There are a variety of “advanced” or “sophisticated” estate planning devices which estate planners can employ for the purpose of reducing, or entirely eliminating in some cases, the federal estate tax which an individual’s estate must pay on his or her death. The common elements among all of these techniques are (1) making value “disappear” in the individual’s estate by means of the valuation reduction (“discounts”) created for the assets in the individual’s estate, (2) shifting growth, and sometimes, income out of the wealthier family member’s estate, (3) leveraging the benefit of discounts and the lower gift tax rate on gifts made, and (4) exempting assets and growth on these assets forever from estate and generation-skipping transfer tax.
Many of these techniques offer advantages beyond transfer tax savings, e.g. satisfying an individual’s wishes to benefit charities, fostering the orderly transfer of the family business or ranch to family members, protecting beneficiaries from creditors and angry spouses, and more.
Included in the following list of techniques is the “Bypass Trust,” which is common place today among spousal estates of more than $3,000,000 in value so that some estate planners would hardly consider it an advanced planning technique. Nevertheless the use of a Bypass Trust at the death of the first spouse to die can yield a significant amount of estate tax savings (at least $2,045,800 and often considerably greater) to the total family estate. The Bypass Trust only can be used in the estates of married individuals.
The Bypass Trust
The Bypass Trust (sometimes also referred to as the Credit Shelter Trust or Exemption Equivalent Trust) is a technique by which the surviving spouse (the “Survivor”) can leverage the deceased spouse’s Applicable Exclusion Amount (“AEA”), also called the unified federal estate and gift tax exemption. Each decedent individual is allowed by the tax code an AEA which can be applied against her gross taxable estate. Such gross taxable estate includes any property or contractual benefit (IRA, life insurance, etc.) which passes to another person or institution at death. The AEA is also applied automatically against any lifetime transfers of property (“gifts”) made by an individual. Pursuant to the new federal tax act of January 2, 2013, the AEA of $5,000,000 was made permanent (and adjusted for inflation to $5,120,000 for year 2012 and $5,250,000 for year 2013), and the top tax bracket was fixed at 40%. Both the federal gift tax exemption and the generation-skipping transfer (“GST”) tax exemption amounts are now equal to the estate tax AEA.
If a Bypass Trust is not established with assets of the deceased spouse (the “Decedent”) at his death, all or most of the Decedent’s estate will pass to the Survivor (assuming the typical spousal plan). The estate passing to the Survivor will not be taxed because an estate tax marital deduction is allowed by the tax code to any estate received by the Survivor. Given a continued life span of more than a few years and sufficient income, the Survivor’s augmented estate should grow considerably. Prior to the new federal tax acts of 2010 and 2013, the Decedent’s AEA was effectively lost if no Bypass Trust was created because his estate became part of the Survivor’s taxable estate upon her death. For a death in 2013 and after, any portion of the Decedent’s AEA which is not used can be elected by the Survivor for addition to her own AEA under a new concept of “portability.” Thus for a death in 2013, the unused portion of the Decedent’s AEA can be added to the Survivor’s own AEA. If the Decedent’s unused AEA is $3,000,000 ($2,250,000 went into the Bypass Trust and/or went to other non-spousal beneficiaries), the Survivor will have a total AEA of $8,250,000 (her $5,250,000 plus the additional portable $3,000,000). If all of the Decedent’s estate went to the Survivor (no Bypass Trust was used and no distributions to other beneficiaries), the Survivor will have a total AEA of $10,500,000. See the 2010 federal estate tax act article for portability.
With a Bypass Trust incorporated into the spousal estate plan, assets equal in value to the AEA of the Decedent are funded into such Bypass Trust after the Decedent’s death. The Survivor can be given rights to income of the Bypass Trust, and even principal if her health, education, maintenance and support justify such principal distributions. The Survivor can be given a special power to appoint the Bypass Trust to certain family members or charities. Because the Survivor’s rights to the Bypass Trust are limited (but not much), the tax code states that such Bypass Trust (and all growth in its assets) will not be subject to estate tax at the Survivor’s death.
The Bypass Trust must be planned for in the estate planning instrument (either Will or Revocable Trust). Because of the unprecedented flux and uncertainty in the federal estate, gift and GST planning law, flexibility in estate planning documents has become the keyword for planning attorneys. The goal is to allow the personal representative of the Decedent’s estate the opportunity to select how much of the Decedent’s estate should be funded into the Bypass Trust. One technique for obtaining such post-death flexibility is to allow the use of a disclaimer by the Survivor. Any portion of the Decedent’s estate which is disclaimer will go into the Bypass Trust. This technique has several weak points (the primary of which is a short nine months after the Decedent’s death to make such disclaimer) not present in a second technique which is now employed by more attornesy. This planning is to have the estate planning document allow the Survivor to qualify any portion of the Decedent’s estate for the marital estate tax deduction. Any portion not qualified becomes the Bypass Trust. Both techniques will give the Survivor a chance to review the estate after the Decedent’s death, and not be locked into a mandatory funding of a Bypass Trust as the traditional formula clause estate planning does. Such traditonal formula clause planning is informally known as the “A-B” or “A-B-C” plan.
