Page 1 of 6 Law.com Home Newswire LawJobs CLE Center LawCatalog Our Sites Advertise Home Advertising Classifieds Public Notices About Contact Free Limited Access Home > This Week's News > Free: Estate Planning in a Low Interest Rate Environment NEWS font size: Print Free: Estate Planning in a Low Interest Rate Environment Transferring wealth in 'hard times' has benefits in the long run. By Sanford J. Schlesinger and Beth E. Spickler September 22, 2008 A primary goal of estate planning is to shift wealth from one generation to another in a tax-efficient manner. Often in an unstable economy, reducing assets through gift-giving strategies is overlooked. This has been especially true since the passage of the Economic Growth and Tax Relief Reconciliation Act1 in 2001. The act scheduled increases in the federal estate tax, the gift tax and the generation skipping transfer (GST) tax exemptions. Under the act, the federal estate tax exemption will increase to a maximum of $3.5 million, effective Jan. 1, 2009. Effective Jan. 1, 2010, the tax exemption is scheduled to be repealed entirely and, due to the act's sunset provision, on Jan. 1, 2011, the exemption is scheduled to revert to $1 million, as it was in 2002. The act increased the federal gift tax exemption from $675,000 to $1 million. In addition to the gift tax exemption, in 2008, each individual may make an annual exclusion gift to any number of individuals of up to $12,000 per donee, indexed for inflation. If spouses "split gifts," this annual exclusion may be doubled to $24,000 per donee, even if only one spouse actually makes the gift. The GST tax exemption, which applies to transfers to skip persons (meaning they are more than one generation below the grantor's generation) and is assessed at the highest applicable transfer tax rate regardless of the amount transferred, is presently $2 million and will increase to $3.5 million in 2009. The GST tax exemption is also to be repealed as of Jan. 1, 2010, and reinstated as of Jan. 1, 2011, when the exemption will be $1 million, indexed for inflation from 2001. It may seem counterintuitive to transfer wealth in "hard times." Yet, such gifts, especially of undervalued assets, can be highly desirable. If the value of assets is artificially depressed by the current market, utilizing annual exclusions and lifetime exemptions with these assets may make good estate planning sense. Assets are removed from the donor's estate at a deflated value, but the donee realizes the full value when the market recovers.
Page 2 of 6 Following is an analysis of some estate planning methods that can be particularly effective in a low interest rate market. GRATS The grantor2 retained annuity trust (GRAT) is a statutorily sanctioned form for gifting a remainder interest.3 A GRAT is an irrevocable trust designed to transfer the appreciation of assets contributed to the trust with no or minimal gift tax consequences to the grantor. When establishing a GRAT, the grantor transfers assets to the trust and retains a qualified annuity interest for a fixed term of years. Internal Revenue Code (IRC) 2702(b) defines a qualified annuity interest as an interest that "consist[s] of the right to receive fixed amounts payable not less frequently than annually." Pursuant to the IRC,4 the value of a gift to a GRAT is the actuarial value of the remainder interest in the GRAT. At the end of the trust term, the remainder interest is distributed to, or in further trust for, the remainder beneficiaries. GRATs are particularly useful due to the tax treatment of trust asset appreciation. This treatment is based upon an assumed growth rate published monthly by the Internal Revenue Service (the Service). This rate is the 7520 rate. The 7520 rate at the trust's inception is the assumed rate of return on the trust's assets. The August 2008 rate is 4.2 percent, which is markedly down from the 6.2 percent rate in August 2007. If the GRAT out-performs the 7520 rate, the excess appreciation passes to the remainder beneficiaries without gift or other transfer taxes. Therefore, given a low 7520 rate, high-performing GRAT assets can serve to transfer significant appreciation to the grantor's beneficiaries transfer-tax free. The annuity and remainder interests are valued at the start of the GRAT. The remainder interest passing to the remainder beneficiaries at the end of the trust term is subject to gift tax based on values at the trust's initial funding. However, a "zero out" GRAT can avoid a taxable gift on creation. With a "zero out" GRAT, the actuarial value of the retained annuity is equal to the value of the assets transferred to the trust, so the actuarial value of the remainder interest and, therefore, of the gift, is zero, but, in fact, remainder beneficiaries will ultimately have the benefit of any "excess" appreciation. After initial resistance, the Service acquiesced to a Tax Court decision approving "zero out" GRATs, Walton v. Commissioner,5 and adopted conforming regulations.6 Pursuant to IRC 2036, if a grantor dies before the GRAT ends, some or all of the GRAT will be includible in his gross estate for federal estate tax purposes. While the grantor of a GRAT does not specifically retain the right to income, he does retain the right to an annuity, which may be more or less than the actual income received by the trust. The Service treats this type of retained interest as if it were the right to receive income from a portion of the trust corpus and requires that portion to be included in the grantor's gross estate. The includible portion is that fraction of the corpus that would be required to be invested at the 7520 