the owner of the trust for income tax purposes and is liable for the tax on any trust income. The trust is a grantor trust because the grantor retains one or more of the powers delineated in the grantor trust rules of the Internal Revenue Code. In the past, the fact that a trust agreement violated the grantor trust rules was viewed negatively. Today, many drafters of trust agreements intentionally include one of the forbidden powers to make the trust a grantor trust. In this way, the grantor can pay the trust's income tax without making a taxable gift. Due to the grantor trust status of the trust, the sale does not trigger capital gains tax. If the grantor dies while the note is outstanding, the only thing remaining in the grantor's probate estate is the promissory note. Any appreciation in the values of the asset is theoretically out of the grantor's estate for estate tax purposes.
To make the trust independent, in addition to the sale of assets to the trust, advisors recommend that the grantor make a gift of seed money, typically of at least 10% of the property being sold to the trust. The gift of seed money may mean using the gift tax exemption or paying gift tax. With a GRAT, by contrast, there is no need to use the gift tax exemption or pay gift tax, particularly using the zeroed out GRAT technique.
For optimal results, both types of grantor trusts (GRAT and IDIT) should be funded with discounted assets, such as limited partnership interests, business interests, and sufficient other assets to generate the income needed to pay either the annuity or the interest payments on the promissory note each year.
With annual interest payments (instead of an annuity), lower interest rates, and the use of discounted assets, an IDIT can produce "staggering" results.
Recently, one of my business owner clients, with the help of their attorneys, created an intentionally defective irrevocable trust (IDIT) and sold $5 million (discounted at 30%) S-Corporation shares to the trust in exchange for a note that the IDIT issued to them.
As mentioned earlier, a "seed gift" is made to an IDIT to avoid a potential IRS argument that the sales transaction is a gift with a retained income interest, which would cause the assets in the IDIT, including any life insurance death benefit purchased by the trust, to be considered included in the seller's taxable estate, thereby negating any potential benefits from the planning. My clients, however, had used up their $1 million (total $2 million; $1 million each for the husband and the wife) lifetime gift exclusion amount in transferring S-Corporation shares a number of years ago using layered GRATs of different terms. They did not want to pay gift tax on the seed gift while avoiding the possibility of having the IDIT assets included in their estates. Their advisors suggested that the beneficiaries of the IDIT (children) personally guarantee the loan. This was not a problem because the children had built a sizeable net worth of their own.
The clients were concerned about the risk associated with this strategy, particularly the risk of payback of the note in the event of early deaths of the grantors, and the lack of overall liquidity available to the estate to pay the estate taxes. After analyzing the cash flow of the IDIT, the clients felt comfortable with the trustee purchasing $8 million of last-to-die insurance. In fact, the company has done very well; the cash flow of the IDIT is a lot bigger than originally thought, and now the trustees are looking at increasing the life insurance coverage because the clients are still healthy and able to buy.
The illustrations at right compare the potential results of sale of the stock to an IDIT and purchasing life insurance in the IDIT, to the clients retaining the stock in their estates.
Case Facts:
o Total estate value: $30 million
o Fair Market Value of S-Corporation: $16 million
o Assumed fractional discount on sale of $5 million (31.25%) of stock: 30%
o Dividend (income) from stock: 10%
o Growth rate of stock: 5%
o Hypothetical income tax rate: 36%
o Long term AFR rate: 4.68%
o Life insurance: $8 million
o Annual premium for 10 years: $298,000
o Available lifetime gift tax exclusion: ZERO.
See the results in the graph and table below.
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Kamal N. Daya, CLU, ChFC, CFP, is owner of Kamal Daya & Associates. Mr. Daya has been an agent for New York Life Insurance Company since 1976. Since 1986, he has focused his practice exclusively on estate planning, business succession planning, and executive compensation planning cases. He also works as a management consultant/coach. Mr. Daya is an active supporter and mentor, with his wife, Connie, of several orphanages in Northern India. He and his family recently partnered with the MDRT Foundation to guarantee 1,000 local needy children in the Mumbai slums access to tools to develop and expand language skills, particularly English. Kamal is a 30-year member of the MDRT, and has qualified five times for Top of the Table, and nine times for Court of the Table. He has authored articles for several trade journals.
This material includes a discussion of one or more tax-related subjects. This tax-related discussion was prepared to assist in the promotion of transactions addressed in this material. It is not intended for the purpose of avoiding any IRS penalties that may be imposed upon the taxpayer. Please note that New York Life, its subsidiaries, agents, and employees may not provide legal or tax advice to prospects and clients. Taxpayers should always seek and rely on the advice of their own independent tax professionals.