To see a schematic of the Bypass Trust for year 2006 when the AEA was $2,000,000, click here.
The Qualified Personal Residence Trust ( “QPRT”)
A QPRT is an irrevocable Trust established for a certain number of years. The owner of the residence is the grantor of this Trust. During the term of the QPRT, the grantor retains the right to live in the residence. After the term has expired, the QPRT dissolves and the remainder beneficiaries (the grantor’s children, probably) become fee simple owners.
The key to this technique is that the grantor is deemed to have made a completed gift at date of creation of QPRT. The value of the gift is reduced to reflect the time the remainder beneficiaries have to wait for outright ownership of the property. The age of the grantor, the length of the term and the AFR (applicable federal rate) at time of creation all factor in to compute the value of the gift. If the grantor does not outlive the term of the QPRT, the entire transaction is unraveled, the value of the residence comes back into the grantor’s estate, and the gift is canceled. The big advantage of a QPRT is that the residence, at a substantially reduced value, plus all appreciation between date of QPRT creation and DOD, are taken out of the grantor’s estate at the time of his death. Typically, the beneficiaries will rent the residence back to the grantor after the expiration of the term of the QPRT. To see the mathematics for a QPRT, go to this QPRT article.
The residence must be under exclusive control of the grantor in order to qualify for inclusion in a QPRT. It can not be partially rented out. An individual can also have a QPRT for one vacation home. In the event the residence is sold during the term of the QPRT, the QPRT will remain valid if a new personal residence is acquired within two years of the sale and before the expiration of the QPRT term. The tax benefit of the QPRT can also be salvaged if the Trust document provides that the sales proceeds are converted into a qualifying annuity Trust (Grantor Retained Annuity Trust).
One disadvantage of the QPRT is that the remainder beneficiaries will take a carry-over income tax basis in the residence (i.e. the presumably low tax basis of the grantor at time of funding) instead of a presumably higher tax basis at the date of death of the grantor, if the residence had been left to the beneficiaries at the grantor’s death.
The Grantor Retained Annuity Trust (“GRAT”)
The GRAT concept is similar in function to a QPRT. Instead of a principal residence, cash, securities or any other investment is used to fund the GRAT. Again, the idea is to make a gift to a family member at a substantially reduced value, and, again, the grantor must outlive the GRAT term for this plan to work.
Two situations exist which create the most benefit for the GRAT. One is when an appreciating asset is used for the GRAT asset. Examples are a stock option that will be exercised for a large gain by the remainder beneficiaries after the GRAT term expires. Another asset might be undeveloped real estate which will yield great profit if subdivided after the GRAT term expires. The other situation is when the actual rate of return on the GRAT asset during the GRAT term is greater than the date of funding Applicable Federal Rate (“AFR”) which must be used for computing the gift valuation deduction. The AFR is published by the federal government each month.
One possible disadvantage of this technique is that the grantor will lose the right to the income after the term expires (not a disadvantage if the grantor does not need the income). Another disadvantage is the beneficiaries will take a carry-over income tax basis in the GRAT asset(s), instead of the DOD tax basis otherwise allowed by the tax code. In large estates, the grantor’s losing the right to the income is a benefit in that he or she has effectively “assigned the income” to another, a result which is typically difficult to accomplish under tax law.
The Charitable Remainder Trust (“CRT”)
There are several varieties of CRTs, all of which accomplish similar results. A CRT usually is set up during a person’s life. During that life, this person (the “grantor”) receives a certain amount of cash each year. This amount can be in the form of an annuity (e.g. 6% of initial Trust value), or in the form of an percentage of the Trust value at a given date each year (e.g. 6% of Trust principal value on January 1 of each year). This form is called a “unitrust” amount.
At his death, all remaining value in the CRT typically passes to the charity (or other qualified non-profit organization such as a church or school). However, the grantor can set up the CRT so that upon his death, the annuity or unitrust amount will continue on for the life of the Survivor (or even children). This remainder value going to the charity is not subject to estate tax because of the estate tax charitable deduction. If the Survivor is the intervening beneficiary, the estate tax marital deduction will apply. However, any annuity or unitrust amount going to non-spouse, non-charity beneficiaries will be subject to federal estate tax based on actuarial valuations.
