Transferring your legacy
Pre-election estate planning moves for high-net-worth families
As Election Day draws closer, it’s prudent to reflect on the intimate relationship between politics, policy changes and your estate planning.
As you may recall, prior to the 2016 federal election, there was a flurry of activity in anticipation of possible changes to the tax code. At the time, campaign proposals drove high traffic to estate planning attorneys, as individuals rushed to protect assets before changes in the laws could be implemented.
Given that precedent, and in order to avoid the stress of last-minute changes to your estate-planning documents, we suggest putting your financial house in order now, while you have time to be deliberate and purposeful in your planning.
Each family’s situation is unique, with its own complexities and dynamics. That being said, there are strategies and best practices in a planner’s toolkit that can help you capitalize on the advantageous estate planning environment that we currently enjoy.
The biggest opportunity for high-net-worth individuals is the ability to gift up to $11.58 million to another person free of transfer tax. This 2020 exemption is more than twice what it was in 2016 ($5.5 million) and is due to sunset in 2026. Of course, given the variability of politics, this provision may be altered sooner than 2026.
For individuals who have estates between $10 million and $20 million, taking advantage of the current laws could provide a substantial reduction in estate-tax liability. Selection of an appropriate strategy depends on whether a person or family is looking to maintain access to the assets they are removing from their taxable estate, or whether they intend to transfer those assets to children and/or grandchildren.
Strategies that allow a person to benefit from assets and appreciation that are removed from the taxable estate:
1. Spousal Lifetime Access Trust (SLAT):
A SLAT is an irrevocable trust set up for the benefit of a spouse that is funded by gift while the grantor-spouse is still alive. The ultimate goal is to move assets out of the grantor spouse’s name into a trust that can provide some financial assistance to a beneficiary-spouse, in a manner that shelters the property from the beneficiary spouse’s future creditors and taxable estate.
2. Beneficiary Defective Inheritor’s Trust (BDIT)
In short, a BDIT is an irrevocable trust that allows one to enjoy the benefits of a traditional trust without giving up control of their property. The BDIT is structured in a way that allows the beneficiary to continue managing and using assets without causing the assets to be included in his or her taxable estate.
Examples of people who may want to consider them:
Tim is the founder of a successful construction business. Shortly after the start of his company, Tim and Mary get married and have two children. Tim transfers $2 million of his interests in the company into a SLAT, naming Mary and their descendants as discretionary beneficiaries.
The SLAT shelters Tim’s $2 million gift plus the growth from the date of the gift and allows Mary, and indirectly Tim, to have access to the trust funds through distributions during Tim’s life. The SLAT assets will avoid being subject to estate taxes at Tim and Mary’s death and the remaining property can be immediately available to their descendants.
Mary owns a family business that is on an upward trajectory. She wants to eventually pass her assets on to her child on a tax-advantage basis, but is not yet ready to give up control. She asks her father (as a third-party donor) to set up a BDIT naming Mary as a beneficiary and her child as a contingent beneficiary.
Mary’s father contributes a nominal amount of cash or property to the trust (usually around $5,000) for Mary’s benefit. The trust documents allow Mary lapsing powers to withdraw funds from the trust. This “beneficiary defect” ensures Mary is treated as the grantor of the trust for income tax purposes, while Mary’s father retains no power or control over the trust.
Mary can sell her business to the trust so long as the trust has sufficient substance to support the sale, which may be difficult for new trusts that have not generated enough value. To fix this issue, the BDIT can get a personal guarantor to guarantee a promissory note with a market interest rate. It is advisable that Mary gets the assets appraised before conducting the sale, so that the IRS does not consider the transfer a gift (which would cause the trust’s assets to be subject to estate tax when Mary dies).
The BDIT will then own Mary’s business, which owns and manages the investment assets. Mary is able to receive distributions from the trust, and her assets are further protected from creditors.
Strategies that transfer assets and appreciation to future generations:
1. Grantor Retained Annuity Trust (GRAT):
A GRAT is an irrevocable trust that allows the grantor to freeze the value of appreciating assets and transfer the growth at a discount for federal gift tax purposes. The grantor contributes assets in the trust but retains a right to receive an annuity from the trust while earning a rate of return specified by the IRS. GRATs work best in a low-interest rate environment because the appreciation of assets over the set §7520 rate goes to the beneficiaries, and at the end of the term, the leftover assets pass to the grantor’s designated beneficiaries with little to no tax impact.
