Austin Wilkie is a Partner in our New York office
Recent changes to the federal estate, gift and generation-skipping transfer (GST) taxes (commonly referred to as "transfer" taxes), together with current historically low interest rates, have created unusual opportunities for individuals to undertake additional estate planning.
In December 2010, Congress dramatically altered the transfer tax regime with the passage of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the "Act"). Among other significant changes, the Act:
- reunifies the estate, gift and GST taxes
- reduces the top transfer tax rate
- increases the applicable transfer tax exemptions
- for the first time, spouses are allowed to share their estate and gift tax exemptions
The Act establishes a top tax rate of 35 percent for estate, gift and GST taxes, which will continue through December 31, 2012. The Act also increases the 2011 estate, gift and GST tax exemptions to $5 million per person, and $10 million per couple. These exemptions are now indexed for inflation, and on January 1, 2012, will further increase to $5.12 million per person and $10.24 million per couple for calendar year 2012.
The executor of the estate of an individual who dies in 2011 or 2012 may now transfer any unused gift or estate tax exemption to the individual's surviving spouse. This "portability" of the exemption allows the surviving spouse to make use of the unused exemption of the deceased individual either during the surviving spouse's lifetime, to make additional gifts, or at death, to shelter a greater portion of the surviving spouse's estate from estate tax (there is no portability of the GST tax exemption).
Note that if Congress does not extend the Act, on January 1, 2013, the following will occur:
- the top tax rate for gift, estate and GST taxes will revert to 55 percent
- the estate and gift tax exemptions will automatically be reduced to $1 million per person and $2 million per couple
- the GST tax exemption will automatically be reduced to $1.4 million per person and $2.8 million per couple
- the portability feature will disappear
The current $5 million gift and GST tax exemption provided by the Act is considerably more generous than the former $1 million exemption, and, with current interest rates at historic lows, affords a unique window in 2011 and 2012 to move considerable wealth to younger generations. Certain estate planning strategies work particularly well in a low interest rate environment. These include five strategies – GRATs, IDGTs, intra-family loans, QPRTs and gifts – which are discussed below.
Grantor Retained Annuity Trust (GRAT)
A GRAT is an estate planning tool that allows an individual to transfer interests in appreciating assets to an irrevocable trust at a reduced transfer tax cost, while retaining an annuity interest in the trust for a specified term of years. At the end of this trust term, the property remaining in the trust passes to the trust's remainder beneficiaries. Generally, a GRAT succeeds (that is, property is kept in the trust for the benefit of the remainder beneficiaries) when the investment return on the trust property exceeds the IRS-established interest rate for valuing the annuity. The IRS-established interest rate for December 2011 is 1.6 percent. Therefore, if the trust investments perform at a rate greater than 1.6 percent, the GRAT is likely to succeed as a wealth transfer tool.
Creating a GRAT currently will lock in the IRS-established interest rate for valuing the donor's annuity while interest rates are low. Another reason to act quickly is because legislation has repeatedly been proposed that would (1) require a GRAT to have a minimum 10-year term, and (2) impose at least some gift component on the donor at the time of creating a GRAT. Under present law, it is still possible to create a short-term GRAT (which generally will most efficiently accomplish the donor's planning goals) with absolutely no exposure to gift tax; but this may change if recent legislative proposals are adopted.
Sale to Intentionally "Defective" Grantor Trust (IDGT)
Another option for transferring assets at a reduced transfer tax cost is an installment sale to an intentionally "defective" grantor trust (a trust in which the transferor would be treated as the owner for income tax purposes, but which is not included in the transferor's estate upon the transferor's death). The transferor sells assets likely to appreciate in value to the trust in exchange for a reasonable down payment and a promissory note for the balance. From an income tax perspective, no taxable gain would be recognized on the sale of the property to the trust, because the trust is a defective grantor trust, which makes this essentially a sale from the transferor to the transferor. For the same reason, the interest payments made by the trust on the note would not be taxable to the transferor or deductible by the trust.
