Double Discounted Transfers

Transcription

1 Advanced Markets planning perspective estate planning Double Discounted Transfers The Silver Lining After the Economic Downturn It seems clear that estate taxes are here to stay. For people who are likely to be exposed to federal estate taxation, now may be an excellent time for common wealth transfer techniques. Why? You have the benefits of a double discount when implementing these techniques through: 1. Reduced market values: Depressed asset values alone help when making gifts to your family. The lower the value, the lower the potential gift tax. Following the economic downturn that began in 2008, many people hold assets that, while significant in value, may be valued at much less than they used to be worth. What s more is that they are perhaps valued at much less than they may be worth at some future point in time. Assets with currently depressed values can be useful if you are looking to transfer wealth at a discount in terms of the taxable gift that may be involved. 2. Historically low interest rates: Low interest rates can drive down the value of gifts. The gift tax value resulting from common estate and gift tax techniques is based on a variety of factors, including current Treasury Note interest rates. Often, the lower the rate, the lower the gift s value. Year 120% of MidTerm AFRs Rate % 6.40% 9.54% 6.89% 7.34% 7.13% 5.59% 7.47% 6.75% 5.40% 4.12% 4.23% 4.53% 5.39% 5.51% 4.31% 2.48% 2.95% 2.34% 1.40% 1.04% 7.6% 6.4% 9.6% 6.8% 7.4% 7.2% 5.6% 7.4% 6.8% 5.4% 4.2% 4.2% 4.6% 5.4% 5.6% 4.4% 2.4% 3.0% 2.4% 1.4% 1.0%

2 How Do Interest Rates Come into Play? With many common gift tax transfer techniques, the Tax Code and the Internal Revenue Service (IRS) require you to use calculations that are, in part, based on current interest rates. These interest rates are called the Applicable Federal Rates, or AFRs. They are based on different durations of U.S. Treasury Notes and are reset by the Treasury every month. Depending on the technique and design, you and your advisors might use a short-term, mid-term or long-term AFR. The various AFRs have gradually decreased in recent years. In January 1991, the mid-term AFR was 9.8%. From 2002 to 2008, it had hovered between 4% and 5%. By early 2009, it dropped to a near-historic low and has dropped even further since then, hitting a new low in What does this mean to you? The lower the AFR, often the smaller the gift value for tax purposes. In effect, you and your family can benefit from the combination of low interest rates and depressed property values. How Does This Work? Let s look at an example of lower AFRs used with a wealth transfer strategy such as Grantor Retained Annuity Trusts (GRATs). A GRAT is a trust to which the grantor, typically the client, transfers property with a retained right to receive payments for a period of years, otherwise referred to as an annuity. GRATs generally result in taxable gifts of a future interest deemed to be made by the grantor. Because the gift, typically given to the children, won t be completed until the future, the value of the gift is usually far lower than the current market value. The value of the gift is determined by subtracting the value of the annuity from the fair market value of the property transferred to the trust. Like a commercial annuity, the amount required to create the specified stream of annuity payments increases as the earnings on the annuity decrease, and vice versa. So, as the AFR decreases, the present value of the annuity increases, and therefore reduces the amount of your taxable gift. You benefit from this because: Lower asset growth rates are assumed by the IRS due to the lower AFR, resulting in lower calculated remainder interests after the annuity payments are satisfied; and The value of the gift made to the trust is already reduced because of the economic downturn. For our example, we will assume a GRAT funded with property assumed to have a fair market value of $1,000,000. We will also assume the grantor, age 60, will receive payments of $75,000 at the end of each year for 10 years. Had the grantor funded this GRAT in January 2007, the AFR used to value the gift would have been 5.6%. If the GRAT had been funded in January 2013, the AFR used would have been 1.0%.

