Take-Away: As we approach the final one-third of 2020 and brace ourselves for the nonstop distractions and the rhetoric of a Presidential election, there are some planning steps we need to bring to the attention of our clients, especially if 2021 also brings a new Congress, a new Chief Executive, and the increasing likelihood of new taxes. Many of these planning steps could also benefit those who have been economically hard-hit by the COVID-19 pandemic. The following strategies move from ‘dead easy’ steps to very complicated steps.

“Dead Easy” Steps (for Anyone):

  1. ‘Annual Exclusion’ Gifts: Currently each individual donor can gift $15,000 to one or more individuals each year gift tax-free. The only technical  requirement is that the gift must be of a present interest. Example: Grandparents could gift $30,000 a year for each of their grandchildren. There are a couple of Bills floating in Congress to limit either the number of annual exclusion gifts, or the aggregate dollar amount of annual exclusion gifts that can be made by a donor in a single calendar year. Any of those Bills would greatly curtail the flexibility of annual exclusion gifts.
  2. IRC 529 Account Gifts: A donor can ‘front-end-load’ 5 years of annual exclusion gifts ($75,000) in a 529 account for educational expenses in a single calendar year for a child or grandchild. Example: grandparents could contribute $150,000 to a 529 account created for their grandchild in one calendar year, gift tax-free. Substantial wealth could be removed from estate taxation by funding several 529 accounts in a single year.
  3. IRC 2503(e) Gifts of Tuition and Medical Expenses: A donor can contribute on behalf of an individual an unlimited amount to pay an individual’s tuition or medical expenses. The only requirement is that the payment must be directly to the service provider. Medical expenses are broadly defined; the only apparent limitation is voluntary plastic surgery. Example: Grandparents directly pay their grandson’s tuition to Stanford University of $60,000 for the year, gift tax-free. The grandparents can also gift their grandson $30,000 in annual exclusion gifts the same year.
  4. Intra-family Loans: The required interest rates used in intra-family loans are the lowest ever. Thus, loans can be made to family members using the low applicable federal rate (AFR) of interest, and if the loan proceeds are invested by the borrower and earn a return greater than the low interest rate charged with the loan, wealth is shifted gift tax-free to the borrower. Example: A father loans $1.0 million to his son for 5 years, charging the current AFR midterm rate of 0.43%. The son invests the loan proceeds and over the 5 year term of the loan earns 5% annually. After 5 years the son will have earned $1,276,000. The son can repay the loan plus accrued interest at 0.43% for the 5 years, and retain the balance of the 5 years of earnings gift tax-free. This is also a good time to refinance any outstanding intra-family loans to use the lower AFR interest rate.
  5. Charitable Gifts of Cash: For 2020 only, a gift of cash to a charity results in a 100% of adjusted gross income charitable deduction.  An individual who is too young to take advantage of a qualified charitable distribution (QCD) from their traditional IRA (they must be age 70 ½) could, if over the age 59 ½, take a distribution from their traditional IRA, incur the income tax, yet gift that IRA distribution to their charity with an off-setting charitable income tax deduction. This step could be treated as an acceleration of a charitable bequest from their Will or Trust to a lifetime charitable gift without any income tax consequence to the donor (when the charitable bequest under their Will or Trust may not save any estate taxes due to the large federal estate tax exemption amount.

Large Lifetime Gifts to Trusts (for the Moderately Wealthy):

