By: Andrew Bechel, Esq.
While it is still unclear what types of tax proposals a Biden administration will make (and whether such policies can even be implemented could depend on two upcoming Senate runoff elections in Georgia), there are several planning opportunities that can still be taken advantage of in the current environment. To be clear, these opportunities are independent of any reforms a Biden administration may propose, but may be combined with other strategies or structured in a way to ensure that you are prepared for any potential reforms, such as reductions to the estate and gift tax exemption.
Interest Rates are Still at Record Lows
The pandemic has brought about unprecedented low interests rates (the November short-term applicable federal rate is still at 0.13%). While these low rates can be used to refinance your current debt, several planning techniques can also take advantage of these low rates, such as certain estate freeze transactions and grantor retained annuity trusts. The goal of these types of transactions is to move assets out of your taxable estate while minimizing the use of your estate and gift tax exemption.
In a fairly standard estate freeze transaction, a person will sell an asset, preferably an asset that is expected to appreciate in value significantly, to a grantor trust in exchange for a promissory note. Sales to grantor trusts are ignored for income tax purposes, meaning that no gain or loss will be recognized on such sales. However, to ensure that such sale also has no gift or estate tax consequences, the note should be issued at the then applicable federal rate. This transaction removes the appreciating asset from your taxable estate. The promissory note will be included in your taxable estate, but such inclusion amount is limited to the note’s fair market value (which is calculated based upon the note’s outstanding principal amount and interest rate). This amount, along with any necessary interest payments, will be minimized due to the extremely low applicable federal rates that we are currently experiencing.
The reason these transactions are called estate freezes is that they “freeze” the value of the asset in your taxable estate at the value of the note. If the asset appreciates after the sale, none of that appreciation is included in your taxable estate because the only asset included in your estate is the note, not the asset. Thus, your taxable estate is reduced by the amount of such appreciation but, because the transaction was structured as a sale rather than a gift, you will not have utilized any of your estate tax exemption. If you consider doing a sale to a grantor trust, it is extremely important that you carefully select an asset that is expected to appreciate significantly because this technique only removes the value of such appreciation from your estate, not the value of the asset on the day of the sale.
Grantor retained annuity trusts also remove asset appreciation from your estate. In a grantor retained annuity trust, you transfer assets to a trust that will make an annuity payment to you, as the grantor, annually. After the annuity payments have all been made, any amount remaining in the trust is transferred to a remainder beneficiary and is not included in your taxable estate. The annuity payments are calculated similar to a loan payments, in that each annuity payment essentially equates to a portion of the face value transferred to the trust plus an additional “interest payment.”[1] The annuity payments are based off of what is called the Section 7520 interest rate, which is slightly higher than the short-term applicable federal rate but is still at some of the lowest levels ever seen.
Grantor retained annuity trusts are a very helpful planning tool, but they are not right for every client. Grantor retained annuity trusts work best with certain types of highly variable assets and can have negative tax consequences if the grantor dies during the annuity period. As a result, if you are interested in this planning technique, you should consult your counsel as well as your financial advisor to ensure that it is the appropriate planning technique for you. However, when used properly, the author has seen grantor retained annuity trusts reduce a client’s taxable estate by tens of millions of dollars.
Depressed Assets
Due to the pandemic, certain asset classes may be depressed. For example, interests held in a family restaurant business are likely severely depressed because of the restrictions placed on dining establishments. Since assets in these depressed classes will, presumably, increase in value after the pandemic, it may be a good time to gift these assets now, while the value is depressed, to remove all of the future appreciation out of your taxable estate. This will allow you to maximize your estate tax savings while minimizing the amount of estate tax exemption you use now, which will further allow you to make additional gifts in the future to further reduce your taxable estate. Depending on how much the value of the gifted assets is depressed, and, of course, the overall economic recovery, this strategy has the potential to save a significant amount of estate tax in the future, and such opportunity only exists due to the current crisis that we are currently facing.
If you choose not to gift depressed assets or do not otherwise have sufficient remaining estate tax exemption, you could also sell these assets to a grantor trust in exchange for a promissory note. The depressed asset would be removed from your estate in exchange for a promissory note, which would be valued at the current depressed asset value. This is identical to the freeze technique described above, except that in this case we are specifically targeting depressed assets for the sale. This example shows that the different techniques described in this post can be combined in a manner that fits your specific circumstances and intentions.
The pandemic has brought about untold hardships for most individuals and families, be it loss of jobs, shuttered businesses, or (most serious of all) caring for sick loved ones. While there is nothing that can be done to alleviate these hardships, due to the unique economic circumstances brought on by this crisis, it does present opportunities to pass assets to future generations with minimal tax consequences. Depending on your specific circumstances, there may be other planning opportunities that we can take advantage of at this time as well. Contact [email protected] International Wealth & Asset Planning team.
[1] This is a simplified explanation of how the annuity payments are calculated, but the author has found it useful to compare the annuity payments to loan payments since most people are familiar with how loan payments are calculated.