rate as of the date of the grantor's death to produce the annual required annuity payment. In a Technical Advisory Memo7 and a Field Service Advisory,8 the Service has taken the position that, pursuant to IRC 2039, the entire corpus of the GRAT is includible in the grantor's gross estate where the grantor dies during the term. However, in July 2008, the Service adopted final amended regulations9 which clarify that, although IRC 2039 may have implications that cause estate tax includability in certain cases, only IRC 2036 will apply to GRATs. The "estate tax inclusion period" (ETIP)10 is the period during which, if the transferor dies, the transferred property would be includible in the gross estate of the transferor (or his spouse) for estate tax purposes. A donor cannot allocate his GST tax exemption to transferred property during the ETIP. Due to the ETIP (during which a grantor cannot allocate GST tax exemption to the GRAT), GRATs are ill suited for multi-
Page 3 of 6 generational dynasty planning.11 Generally, with an outright gift to a skip person, GST tax does not apply if the gift qualifies for the gift tax annual exclusion. However, a gift to a trust that would otherwise qualify for the gift tax annual exclusion (e.g., due to Crummey12 withdrawal powers) is generally not automatically exempt from GST tax. Thus, except for the trusts described in IRC 2642(c)(2) (a topic beyond the scope of this article), the donor must allocate GST tax exemption to a generation skipping gift in trust in order to exempt such gift from GST tax. For income tax purposes, a GRAT is a grantor trust and is not treated as a taxpayer separate from the grantor. As a result, transfers to a GRAT are incomplete for income tax purposes, as opposed to gift tax purposes. Therefore, the annual annuity payment to the grantor is not a recognition event for income tax purposes.13 The grantor is liable for income taxes on any income earned in the trust during the GRAT term. In effect, the payment of the income taxes allows the grantor to transfer additional assets to the remainder beneficiaries without incurring additional gift tax. Sales to Grantor Trusts The sale to a grantor trust is another potentially effective estate planning technique for consideration in a down economy. After forming a grantor trust, the grantor sells one or more assets to the trust (which should be property that the grantor has reason to believe will appreciate in value) in exchange for a promissory note from the trust. Because the trust is not a separate taxpayer for income tax purposes, the sale to the trust will not result in the realization of capital gain or loss to the grantor or the trust (nor will the sale increase the basis of the property sold to the trust) and the grantor will not be taxed on the interest payments he receives on the promissory note. The note must bear interest not lower than the IRC 7872 applicable federal rate (AFR). The annual AFR for August 2008 is 2.54 percent for short-term loans, 3.55 percent for mid-term loans and 4.58 percent for long-term loans ("short term" means a maturity of three years or less; "midterm" a maturity of three to nine years and "long term" a maturity of more than nine years). Appreciation and earnings on property sold to the trust above the sales price will pass to the trust's beneficiaries entirely free of transfer taxes. As with a GRAT, the trust's income is taxable to the grantor. It is necessary that the trust have some measure of economic significance apart from the sale and the trust should be funded with assets (commonly known as "seed money") other than the purchased property. Otherwise, the Service can seek to disregard the trust for transfer tax purposes and treat the grantor as having retained an interest in the property sufficient to make the property includible in the grantor's gross estate at death under IRC 2036(a). Generally, the "seed money" should be equal to at least one-ninth of the value of the assets sold by the grantor to the trust. The transfer of the "seed money" to the trust is a gift for gift tax purposes. When funding the trust, the grantor can structure the gift to take advantage of his (and possibly his spouse's) $12,000 per donee annual gift tax exclusions. For a gift to a trust to qualify for the annual gift tax exclusion, it must be a gift of a "present interest" either through Crummey powers or through other trust provisions. Additional funding of the trust can utilize the grantor's lifetime gift tax exemption (presently fixed at $1 million) and, as distinguished from a GRAT, if the trust is to benefit the grantor's grandchildren or more remote persons, the grantor's GST tax exemption can be allocated to the trust at the time of the sale. Such an allocation will shield the trust assets from GST tax no matter how much they appreciate and no matter how long the trust remains in