Besides the estate tax avoidance benefit provided, the CRT also provides that (1) in the year of creation, the grantor receives an charitable income tax deduction (subject to AGI limitations with 5-year carryover) and (2) any appreciated assets sold by the CRT are not subject to capital gains tax because the CRT is a tax-exempt entity.
Certain mathematical rules established by tax law must be satisfied in order for the CRT to qualify as a tax-exempt entity. The two main rules are: (1) For all CRTs, the valuation of the charitable remainder interest must be at least 10% of the principal value of the CRT. The tax code does not want the grantor to set up a CRT, and provide for a intervening remainder interest to spouse and children which may likely deplete the CRT before these beneficiaries die, leaving the charity virtually nothing. (2) For CRATs only (Charitable Remainder Annuity Trust), there must be greater than a 5% chance that the CRAT will not be totally exhausted at the death of the grantor (and other intervening beneficiaries). Because the CRAT payment is a set sum of money each year, regardless of the principal value of the CRAT each year, it is possible that the yearly CRAT payment will exceed the actual rate of return earned by the CRAT each year, thereby reducing the CRAT in value each year.
CRTs often result in a win-win situation for the grantor, especially if appreciated assets are funded into the CRT. Here is a typical scenario: A grantor can fund an appreciated asset which is not producing enough income for his needs (e.g. a farm leased out for only 2% net per year) into the CRT, and receive an immediate charitable income tax deduction for gift (computed on the actuarial value of the grantor’s life expectancy). The Trustee of the CRT (who can be the grantor) can decide to sell the appreciated asset at no realization of capital gain. The CRT cash proceeds can be wisely invested, yielding a much higher rate of return than the farm. Much of this return will be passed to the grantor who is the present income beneficiary. When the grantor dies, the remaining value of the CRT is passed to the charity free of estate taxation. And, perhaps most importantly of all, the charity receives a substantial benefit.
One disadvantage of a CRT is that the ultimate beneficiaries of the CRT will not be the children (or other desired beneficiaries) of the grantor. However, if the grantor is insurable, he or she can obtain a life insurance policy, premiums being paid for with the increased income generated by the CRT, which will name the children as beneficiaries. Also, it is likely that the increased income received by the grantor during her lifetime will result in her having a larger estate available at her death than if she had kept the farm.
The Charitable Remainder Unitrust (“CRUT”) comes in several different species, namely the NICRUT (the grantor receives the lesser of the unitrust percentage or net income during the year), the NIMCRUT (if net income is less than the unitrust percentage, the difference will be made up in future years), and the FLIP-CRUT (the NICRUT will switch to a standard CRUT upon the occurrence of a certain event in the future, such as the sale of a particular parcel of real estate)
The Charitable Lead Trust (“CLT”)
The CLT, most commonly a Charitable Lead Annuity Trust (“CLAT”), is most appropriate when the grantor’s income needs can be satisfied from sources other than the assets funded into the CLAT. The CLAT essentially is the opposite of the CRAT in that the charity receives the annuity income and the individuals (usually children or grandchildren) receives the principal balance after the CLAT term ends.
The CLAT works like this: The grantor establishes an irrevocable Trust for a term of years. During this term, a charity (or other non-profit institution) receives an annuity amount established by you. At the end of the term, the CLAT terminates and remainder beneficiaries then receive the CLT balance. The same concepts of gift value reduction discussed above for a GRAT apply here. A 10-year CLAT will produce the same results as a 10-year GRAT. A CLAT provides most benefit when the CLAT assets appreciate and when the actual rate of return on the CLAT exceeds the AFR effective at date of funding.
There are two main differences between the CLAT and the GRAT. (1) The annuity income for the CLAT goes to the non-profit, not to the grantor. (2) The grantor does not have to outlive the term of the CLAT. The CLAT will continue in force even if the grantor dies.
The “life” portion of the transfer (value of CLAT assets at date of funding less the value of remainder interest) is eligible for a charitable income tax deduction only if the grantor chooses to report the annuity income on his or her personal income tax return.
Unlike a CRT, the CLAT is not a tax-exempt entity, so the sale of an appreciated Trust asset by the CLAT Trustee will not avoid capital gain. Also, when the CLAT property ultimately goes to the remainder beneficiary, it will take the lower carry-over tax basis with it.
For more on the CRT and the CLT, see the Charitable Planning Seminar outline for July 2011.
Family Limited Partnership (“FLP”)
The FLP is an aggressive technique which can yield substantial tax and non-tax benefits. Large valuation discounts for the transfer of fractional ownership interests in a FLP, represented by limited partnership interests (and not the assets owned by the FLP) will result because of the lack of control and lack of marketability attached to these interests. This area of tax law has been hotly litigated for the past decade, with the IRS losing most cases until recently when the IRS based its attack on the theory the taxpayer/creator of FLP had retained sufficient interest in the FLP to allow a judge to conclude the taxpayer created the FLP solely for the purpose of reducing his estate tax.