3 Note the difference in the value of the taxable gifts based just on the change in interest rates: Date GRAT Funded AFR FMV of Property Transferred Minus Value of Annuity Equals Value of Gift January % $1,000,000 $562,620 = $437,380 January % $1,000,000 $710,348 = $289,652 Reduction of Taxable Gift: $147,728 Gift Tax Saving at an assumed 40% Gift Tax Rate: $59,091 Additional leverage is gained by market value lost. If we assume a 28% property value reduction over that time frame, the gift tax savings is over five times greater: Date GRAT Funded FMV of Property Transferred Minus Value of Annuity Equals Value of Gift January 2007 $1,000,000 $562,620 = $437,380 January 2013 $720,000 $710,348 = $9,652 Double Discounted Reduced Taxable Gift: $427,728 Double Discounted Gift Tax Saving at an assumed 40% Gift Tax Rate: $171,091 There are a number of different opportunities along these lines. A chart at the end of this piece details common estate planning techniques from which you can benefit. Another way you might benefit from low interest rates is using Private Financing (a personal loan) to help fund your trust. Private Financing A Personal Loan to Help Fund Your Estate Plan Another strong possibility for taking advantage of depressed market values and low interest rates is using Private Financing, also known as Private Split-Dollar Loans. With these arrangements, you (or your spouse) typically pay the premiums on a life insurance policy held by an Irrevocable Life Insurance Trust (ILIT). The premium payments are treated as loans from you to the trust. Here, too, the IRS-mandated rates, AFRs, are used to determine the minimum interest rate the premium payer charges for the loan. With low interest rates, you need to transfer less money or other property to the trust in order to enable it to make the required interest payments.

4 These arrangements usually treat each premium payment as a separate loan, usually annual loans. However, it s possible to lock in today s low rates. You have two options to accomplish this: The first option: Make a large loan this year to help jump start a life insurance policy and provide the trust with sufficient funding so that you can make small annual gifts for future premiums. The second option: Combine both depressed property values and low interest rates. If you have property that generates income, even with depressed market values, why not make a loan of the property today? With depressed property values and depressed interest rates, the loan interest the trust needs to pay is likewise reduced. The benefit is that more of the money generated by the property can remain in the trust and benefit your family. For example, a piece of property worth $1,000,000 four years ago and generating 5% income (or $50,000) is still generating that same $50,000, even if it might now only be worth $750,000. You can make a reduced loan of $750,000 and still generate $50,000 each year in the trust for the premium payments. This assumes that the property is still generating the same income. If this were not the case, the trust may not be able to satisfy the necessary premium payments. And look how rates are depressed. If you use a loan with a term longer than nine years, you can lock in rates for a long period of time. For January 2013, the long-term, IRS-mandated AFR was 2.31%. Compare this to the rates established by the IRS over the prior 20 years: Measure AFR Difference from 1/2013 High (1995): 8.17% 5.86% Mean (2004): 5.01% 2.70% Average: 5.17% 2.86% Low (2013): 2.31% 0.00% Low AFRs can provide substantial leverage for clients who have limited or even no remaining annual gift exclusions and properties that can generate significantly more income than 2.31%. For example, a property worth $1,000,000 generating $80,000 of rental income could service interest payments of $23,100 as well as premium payments of $56,900. On a 60-year-old male in good health, $56,900 in premiums could buy a universal life insurance policy with a Face Amount of over $3,000,000 3 with no gifts involved. What if this property was still generating the same level of income, but the fair market value had dropped to $720,000 like our previous GRAT example? The loan interest on the note would be only $16,170, leaving $63,830 for life insurance premiums. If you re a 60-year-old male, that amount of premium may buy over $3,750,000 of universal life insurance. 2 In Summary You potentially have an opportunity that may not present itself again. If you have been considering implementing a wealth transfer strategy, there may never be a better time to do so from a gift-tax leverage perspective.

