3 Estate Planning Tools and Why to Consider Them Now

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If your business is feeling the impact of the slump in oil prices, it may be hard to find a silver lining, but there is a spot of good news: You can significantly reduce your estate taxes by taking steps to preserve family wealth now before the outlook improves. Transferring wealth to family members now, when the value of your business may be lower, versus gifting upon sale of business, when value is likely up, can significantly reduce your estate taxes, since taxes will be based on today’s value. There are many estate planning tools to consider, but here are three popular strategies:

Sales to Grantor Trusts

This strategy involves setting up an irrevocable trust that’s structured as a grantor trust for income tax purposes. You make a taxable gift of seed money to the trust (usually 10 percent or more of the purchase price) and then sell your business interest to the trust in exchange for a promissory note. The business interest, together with all future appreciation in value, is removed from your estate. And, because a grantor trust may be ignored for income tax purposes, you don’t recognize any capital gain or loss on the sale, as you are treated as having sold the asset to yourself. In addition, as long as the trust purchases the interest for fair market value and pays interest on the note that’s no less than the applicable federal rate, there will be no additional gift tax consequences. You can maximize growth and income within the trust by structuring the note with a balloon payment. And unlike a grantor retained annuity trust (more on this below), there’s no mortality risk, though your estate will be subject to income taxes attributable to the unpaid principal should you die before the note is paid off.

Intentionally Defective Grantor Trusts

In an intentionally defective grantor trust (IDGT), a trust owns the assets for estate tax purposes, but you, as the grantor, own the assets for income tax purposes. In fact, you’re responsible for paying income tax on income you never receive. But that isn’t a bad thing in this scenario. According to the IRS, as long as the IDGT is properly structured, when you pay income tax on trust earnings, it won’t be considered a taxable gift. So you are, in essence, making an additional tax-free gift to the trust each time you pay tax that would otherwise be paid by the trust itself. This allows you to accomplish two important objectives:

  1. The trust assets can grow free of income taxes
  2. You can further deplete your estate – and the associated estate tax – each time you pay the income tax on the trust earnings

Keep in mind, however, that other transfers you make to the trust will be considered taxable gifts. But you can avoid this by selling assets, such as stock in a closely held business, real estate and securities, to the trust in exchange for an installment note with interest.

Annuity Trusts: GRATs and CLATs

Grantor-retained annuity trusts (GRATs) and charitable-lead annuity trusts (CLATs) work in essentially the same way: You contribute assets to an irrevocable trust, which makes annuity payments to a designated beneficiary during the trust term. At the end of the term, any remaining assets are transferred to your children or other beneficiaries free of estate and gift taxes. The main difference between the two techniques is that a GRAT pays the annuity to you, as grantor, while a CLAT pays the annuity to a charity. In either case, when you fund the trust you make a taxable gift to the remainder beneficiaries equal to the value of the assets contributed to the trust less the present value of the annuity payments. Present value is computed using an assumed rate of return known as the Section 7520 rate. If you set the annuity payments high enough, their present value will be equal to the value of the trust assets, resulting in no gift tax consequences. Example: Scott contributes $1 million to a 10-year GRAT or CLAT for the benefit of Emily. If the applicable Sec. 7520 rate is 4 percent, an annuity payment of $123,291 will “zero out” the trust. In other words, assuming the trust assets grow at a rate of 4 percent, the annuity payments will completely deplete the trust assets during its 10-year term, leaving nothing for Emily and, therefore, no taxable gift. But if you assume that Scott funds the trust with assets expected to grow at a 6 percent rate, earnings in excess of the hurdle rate result in a tax-free gift to Emily of nearly $166,000. If your goal is to transfer wealth to your heirs free of gift and estate taxes while generating an income stream for yourself, a GRAT may be the ideal vehicle. It’s also an effective way to transfer an interest in a closely held business at a minimal tax cost. If your objectives are philanthropic, however, a CLAT may be worth a look. One disadvantage of a GRAT is “mortality risk”; that is, if you die before the end of the trust term, all of the assets will be included in your taxable estate. There is no mortality risk with a CLAT. To explore your estate planning options and how to put these strategies to work preserving your wealth, contact our tax advisors in Florida, Michigan, North Carolina or Texas.

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