A 2005 U.S. Tax Court case did provide a standard which the court would like satisfied before the FLP will be respected by the tax law. If the taxpayer/creator can document at least one non-tax reason for creating a FLP and if the distribution of FLP profits and recognition of FLP losses are realized by each general partner and each limited partner in proportion to each partner’s ownership interest in the FLP, the FLP is likely to pass muster with the court (and with the IRS). Setting up the FLP and then later providing for gifts to donee family members need to be done carefully, but such work is not enough. The post-formation actions of the general partner/s of the FLP must be done appropriately and consistent with the reality of the partnership entity. As a general rule, the taxpayer should have sufficient income sources outside of the FLP to survive upon, and not rely just on distributions from the FLP.
The typical FLP plan begins with a parent (or parents or grandparents) creating a limited partnership. Real estate, securities and cash (not residences) are assets usually transferred into the FLP by the parent. The parent will be the sole general partner of the FLP usually, and the owner of most of the limited partnership units. He then will gift limited partnership units to the kids at discounted values. For instance, he may gift limited partnership units equal to $21,538 in actual value and report a discounted value of $14,000. A 35% discount is fairly conservative in most cases. The parent may also gift his Applicable Exclusion Amount (“AEA”) at a discounted value in year one, and then gift the $21,538 of limited partnership units in subsequent years.
As general partner, the parent can retain sole management control of the partnership, which can be an important non-tax benefit of the FLP. The kids, as limited partners, can not vote on how the FLP is run or when it will terminate. The kids can not use the funds or assets in the FLP, and the FLP agreement will typically limit their ability to sell or transfer their interests. The kids will not get distributions unless the general partner approves, although pursuant to the 2005 tax court case mentioned above, the general partner should not make distibutions to himself unless the other partners receive distributions proportionate – with all such distributions being made proportionate to ownership shares. The kids can not use the FLP interest as collateral on a loan.
At the parent’s death, his limited partnership shares which will pass to the kids by his Will or Living Trust will also receive a discount based on the lack of control and lack of marketability doctrines. The discounts taken both for life-time gifts and post-death transfers of limited partnership interests will have the saluatory effect of allowing a large amount of actual estate value transfer to the parent’s kids free of gift or estate tax.
The language found in the limited partnership agreement (which can not be more restrictive than state statutory law for limited partnerships) will provide for a limited right to transfer the limited partnership interests, thus making the interest less valuable on a willing-buyer, willing-seller basis. Some cases and revenue rulings have allowed discounts up to 60%, although 30% to 35% discounts seem to be more in the safe range. Critical to the success of the FLP is the use of expert “discount” appraisers to value the discounts of the transferred limited partnership interests. However, one IRS estate tax attorney for the Northern District of California has told this author that he will not challenge a “reasonable” discount, probably in the area of 30 to 35% (depending on the underlying assets owned by the FLP), in FLPs valued at less than $5,000,000, which do not obtain “discount” appraisals. Such appraisals can be garnered at a later time if the IRS does challenge the discounts taken.
Other non-tax advantages of a FLP include the inability of a spouse or girl/boy friend of a child from becoming a limited partner (important in the case where a divorce or other problem may exist in the future or now), insulating the LP interests and distributions from creditors of the limited partners, creating an efficient way of centralizing management of a family business (real estate and other holdings), and more.
A family limited liability company (“FLLC”) can be used instead of a FLP in most states, including California. In certain case, a FLLC may provide advantages that a FLP can not.
The disadvantage of a FLP (or a FLLC) is that it is expensive to set up correctly. A top attorney must be hired to ensure that the multitude of FLP tax traps are avoided, and as mentioned above, expensive expert “discount” appraisers, who have a proven track record with the IRS, must be hired for the larger FLPs.
For more detailed information on the FLP, go to this article.
Irrevocable Life Insurance Trust (“ILIT”)
The typical purpose for the use of an irrevocable life insurance Trust is to remove the cash value and death benefit value from the taxable estate of the insured person. If the insured has no control over the insurance policy, i.e. can not revoke, can not change beneficiaries, etc. the tax law will not include the death benefits in his estate for federal estate purposes at his death. An independent Trustee will manage the ILIT, pay the premiums, etc. It is possible for the insured to make contributions to the Trustee for inclusion into the ILIT. The Trustee may use these funds, plus growth on them, for payment of premiums on life insurance on the life of the insured. If the beneficiaries of the ILIT are given a limited right of withdrawal from the ILIT, typically in the form of a “Crummey Power” for a window period of 30 days or so, it is possible for the gifts to the Trust to fall within the $14,000 per beneficiary/per year exclusion from gift taxation.