5 Common Estate Planning Techniques Strategy Sale to an Intentionally Defective Grantor Trust (IDGT) Property is sold, subject to a promissory note, to a trust whose income is taxed to its grantor, typically the trust creator. In effect, it relieves the trust of paying taxes. Although counterintuitive, the tax payments are made by the grantor, thereby providing more funds to the trust and its beneficiaries. Property sold to the trust usually has depressed market values due to lack of marketability and minority interest discounts. Income from the property sold to the trust is often used to buy life insurance. Charitable Lead Trusts (CLTs) A selected charity receives payments from the CLT for a specified period or for the life of the grantor(s). The remainder after the payments cease is generally transferred to family members. CLTs come in two forms: Annuity Trusts (CLATs), which have level payments based on the initial value of the property transferred, and Unitrusts (CLUTs), which have varying payments based on a percentage of the annual value of the property held by the trust. Charitable Remainder Trusts (CRTs) A selected charity receives the remainder value of property transferred after a series of payments from the CRT for a specified period or for the life of the grantor(s). CRTs come in two forms: Annuity Trusts (CRATs), which have level payments based on the initial value of the property transferred and Unitrusts (CRUTs), which have varying payments based on a percentage of the annual value of the property held by the trust. Self-Cancelling Installment Notes (SCINs) An installment sale of appreciating assets is made to a trust that calls for the note to be canceled upon the seller s death. To ensure the sale is made for adequate consideration, it is structured to include a risk premium to compensate the seller for assuming the risk that the seller may die before the note is repaid. Using an IDGT as the purchaser can avoid the recognition of capital gain and interest income that may accompany installment sales. Private Annuities The seller/annuitant transfers property to the buyer, who becomes an obligor of annuity payments to the seller. Traditionally, the buyer promises to pay the seller for the transferor s lifetime, or the joint lifetime of the transferor and the transferor s spouse. Value of Gift Although there is generally no gift as a result of this transaction, a seed gift of at least 10% of the sale price is typically made to reduce the likelihood of the IRS asserting that the sale transaction was actually a transfer with a retained interest because the trust had no means to repay the loan other than retransferring the property in kind. The market value of the transferred property minus the value of the annuity. Generally, there are no gift tax implications of CRTs, unless the stream of payments is directed to someone other than the grantor(s). There is no gift unless the sale price is less than adequate consideration. Like the SCIN, there is no gift unless the sale price is less than adequate consideration. Interest Rate and Market Value Impact Lower AFRs allow the grantor to charge a lower interest rate on the promissory note, making the note more serviceable by the trust if desired. Lower market value prior to marketability and minority interest discounts further compresses the size of the note and offers the potential for more leverage, particularly if the property s value is likely to rebound. In addition, depressed market values, in lowering the sale price, also lower the threshold seed gift typically recommended by planners. Reduced interest rates increase the value of the annuity in CLATs, thereby reducing gift or estate value and increasing the income tax deduction. With CLUTs, results are neutral with respect to the impact of the AFR, as the payout rates of Unitrusts go up and down with the actual value of the assets in the trust. Reduced market value generally results in lower annuity payments to the charity, and therefore lowers the deduction. However, if the property s market value rebounds, the remainder transferred may be substantially more than the transfer value. The effect of lower AFRs is not beneficial with Charitable Remainder Annuity Trusts (CRATs). The calculated remainder of a CRAT after the grantor takes his/her income stream is lower, similar to a GRAT. Since the remainder is what is going to charity, the charitable deduction is lower. However, depressed market values would reduce the gift or estate tax value of those remainder interests. Lower AFRs result in lower payments required by the buyer. As with sales involved with the other strategies, the depressed value would typically produce a lower sale price, therefore further reducing the installment note payments. The impact of lower AFRs and depressed market value mirrors the impact on SCINs.

6 1 Rates are for the month of January each year. The section 7520 rate is used to discount the value of annuities, life estates and remainders to present value, and is revised monthly. It is equal to 120% of the applicable federal mid-term rate rounded to the nearest two-tenths of a percent. 2 The policy premium and death benefit amounts used for this case are intended only to help demonstrate the planning concept discussed and not to promote the sale of a specific product. The rates are broadly representative of rates that would apply for a policy of this type and size for Insureds of good health in the ages mentioned. To determine how this approach would work with your clients, individual illustrations should be prepared or requested for your review. If different rates were used, there might be significantly different results. Please be advised that this document is not intended as legal or tax advice. Accordingly, any tax information provided in this article is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or marketing of the transaction(s) or matter(s) addressed, and you should seek advice based on your particular circumstances from an independent tax advisor. Life insurance is issued by AXA Equitable Life Insurance Company or MONY Life Insurance Company of America, an Arizona Stock Corporation with its main administrative offices in New York, NY, and is distributed through AXA Distributors, LLC and AXA Network, LLC and its subsidiaries. AXA Equitable, AXA Distributors and AXA Network are affiliated companies. All guarantees are based on the claims-paying ability of AXA Equitable Life Insurance Company or MONY Life Insurance Company of America AXA Equitable Life Insurance Company. All rights reserved Avenue of the Americas, New York, NY 10104, (212) G30764 GE (12/12) (Exp. 12/14) Cat. # (1/13) Life Insurance: Is Not a Deposit of Any Bank Is Not FDIC Insured Is Not Insured by Any Federal Government Agency Is Not Guaranteed by Any Bank or Savings Association Variable Life Insurance May Go Down in Value For Financial Professional Use Only. Not for Use with, or Distribution to, the General Public.