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Why Everyone Needs an Estate Plan, Part 3: Avoiding the Estate Tax

Mar 31st 2017
Founder/CEO CWSEAPA PLLC
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estate tax return
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Should you be lucky enough to work with a client who is trying to avoid the estate tax, you need to temper your enthusiasm with a dose of reality. Remember, what you are planning is something that your client will have to live with.

When I had my first estate planning client, I inadvertently made his situation so complicated that I ended up losing him as a client. We must remember that just because it can be done doesn’t mean that it should. But sticking it to the government can be fun ... or what I mean to say is that finding a creative way around a regressive tax that causes families to hold onto wealth can be quite the rush.

In this article, we are going to discuss certain ways to remove assets from one’s estate so they aren’t taxable at death.

Know the Gifting Rules
First and foremost, what you want to do is use the gifting rules. But first, a word about gifts. The downside to gifts is that once they are completed, the client loses control of the asset being gifted. For example, if the client and his spouse give their 18-year-old kid $28,000, they cannot control what that teenager does with the money. The exception is if they put the money in a trust.

When I meet with a client for estate planning, I ask what is important to them. Outside of avoiding the estate tax, they want to pass wealth on to their family. However, as planners, we know that people are imperfect. I would no more want my 18-year-old to have unchecked access to $28,000 that is gifted than I would want to avoid a tax. For this reason, there are irrevocable trusts. I like to start off the explanation of an irrevocable trust by saying that irrevocable means that it can’t be changed, while trust simply means a legal contract.

In my first article, I explained the different parties to a trust, but I will review them briefly for clarity’s sake. The grantor of the trust is the person who creates the trust, the trustee is the person or entity that controls the assets, and the beneficiary is the person or entity that ultimately benefits from the assets.

With an irrevocable trust, you can put restrictions on the corpus (the assets) of the trust. For example, you can have your kid inherit 25 percent of the assets of the trust when she is 23, as long as she is a full-time student with a B average and drug and alcohol free. This provides some sort of control to your client. Note that in an irrevocable trust, in order for the assets to be removed from your client’s estate, the grantor cannot be associated with the trust. What that means is that he or she can’t be the trustee of the trust. Usually the lawyer or accountant would be the best choice for the trustee.

Another thing to keep in mind is that an irrevocable trust is a taxable entity. The trust needs to have a fiduciary return filed, and the beneficiaries of the trust will receive K-1 forms. This usually isn’t a big issue, as the trust simply invests the corpus of the trust.

Another thing to keep in mind is the basis of gift rules so it can be used to your advantage. Without proper attention, this can cause someone to give above and beyond the gifting limits. When gifting, the donor’s basis is what they purchased the asset for.

For example, if the asset was purchased for $14,000 but is now worth $35,000, the client can get rid of the asset at the lower amount. But the actual asset is higher in value. This is common with things like securities. If you have a client who has an extensive portfolio, you need to use these rules to the client’s advantage. One other thing to keep in mind: The donee picks up the basis of the donor, meaning that if the asset is sold, it can mean a substantial capital gain to the donee.

Grantor Retained Annuity Trust
One issue that you will undoubtedly run into with estate planning is the family business. This is usually someone’s biggest asset and requires diligent care. Most clients want to “give” this asset to their children. However, as we previously explained, there are concerns with gifting an asset like the family business.

First of all, the asset is usually more valuable than the gifting rules allow. Secondly, as I stated before, once a gift is made, the client loses control of the asset. Typically, the client is still working in the business, so another strategy needs to be employed.

There are literally hundreds of ways to remove a family business from a taxable estate. The most common method is through a grantor retained annuity trust (GRAT). A GRAT is an irrevocable trust in which the grantor retains a right to receive fixed amounts payable at least annually for life or for a term of years.

In essence, a GRAT is a fixed annuity. At the end of the term or life of interest, the remaining trust principal is distributed to the designated beneficiaries free of any additional gift tax, even if the property has appreciated while held in trust. The purpose of the GRAT is to freeze the value of the asset.

Example: Jill owns a pet store that is taxed as an S corporation for federal income tax purposes. She would like to pass the family business on to her daughter, Janice. The store has traditionally had a very steady cash flow and earnings are expected to rise. Jill decided to use a GRAT to assist in the business succession plan after her tax planner told her that a GRAT could be used to transfer the stock at a substantially reduced gift tax cost while providing a steady cash flow.

Assuming the GRAT qualifies as a grantor trust (in which all of the income and principal is treated as if it is owned by the grantor), the S corporation status will be preserved, and cash generated from the business could be used to make the required annuity payment. As the S corporation’s earnings increase (as expected), it will be easier for the S corporation to meet the cash requirements of the fixed annuity payments. Any appreciation in the stock’s value will be removed from Jill’s estate and distributed to Janice.

The big downside to a GRAT is that if the client dies before the term of the GRAT is over, it remains in the taxable estate.

Intentionally Defective Grantor Trust
One way that I have worked around this is by using an intentionally defective grantor trust (IDGT). An IDGT is a term used for a trust that is purposely drafted to invoke the grantor trust rules. It can be created in one or more of the following ways:

  • The grantor or his or her spouse retains the power to recover the trust assets (e.g., the grantor retains the right to reacquire property out of the trust in exchange for property of equal value).
  • The grantor or his or her spouse can or does benefit from the trust income (e.g., the grantor and/or a nonadverse trustee can sprinkle income for the benefit of the grantor’s spouse).
  • The grantor or his or her spouse possesses a reversionary interest worth more than 5 percent of the value of the trust upon its creation.
  • The grantor or his or her spouse controls to whom and when trust income and principal is to be distributed, or possesses certain administrative powers that may benefit the grantor or his or her spouse (e.g., a nonadverse trustee may add beneficiaries of the trust income and/or principal).