The greatest benefit associated with the ILIT is when the ultimate beneficiaries are grandchildren (and other descendants below the grandchild generation) of the insured person. At the time each funding contribution of $14,000 is made to the ILIT, the insured person will allocate a portion of his generation-skipping transfer (“GST”) tax exclusion (which is currently $5,250,000) to the cash gift on a timely gift tax return. Over twenty years, the insured person can make gifts totaling $280,000 per beneficiary, a cash pot completely covered by his GST tax exemption. Assume gifts are made to only one grandchild. Also assume the life insurance policy is for $5,250,000. At the insured person’s death, the estate (life insurance death benefits) generated by $280,000 of premiums will be $5,250,000, all of which will be GST tax exempt. Bottom line: the $5,250,000 will pass free of both estate tax and GST tax to the grandchild, or to a Trust for a child, with remainder to grandchild, or perhaps to a Dynasty Trust arrangement where grandchild, great-grandchild, and further descendants will enjoy the benefits of the non-taxed estate.
The Dynasty Trust
A Dynasty Trust is a multiple generation-skipping transfer tax (GST) Trust designed to optimize the exclusion from the GST tax. A Dynasty Trust is used to transfer assets to multiple generations with transfer tax being paid only at the initial transfer to the Trust, thus avoiding both estate and GST tax at the transfer of assets at each subsequent generation.
A Dynasty Trust can be established at the death of the second spouse, or established now while both spouses are living. More benefit is realized if established now due to the inevitable long term growth in asset values.
A Dynasty Trust will generate the most benefit for a Trust established under the law of states which have repealed the common law rule against perpetuities. A Dynasty Trust which never terminates provides for amazing savings in the transfer taxes because of huge amounts of Trust value that may be accumulated free from both the estate and the GST tax. In a state like California, which still recognizes the rule against perpetuities (which will force termination of the Trust in approximately 90 years), a large amount of accumulated tax-free benefit nevertheless can be recognized. The California resident may, if he or she wish, establish a Dynasty Trust under the law of one of the states which has repealed this common-in-law rule.
Among the states that have repealed the rule against perpetuities, Delaware, Alaska and Florida in particular have a favorable and sophisticated body of estate and trust law. A Dynasty Trust established in one of those states will take advantage of the repeal of the rule against perpetuities and take maximum advantage of the federal GST tax exclusion.
While the income of most Trusts is subject to state income taxes because the Trusts are set up locally in states that tax such income, Delaware, Alaska and Florida do not tax such income.
The potential tax savings can be illustrated by comparing the following three estate plans:
Assume that a set of parents possess $15,000,000 in estate value. They wish to benefit their children and generations of descendants beyond. The second parent to die lives for 30 years after the beginning date of this example.
First plan – no GST Trust. The parents will invest the $10,500,000 of their estate outside of any Trust, i.e. they will not transfer any money into a Trust while they are alive. Assume no GST Trust planning will be involved at any subsequent generation below the parents.
Second plan – Standard GST Trust. The parents will transfer (give) $10,500,000 to an irrevocable “standard” GST Trust, retaining income on this Trust until the second spouse dies. Each each child will have a GST sub-Trust share of this $10,500,000 Trust. A standard GST Trust will be funded with assets equal to the parents’ two GST exclusions totaling $10,500,000. At the death of a child, that deceased child’s children will become the beneficiaries of the child’s GST sub-Trust. The GST Trust (and sub-Trusts) will continue to exist until the “rule against perpetuities” of the state where the Trust is established requires the Trust to terminate and all assets distributed outright to the then-beneficiary. This old common-law rule generally results in a maximum Trust period of 90 years.
Third plan – Dynasty GST Trust. The parents will transfer (give) $10,500,000 to an irrevocable Dynasty GST Trust, with each child having a Dynasty sub-Trust share. Again the parents will retain income interests until the death of the second spouse. The Dynasty GST Trust will never terminate if established under the law of a state which has repealed the common law rule against perpetuities. A Dynasty GST Trust that never terminates can result in amazing savings in transfer taxes because of the huge amount of Trust value which may be accumulated free from the imposition of both GST tax and estate tax over many generations.
In both the second and third plans, the intervivos transfer by the parents of $10,500,000 to an irrevocable Trust for the ultimate benefit of their descendants will be accomplished without imposition of either gift tax or GST tax because each parent will allocate his and her maximum $5,250,000 gift tax and GST exclusion to the value of transfers into the Trusts.
Compare the economic results for each of the three plans.