If the value of the trust assets grows at a greater rate than the prevailing IRS-established interest rate (which for sales in December 2011 will be .20 percent), as with a GRAT the excess appreciation will pass to the trust beneficiaries free of gift and estate tax. The current record-low interest rates make sales to defective grantor trusts most opportune to structure now.
Intra-Family Loan
Again, because interest rates are so low, techniques involving the use of intra-family loans should be considered. In a typical intra-family loan transaction, the lender, usually a member of the senior generation, loans money to the borrower, a member of a more junior generation. The borrower may use the funds to purchase an asset, such as a home or investment asset, or to start a business.
If the borrower invests the loan and is able to realize a rate of return in excess of the interest rate, the lender has in essence made a tax-free transfer to the borrower. If the borrower uses the loan to purchase a home, the lender has made a tax-free transfer to the borrower measured by the savings the borrower achieves compared to a commercial loan. Often the promissory note is structured as a balloon note, requiring repayment only at the end of the note term, with the borrower making interest payments only until the balloon payment is due. The transaction could also be structured with the creation of trusts by older generation members for the benefit of younger family members, to which the older generation members loan funds. The spread between the investment return earned by the trust and the interest paid by the trust will create a transfer tax-free gift.
Under the prevailing IRS-established interest rates, loans made during December 2011 with a term of three to nine years can utilize an interest rate as low as 1.27 percent. Loans with a term of nine years or more can utilize a rate of 2.80 percent.
Qualified Personal Residence Trust (QPRT)
A Qualified Personal Residence Trust is an irrevocable trust created by an individual (the "donor") and funded with the donor's ownership interest in a personal residence. The donor may transfer title to the donor's primary residence or vacation home to a QPRT, retaining the right to continue to use the residence for a term of years. Since the donor retains the right to occupy the residence until the end of the QPRT term, at the time the QPRT is created the only gift made by the donor is a gift to the remainder beneficiaries of the future right to the residence at the end of the QPRT term. This deferral of the beneficiaries' full ownership rights in the residence reduces the value of the donor's gift of the residence, typically by 25 percent to 50 percent of the residence's value depending on the duration of the QPRT term selected and prevailing interest rates. In addition, all appreciation in the residence's value after the transfer to the QPRT will escape estate and gift tax. If the donor wishes to continue to use the property after the QPRT term, the donor may lease the residence from the beneficiaries at fair market rent.
While the use of a QPRT is typically most advantageous when interest rates are high (since the value of the donor's retained interest is computed based on prevailing IRS-established interest rates), a QPRT should still be considered in the current economic environment where the value of real estate has declined precipitously. As long as real estate values remain depressed, a transfer of a future interest in real estate to a junior generation using a QPRT may continue to be attractive.
Gifts
For both 2011 and 2012, a donor may make up to $13,000 in annual exclusion gifts per donee (or $26,000, where the donor's spouse agrees to "split" the gift) without incurring gift tax or using any portion of the donor's transfer tax exemption. A cash gift may be given up to 11:59 p.m. on December 31, 2011, and still count as a 2011 gift. A check, however, must be cashed by the individual donee before January 1, 2012 to count as a 2011 gift. In addition, a donor may make direct payments for a donee's tuition, medical expenses and health insurance premiums, none of which count against the donor's transfer tax exemption.
Looking Ahead to an Unpredictable Future
In recent years, the federal and state laws which affect estate planning have been in constant flux, and, as always, future developments are difficult to predict. Will the federal transfer tax exemption remain at the current $5 million level beyond 2012? Or will it retreat to the $3.5 million exemption in effect in 2009, as the Obama administration has urged? Or will a 2012 legislative gridlock usher in a sunset of the Bush tax cuts and a return to the $1 million transfer tax exemption last seen in 2003?
Nothing is certain, but in all likelihood low interest rates will not last forever, and some estate planning tools which are effective today may be restricted by future legislative action. This is why anyone with significant wealth should be re-evaluating their estate planning goals and options now.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