Page 4 of 6 effect. It is important to have the property appraised at the time of the sale in order to establish that the sale to the trust is at fair market value. Otherwise, to the extent the property is sold for less than the fair market value, the grantor will be treated as having made a gift of the difference between the fair market value and the sales price. Provided that the value of the note is equal to the fair market value of the property at the time of the transfer, the grantor has received adequate consideration and the transaction should not be deemed a gift. This method is effective, especially in a low interest rate market, if the transferred asset earns more than the annual interest payment due to the grantor on the note. For example, if the mid-term AFR rate is 3.55 percent (as at present) and the trust assets are earning 8 percent annually, after the interest payment the trust will have increased by 4.45 percent annually, compounded, and the excess will pass transfer-tax free to or for the beneficiaries. Installment Note Another method of accomplishing the sale to a grantor trust is with a self-canceling installment note (SCIN). A SCIN is a sale for an installment note that is cancelled upon the grantor's death. In the case of a SCIN, the decedent has no interest in the installment note after his death and, therefore, any remaining balance due under the installment note is not includible in the grantor's gross estate.14 To avoid a taxable gift, the trust must pay a premium for the self-canceling feature, either in the principal value of the installment note or in the interest rate of the note. The preferred method is to pay the premium in the principal amount of the installment note rather than in the interest rate, since the advantage to a SCIN is that the property will likely appreciate at a rate higher than the AFR. Appreciation and earnings on the assets sold to the trust in excess of the AFR passes to the beneficiaries entirely free of transfer taxes. Payments required under the SCIN should be made when due to avoid the Service treating the entire sale as a gift. As with a sale to a grantor trust, in a SCIN transaction the trust should be funded with property other than the sale property and the property should be appraised at the time of the sale. Family Asset Management The family limited partnership (FLP) is another estate planning technique that provides both tax planning benefits and non-tax benefits. The non-tax benefits include, among others: (i) joint management of family assets; (ii) maintenance of family assets in a single pool to allow for investment opportunities not otherwise available; (iii) ensuring that family members continue to hold interests of equal worth in family assets; and (iv) the ability to provide for greater protection from potential creditors through transfer restrictions. Care must be taken with respect to the transferor's continued control over the transferred assets in order to avoid an effort by the Service to include the property in the transferor's gross estate under IRC 2036. In recent years, the Service has attacked the use of FLPs for estate planning purposes under a number of theories.15 A comprehensive analysis of the Service's challenges to this technique is beyond the scope of this article. An FLP will have at least one general partner who will control the partnership and one or more limited partners who will have no management control and will have substantial restrictions on the transfer of their interests. Subject to a general partner's fiduciary responsibilities to the limited partners, the general
Page 5 of 6 partner controls the operation of the partnership, management of the partnership assets and the timing of distributions to partners. For gift tax purposes, the lack of control and transfer restrictions (as well as a lack of marketability) may result in the limited partnership interests being valued with significant discounts. It is important that an appraisal of partnership interests be obtained to establish the appropriate valuation discounts for lack of marketability and transferability. In order to achieve further discounts on the transfer of a limited partnership interest, the limited partnership interest can be gifted to a GRAT or sold to a defective grantor trust. (Note that similar estate planning can be implemented using a limited liability company, an LLC, in lieu of an FLP.) Without a valid business purpose, the Service is likely to challenge discounts for gifted FLP (or LLC) interests. Additionally, near-death transfers are likely to be challenged by the Service as testamentary schemes to avoid estate taxes. Conclusion Given the present economic outlook and looming budget deficits, it will be difficult for Congress to find room in the budget to justify permanent repeal of the estate tax. While it might be difficult to part with wealth in these challenging and uncertain economic times, taking advantage of estate planning opportunities that are available in this type of economy may prove to be a very effective wealth transfer strategy. Sanford J. Schlesinger is a founding partner of Schlesinger Gannon & Lazetera, and chair of its wills and estates department and family business group. Beth E. Spickler is an associate at the firm. Schlesinger Gannon & Lazetera is an affiliate of Dreier. Endnotes: 1. Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16). 2. References to the masculine shall also include the feminine. 3. IRC 2702(b). Unless otherwise noted, all Section references are to the Internal Revenue Code of 1986, as amended. 4. IRC 2702(a)(2)(B). 5. 115 T.C. 589 (2000). Internal Revenue Notice 2003-72, 2003-2 C.B. 964. 6. 26 CFR Part 25. 7. TAM 200210009. 8. FSA 20036012. 9. Treas. Reg. 20.2036-1 and 20.2039-1. 10. IRC 2642(f).
Page 6 of 6 11. IRC 2642(f)(1). 12. Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968). 13. Rev. Rul. 85-13, 1985-1 C.B. 184. 14. IRC 691(a)(2) and (4); see also, G.C.M. 39503 (May 7, 1986). 15. See, e.g., Thompson v. Commissioner, T.C. Memo 2002-246 (2002); Hillgren v. Commissioner, T.C. Memo 2004-46 (2004); Estate of Lillie Rosen v. Commissioner, T.C. Memo 2006-115 (2006); Estate of Temple, 423 F.Supp.2d 605 (E.D. Tex. 2006); Estate of Gore, T.C. Memo 2007-169 (2007); but see also, Estate of Mirowski v. Commissioner, T.C. Memo 2008-74 (2008). terms & conditions privacy advertising about nylj.co