In the first plan (no Trusts), the assets outside of Trust will grow to $769 million, but this amount will be reduced by $305 million because of imposition of estate tax for three generations, resulting in a net transfer of $458 million. In the second plan (standard GST Trust), the assets will grow to $1.6 billion. At the 90-year mark, this $1.6 billion pot will be distributed outright, free of trust, to the then-beneficiaries of the Trust. When these beneficiaries die, this value will be subject to an estate tax. In the third plan (Dynasty GST Trust), the asset value will stay in the Dynasty Trust which does not have to terminate. There is no violation of the rule against perpetuities in a state like Delaware, Alaska or Florida which has repealed the rule. The $10.5 million has compounded to $2.6 billion and this sum will be passed on to generation to come – free of gift, estate or GST taxes.
For more detailed information on the Dynasty Trust, go to this article.
Installment Sale to a Defective Grantor Trust (“DGT”)
A common “estate freezing” technique is for a person (the “grantor”) to sell appreciated assets on an installment basis to a Defective Grantor Trust (“DGT”) created by that same person. The goal is for the installment sale note to be forever frozen in value, while the sold assets an the income earned on them will continue to grow in the hands of another.
The irrevocable DGT is intentionally defective for income tax purposes. The DGT is not defective for estate tax and generation-skipping tax purposes. This means two things. (1) Any income earned on the assets inside the DGT will be taxed to the grantor. This is a good thing because payment of the tax will further deplete the size of the grantor’s estate without using up any of his estate and gift tax exclusion. Such intentional defective is caused by giving the grantor certain administrative powers. (2) The grantor’s retained interest over the DGT is not sufficient to cause the assets in the DGT to be deemed by the tax code as included in his estate when he dies.
The structure of this technique is this: The grantor creates the irrevocable DGT. The beneficiaries of the DGT can be his children, grandchildren, whomever. Generally the Trustee will be a neutral fiduciary, although it can be the grantor (care must be exercised in such case). The grantor first will give assets to the DGT in an amount equal to about 10% of the appreciated assets which later will be sold to the Trustee of the DGT. By doing this, the IRS is unlikely to argue this technique is actually a gift of all the assets with a retained interest in the gifted assets, a result which would cause all of the assets to be deemed as part of the grantor’s estate at his death.
The grantor next will sell the appreciated assets to the Trustee of the DGT. No capital gains will be incurred because the grantor effectively is selling the assets to himself (because of the defective income tax status of the DGT). Any income received by the grantor as part of the installment sale also will not be considered income to the grantor. The interest paid on the installment sale must be no less than the federal tax code section 1274 rate to avoid any IRS argument that a gift of the difference was made.
Thus the grantor will benefit in three ways in the estate tax arena: (1) He freezes the value of an appreciating asset; (2) he will make a gift-tax free transfer to the DGT beneficiaries if the income and appreciation on the transferred assets exceed the section 1274 rate; and (3) he will further reduce the size of his estate by paying income tax on any income earned by the DGT.
This technique resembles the GRAT technique. However, it is better in several ways. (1) If the grantor dies after the sale of the assets to the DGT, the transaction will not unraveled as it is when the grantor does not survive the term of his retained interest in the GRAT, (2) the GST exemption can be allocated to the DGT upon creation, while the GST exemption cannot be allocated until the GRAT term expires (when most likely the value of the GRAT will be greater in value, (3) the section 1274 rate is almost always lower than the federal AFR which must used for the GRAT, meaning even more growth can be transferred tax-free from the grantor’s estate.
If minority interests in legal entities (interests in FLP, etc.), with their discounted valued,are sold to the DGT, the combined effect can be dramatic for reducing the size of the grantor’s estate.
Self Canceling Installment Note (“SCIN”)
This technique typically involves a parent selling an asset to a child in exchange for a note. The note requires that payments be made on an installment basis, and if the parent dies before the note is paid off, no further payments are required. Thus, if the parent dies before the note is paid off, the unpaid portion is effectively removed from the parent’s estate at no tax cost.
The parent reports the gain on the installment method, in most cases as capital gain. The buyer-child is probably entitled to an interest deduction.
The IRS will argue a gift has been made by the parent if the selling price is not adjusted upwards to account for the “cancellation premium” reflecting the chance the parent may die early. The amount of the cancellation premium is determined with reference to the tax code actuarial tables.
At the death of the parent, the tax law is unclear with the IRS likely to argue that the estate’s first income tax return should report ordinary income for the canceled amount of note. The better view probably is that the decedent should recognize gain, in which case the decedent’s estate will have an estate tax deduction for income tax paid.
Private Annuity Sale
This technique consists of a sale of property by, typically, a parent to a child in exchange for fixed periodic payments to be made for a term of years or until the parent dies. In either case, nothing is included in the parent’s estate at death. The payments are made on actuarial tables set forth in the tax code regulations.