2. Gift or sale of interest in family partnerships:
Family Limited Partnerships allow for the transfer of assets, via partnership interest, from one generation to the next without giving up control of the property. These partnerships also have the opportunity to be transferred at a discount to net asset value, which can reduce gift and estate tax liability.
People who may want to consider them:
Mary’s business holdings are valued at $3 million, and have been growing steadily for the past five years. She wants to pass these business interests on to her children, but she is concerned estate taxes will significantly lower the ultimate value of the businesses when her children receive them.
Mary places her business holdings in a GRAT with an eight-year term naming her children as beneficiaries. Using the §7520 rate, the IRS projects that in eight years her business holdings will be worth $4 million. She then sets up the annuity to pay herself exactly $4 million over the next eight years.
Over the eight-year term, Mary’s business actually grows to $6 million. The $2 million then passes to her child tax free.
Family limited partnership:
Tim and Mary Smith own a business worth around $3 million, and they want to pass it on to their children one day. They set up a FLP as general partners and gift limited partnership interest to their adult children. Tim and Mary are able to control cash flow while the children are able to collect dividends, interest and profits.
As a result of the FLP, the assets are restricted, and consequently their value is discounted for gift tax purposes at the time the limited partnership interest is transferred.
Strategies that benefit charitable interests while also benefiting grantors or heirs:
1. Charitable Lead Trust (CLT):
A CLT allows gifts to have immediate impact on charitable organizations during the grantor’s lifetime while providing eligibility for advantageous tax benefits for either the grantor or the grantor’s heirs. This trust works by paying a set annuity to a specified charity for a set term, and when it expires, the balance of the trust is available to the trust beneficiary. CLTs are most beneficial in a low-interest environment because a lower interest rate will reduce the taxable portion of a grantor’s gift to the remainder beneficiaries, and the assets in the CLT may appreciate at a higher rate.
2. Charitable Remainder Trust (CRT):
A CRT is thought of as an inverse to a CLT. In a CRT, the grantor receives an income stream from the trust for a term of years, and a charitable organization receives the remaining assets at the end of a trust term. CRTs work best in a high-interest-rate environment because they assume the money in the CRT will grow quickly, leaving more for the charity when the income interest ends. The grantor receives an immediate income tax charitable deduction when the CRT is funded based on the present value of the estimated assets remaining after the annuity term ends.
People who may want to consider them:
Mary funds a CLT with $1 million. The CLT provides for a level annuity payable to the American Cancer Society each year for 10 years. Mary names her child as the remainder beneficiary, who will be entitled to any remaining assets after the term expires.
Mary will receive a gift or estate tax charitable deduction for the present value of the total estimated benefit to the American Cancer Society. At the end of the 10-year term, any remaining assets in the trust will pass on to her child. Depending on the performance of the trust investments above the initial calculation of the remainder value, the transfer could happen at a reduced value for gift tax purposes.
Mary makes a $1 million contribution to a CRT with a 10-year term. Mary lists the American Cancer Society as the remaining beneficiary. Her contribution makes her eligible for a partial income tax deduction, and Mary set up the trust so she receives a percentage of the assets on a monthly basis.
After the 10-year term, the CRT terminates, and the remaining CRT assets are distributed to The American Cancer Society.
Each of these strategies has nuances that should be examined carefully in consultation with an estate planning attorney before being implemented. While the present opportunity for significant estate and gift-tax savings is substantial, careful planning is required to ensure that each family’s objectives are supported by the wealth-transfer vehicle they employ.
While 2020 gave us a global pandemic, the blastoff of the Mars Mission and headlines like no other year, you would like to be able to greet the election news on Nov. 3 with the satisfaction that, whatever the outcome, you have taken proactive steps to preserve assets and advance the legacy you envision for yourself and your loved ones.
The contents in this article are being provided for educational and informational purposes only. The information and comments are not the views or opinions of Union Bank, its subsidiaries or affiliates.