An IDGT is an essential component for many estate planning techniques. For example, the most basic plan includes a revocable living trust (to avoid probate and allow for full use of the applicable exclusion amount for estate tax), which is an IDGT. Irrevocable trusts, held for the benefit of the grantor’s beneficiaries, can be IDGTs also. Because the grantor pays the income taxes incurred by the IDGT, the assets held in the IDGT can grow unreduced by such income taxes. This, in turn, increases the value of the assets available for the trust beneficiaries. In essence, the payment of taxes by a grantor is a gift to the trust beneficiaries that is not subject to transfer tax.

An IDGT also is beneficial because the trust is taxed as a “grantor trust.” Code Section 671 provides that all the trust income tax attributes are taxed to the grantor. As a grantor trust, there is no income tax to the grantor on the sale of assets to the IDGT. The trust income also is taxed to the grantor, thereby resulting indirectly in greater tax-free gifts to the trust beneficiaries. Transfers to such a trust are said to be “effective” for estate tax purposes, but “defective” for income tax purposes.

The provisions set forth in sections 671 to 679 determine whether a trust is taxed for income tax purposes as a grantor trust. These income tax provisions do not dovetail with estate and gift tax provisions. This inconsistency between the estate and income tax provisions creates the planning opportunities.

Assets can be transferred to an IDGT by use of several methods. The first is by gift or by a part gift and part sale. If the assets transferred are $5.49 million or less ($10.98 million for a husband and wife) and the transferor has his or her full exemption available, a simple gift can be made to the IDGT. However, the assets are often both given as gifts and sold to the IDGT to leverage the amount of assets that can be transferred, preserve the exemption amount, or retain income.

Now, there is something here that I want to make sure is not lost on you. You can structure this as a partial gift and sale. In that scenario, the gift acts as the down payment, sort of like a down payment in a third-party sale. I like to follow rules that are really not rules, but they’re Tax Court rulings or other factors the tax code and IRS regs are silent on. So, the value of this “seed” gift should be at least 10 percent of the value of all assets transferred to the trust, including assets transferred by both gift and sale.

When the gift is made, the transferor would use his or her lifetime gift exemption to avoid paying gift taxes. So, if you are keeping up, that would be $5.49 million in an exemption.

Next, the transferor sells assets to the IDGT. This typically includes things such as company stock, LLC interests, or real estate, in exchange for an installment note. This technique uses Section 453. The note would bear interest at the applicable federal rate (AFR) required under Section 1274(d). This rate is set for the life of the loan. The incredibly low AFR rate for a nine-year note for this year is right around 0.92 percent to 1 percent.

Because the IDGT is a grantor trust for income tax purposes, the sale of the asset would not result in any taxable gain to the grantor (for income tax purposes, the grantor is considered to be selling an asset to him or herself). There also is no interest income reported by the grantor or interest deduction to the IDGT. The grantor is my client.

I want my client to retain control of the business until his death, but in an S corporation, you can only have one class of stock, which is common stock. All shareholders of common stock have the same rights, and no one other than the majority shareholder can out-trump any other shareholder. What I did was separate his stock holdings into two categories: voting stock and nonvoting stock. The shares of stock are still common shares, but now we have a class called voting. My client held all the voting shares in this transaction.

For example, my client, Tom, could transfer $7.65 million of company’s stock to an IDGT for his wife, Julie, their children, and future generations, and remove the value and its appreciation from his estate. This is accomplished by doing the following:

  • Give $765,000 in stock as a gift to the IDGT.
  • Sell $6.885 million in stock to the IDGT. The promissory note is annual interest-only, 0.92 percent, with a nine-year-term balloon payment. The annual interest payment would be $633,420 ($6.885 million principal times 0.92 percent AFR interest rate).
  • If the dividend on the $6.885 million of stock is 7 percent each year, the IDGT income would be $479,850.

After the payment of interest, the balance of the IDGT income may be accumulated and reinvested by the IDGT and used to pay down principal or get disbursed to the IDGT beneficiaries.

My client did this:

  • Retained 100 percent of the voting stock of the S corporation, which was 1 percent of the overall stock.
  • Gifted $757,350 of the nonvoting stock to the IDGT.
  • Sold the remaining $6,816,150 in nonvoting stock to the S corporation on an interest-only note with a 15-year balloon payment at 0.92 percent, giving him income of $627,086 per year until what would presumably be his death. This income is taxable to my client as interest.

The income from the S corporation was $2.5 million per year. After the interest was paid, my client had the option of receiving additional principle on the note or taking a distribution of the profit. Because he did not materially participate in the S corporation activity, the income to him was considered passive and he was not required to take a salary.

What we accomplished was this: He sold his S corporation to the beneficiaries of the IDGT, which were his four children. The income from operations was used to pay the interest to the client, so there was no additional strain on the company’s finances or undue hardship on the children who inherited the business. My client used the income from the interest to live on and the company paid him a small distribution. He removed the business from his taxable estate, and his rights to the promissory note are owned by his revocable living trust and passed to his wife at death. Using portability of the estate tax, neither the husband nor the wife will owe any estate tax on the passing of the S corporation.

Estate planning to avoid the estate tax can be a lot of fun. However, when doing something like an IDGT, you need to first take into consideration whether the client will want to add this complexity to his or her life for tax savings. Some will not.

Related articles:

Why Everyone Needs an Estate Plan, Part 1: The Basics
Why Everyone Needs an Estate Plan, Part 2: Passing Assets to Children
The Beauty of Grantor Retained Annuity Trusts

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