If the parent lives beyond his actuarial life expectancy, the payments will continue (where no term is set) which could be a detriment to the parent’s estate because his estate will increase with each additional payments received, perhaps beyond the value of the property sold. The best situation is where the seller’s life expectancy is expected to be shorter than his actuarial life expectancy. However, the seller can not be “terminally ill” which the tax code regulations define as having a more than 50% chance of dying within one year. Otherwise, a gift will be deemed having been made by the tax code.
Each annuity payment will be recognized as part return of tax basis, part ordinary income, and part capital gain (in some cases) under the tax code. No income tax is recognized at the death of the seller parent. The buyer child does not receive an income tax deduction.
A private annuity sale is like a GRAT in that the required payments are a fixed amount each year. Main differences are that income tax treatment of the seller-annuitant are determined under different rules than for a GRAT, and payments to the annuitant will generally continue for the life of the annuitant rather than for a certain term of years. Annuity payments can be made subject to a fixed term of years, thereby putting a ceiling on the payments. If there is such a ceiling, the annuity is converted into an installment sale with a contingent sale price when the annuitant’s actuarial life expectancy is longer than the fixed term.
In general, a GRAT is preferable to a private annuity with a ceiling, primarily because the grantor can pay income taxes on GRAT property, thereby making a nontaxable gift to the GRAT. On the other hand, the private annuity has the advantage of getting the subject property immediately out of the seller-annuitant’s estate without requiring the seller to outlive a fixed term as for the GRAT.
Charitable Conservation Easement
This technique can bring a three-fold tax benefit to the creator of the easement. In a nutshell, a landowner will voluntarily restrict the use of his property for a conservation-related purpose. Typically, the conservation easement takes the form of a written agreement between the donor and the donee organization which is recorded in the County Recorder’s Office. The agreement will specify the types of uses that are restricted and types of prohibited activities. The donor usually will reserve certain specific rights to use the property, including limited development rights. The donor retains the rights to sell, lease, mortgage or otherwise convey the property to anyone he pleases, subject to the perpetual conservation easement. The end result: the property is protected from unwanted future development.
For an owner of valuable real estate to forever bind himself and all successors in interests to the land is an act which requires careful consideration and a strong conservation motivation. The donee organization’s role in the easement is to monitor its use and see that the terms of the conservation agreement are being enforced. In Marin County, California, for instance, a non-profit organization like the Marin Agricultural Land Trust is a major donee organization for agriculture land which will be forever immune from any major development.
The three tax benefits that can result, if all requirements found in the appropriate tax code, are met are (1) a current income tax deduction, subject to a yearly limit of 30% of the donor’s adjusted gross income, (2) a reduction in value in the subject property because the conservation easement by its nature makes this property a much less desirable property to acquire, (3) and, new as of the 1997 federal tax law, an estate tax exclusion at the death of the donor in an amount of 40% of the already reduced value of the property, subject to a maximum exclusion amount of $500,000.
Combinations of Techniques
Clients often combine several or many of these techniques in one estate plan. Married clients may decide to fund their residence into a QPRT, their growth stock (perhaps stock options with almost guaranteed gain upon exercise) into a GRAT, securities and real estate into a FLP or a FLLC, highly appreciated property which they wish sold inside a Charitable Remainder Trust, and on and on. Their overall estate plan would incorporate a joint Living Trust (with a Bypass Trust possible to create) within a Dynasty or Standard GST Trust package. Many of the clients’ wishes, both income and transfer tax (gift, estate and GST) concerns and non-tax concerns (retaining control of investments, keeping family estate out of the reach of creditors or in-laws, etc.) can be accomplished with a properly drafted estate plan.
All of the combined plans described below assume either that deaths occur before year 2013, when our current “generous” estate tax law expires and Congress has not passed another estate tax law similar to what we have now.
FLP and GRAT. This is an example of a terrific way to leverage large discounts is to combine gifts made to limited partners (typically children) with a GRAT. The gift of the limited partnership interests can be made to a term certain GRAT of 20 years. A gift of limited partnership interests representing $1,000,000 of underlying assets, at a 35% discount, will result in a discounted transfer value of $650,000. For computing the GRAT numbers, we use $650,000 (the discounted amount), not $1,000,000. Assume the following: The applicable Section 7520 rate (“AFR”) at date of the GRAT is 2.0% (September of 2013), the yearly annuity paid to the donor is $39,751, and the FLP grows at an annual rate of 5% non-compounded. If the donor (parent) outlives the 20-year term, no gift tax will be due on this gift because the total annuity amounts returned to the donor’s estate equal and offset the discounted value of the gift made. This an example of a “zero’ed out GRAT,” a highly-desired result. A 2000 tax court case held that this technique is allowed. At the end of the GRAT term, the remainder beneficiaries (the kids probably) will receive a GRAT balance worth $410,207 based on yearly growth of 5%. No gift tax is paid on this gift. The grantor parent did not have to use any of his gift tax exemption. These GRAT assets will be held as limited partnership interests by the remainder beneficiaries of the GRAT. The grantor parent will receive $795,020 in annuity payments over twenty years. The GRAT is especially valuable if the assets funded into the GRAT grow faster than the AFR at time of funding, which is the case in this example (5% versus 2%). Stock options, quality growth stocks, quality real estate located in good areas are good candidates for the GRAT. If the FLP grows at an annual rate of only 3%, the GRAT balance will be much less after 20 years – $105,822. The donor does have to outlive the 20-year term of the GRAT in order for this plan to work.
This technique is often used with S corporations. In this plan, the director/parent first recapitalizes the corporation into 2% voting stock and 98% non-voting stock. Then, the parent gives non-voting stock to the children. This non-voting stock, possessing no control over the S corporation and having a limited market, will receive a substantial discount.
FLP and CLAT. This is an excellent way to leverage the Section 7520 rate for remainder interests. For example, assets valued at $200,000,000 are put into a Family Limited Partnership by a married couple. Then in September of 2013, the married couple give limited partnership interests represented by $150,000,000 of underlying assets to a CLAT with a 20-year term. The discounted value of these gifted LP interests, computed at a 35% discount, is $97,500,000. The CLAT will pay 6% annually to the charity or charities. For twenty years, the charity will receive a yearly annuity amount established at $5,850,000 (6% of the discounted value, not the actual value) by the married couple donors.
The CLAT remainder interest, computed using a 1.4% AFR (August of 2013 – you can use the lower of the month of gift or two prior months), is zero, which means no gift tax return will be filed. The value of the remainder interest of the CLAT is subject to gift tax, computed at the time of the transfer of the limited partnership interests into the CLAT, but in this example no gift tax will be paid. If the annuity payments had been lower, the CLAT remainder interest would have been a positive number. In such case, the donor married couples’ combined gift tax AEAs of $10,500,000 would have to cover the discounted value of the CLAT remainder interest gifts in order to make such gifts to the remainder beneficiaries non-taxable. The remainder beneficiaries are the married couple’s children (or grandchildren) who were given the limited partnership interests.
The donors’ GST exemptions also will be allocated against the CLAT remainder interest if a standard GST Trust or Dynasty Trust is the remainder beneficiary. Therefore, at the end of 20 years, the remainder beneficiaries (children or grandchildren) will take the entire CLAT balance, plus all accumulated growth and income earned for twenty years and less annuity payments made, free of any sort of gift, estate or GST tax.
Assume the CLAT grows an average of 7% per year (1% higher than the annuity payout rate of 6%). At the end of the 20-year CLAT term, the children (or grandchildren) will receive a total non-discounted value of $183,028,506 of limited partnership interests. Because such actual CLAT remainder value of $183,028,506 will be held in the FLP, the remainder value will be discounted by 35% to $118,968,529 in the hands of the children (and grandchildren).
The remarkable result of this plan will be this: After 20 years, the children will hold FLP interests represented by $183,028,506 of underlying value. The parents’ gifts of limited partnership interests will consume none of their AEAs at the time the gifts were made. Over $183,028,506 of value will escape transfer taxation. Finally, during the course of 20 years, the charity will receive $117,000,000 of annuity payments. The married couple donors do not have to outlive the 20-year term of the CLAT. The downside – no one in the family can enjoy the income on the gifted FLP assets for 20 years.
ILIT and Dynasty Trust. This is another combination of techniques is the funding of a Dynasty Trust or standard GST Trust with life insurance. Such Trust would be a form of an Irrevocable Life Insurance Trust. The transfer tax value of life insurance is relatively small. The transfer of the life insurance into the Trust therefore will use up a small amount of the donor’s AEA and/or will be covered by the $14,000 per year per beneficiary exclusion rule. The donor’s GST exemption to be allocated to the Trust will also be relatively small. When the donor dies, the Dynasty Trust or standard GST Trust will now hold a large amount of death proceeds, all of which are forever exempt from GST tax and estate tax. This a classic example of how to leverage the GST exemption for gifts into a remarkably large transfer taxing savings benefit.
FLP and DGT. Selling limited partnership interests, discounted substantially in value, to a DGT on an installment sale basis can result in tremendous leveraging of valuation reduction. Benefits received will be the disappearance of asset value through discounting FLP interests, shifting the growth in the FLP to the buyer-children, reducing the estate of the parent-seller by means of his paying the income tax on FLP income received by the DGT.