  1. Grantor Retained Annuity Trust: An individual can transfer an unlimited amount to a grantor retained annuity trust (GRAT.) The grantor receives an annuity from the GRAT for a specific period of time. The remainder interest in the GRAT is a taxable gift by the grantor. However, the value of the grantor’s retained annuity interest in the GRAT is determined by using the very low AFR interest rate, which tends to over-value the grantor’s retained interest and thus undervalues the gift of the remainder interest in the GRAT. Like the intra-family loan, if the assets transferred to the GRAT grow faster than the interest rate used when funding the GRAT, that shifts wealth in the GRAT, at its conclusion, to the remainder beneficiaries gift tax-free. Example: A grantor transfers $1.0 million of marketable securities to a ‘zeroed-out’ GRAT, which means there is no value attributable to the remainder interest in the GRAT. The interest rate used to value the annuity interest of the grantor is 0.40%. If the GRAT assets grow at a rate of 1% a year, when the annuity stream period comes to an end, there will be remaining assets in the GRAT (the spread between 1% and .40% ) will pass to the remainder beneficiaries gift tax-free. So for individuals who have already used their federal transfer tax exemption, the GRAT is a way to continue to remove assets from their taxable estate gift tax-free. Creating a GRAT now may also make sense, as there is a Bill in Congress that would negatively impact the use of GRATs in the future, in effect making it more difficult for the GRAT to perform well to shift wealth to the remainder beneficiaries gift tax-free, including eliminating ‘zeroed out’ GRATs (Bernie Sanders’ proposals.)
  2. Spousal Lifetime Access Trusts: The currently high federal gift, estate and GST exemptions ($11.58 million) are set to return to $5.0 million (adjusted for inflation) in 2026. Candidate Biden proposes to reduce an individual’s transfer tax exemptions to $3.5 million sooner than 2026. In order to exploit the large exemptions, while they still exist, a lifetime gift to a long-term irrevocable trust would use the donor’s gift and GST exemptions now. The trust would benefit the donor’s spouse. This type of trust is called a spousal lifetime access trust (SLAT). Rather than rely upon the unlimited marital deduction, the gift to the SLAT would use the donor-spouse’s gift and GST exemptions. The SLAT would pay all the income to the donor’s spouse. Care must be taken to avoid the reciprocal trust doctrine, however, so the two SLATs cannot be identical. Example: Husband funds a SLAT for his wife with $10 million; wife funds a similar, but not identical, SLAT for her husband with $10 million. Together, they have removed $20 million from their taxable estates, but between the two SLATs, the husband and wife will continue to have access to the income generated by the transferred $20 million in assets.
  1. Domestic Asset Protection Trust: A single individual can create a self-settled asset protection trust (DAPT) in Michigan, where the settlor is a discretionary income and principal beneficiary. The transfer of assets to the DAPT can be structured as a completed gift, thus using the settlor-beneficiary’s currently large gift and GST transfer tax exemptions. Example: Divorced father funds a DAPT with $5 million. He names himself, his children, and his grandchildren as discretionary beneficiaries of the trust. No gift tax is paid, as the father’s large exemptions are used while they are still available, and the father continues to have indirect access to the assets that he transferred to the trust as a discretionary beneficiary of the DAPT.

Large Lifetime Gifts to Trusts (for the Very Wealthy)

  1. Gifts to Dynasty-Type Trusts: The full exemption amounts of assets are gifted by the donor to a long-term trust established to benefit the donor’s children, grandchildren, and great grandchildren. Example: Parents gift $20,000,000 ($10,000,000 each) to a dynasty trust for the benefit of their descendants while the large exemptions exist. The $20,000,000, and all future appreciation, is removed from their taxable estates. Nor will the $20,000,000 plus any future appreciation be subject to estate taxation on a child’s death or estate or GST taxation on a grandchild’s death. There is some discussion in Washington limiting the duration of a dynasty trust, or the tax-free nature of such a trust, to 50 years. Thus, creating a dynasty trust at this time might be ‘grandfathered.’
  • Basis Step-Up: Currently the Tax Code provides that if an appreciated asset is held until the owner’s death, and thus it is included in the owner’s taxable estate, the income tax basis in that appreciated asset is adjusted to the asset’s fair market value as of the date of the owner’s death. Candidate Biden proposes to treat the owner’s death as a sale, which means that the appreciation in the asset will be taxed on the owner’s death, in addition to the estate tax. Similarly, candidate Biden proposes to treat a lifetime gift of the appreciated asset as a deemed sale, again causing the gain to be recognized, and the tax paid, at the time of the gift. A lifetime gift of low basis assets to a dynasty trust at this time would avoid these deemed sales; while the trust would ultimately have to pay the capital gain, the trustee can decide when to sell the appreciated asset and recognize the gain.

“Head Spinning” Planning Steps

  • Sale to a Grantor Trust: If an individual has already used their federal transfer tax exemptions so tax-free gifts are not possible, the individual could sell their valuable assets, e.g. a closely held business; commercial real estate,  to a grantor trust, created for the grantor’s children and grandchildren. That sale would not be a gift. Since the sale is to a grantor trust, there would be no capital gain that would be recognized by the grantor, as he/she is treated as dealing with their self. The grantor-seller receives in exchange from the trust an installment promissory note, using the current low AFR interest rate- the long-term AFR rate for this month is 1.01%. Example: The grantor creates a family limited partnership with his marketable securities portfolio and some commercial real estate. The grantor receives 99% limited partnership interests. The 1% general partnership interest is held by the grantor’s children, or an LLC that they form to hold the 1% interest. Those 99% limited partnership interests are then sold by the grantor, at a discount, [due to the lack of control and lack of marketability of the limited partnership interests ] to a grantor trust in exchange for a 20-year promissory note, with interest accruing on the note at 1.01% per year, the current AFR.
  • If candidate Biden is elected in early November, grantor uses his available gift and GST exemptions (if any) in December and gifts the promissory note to his children and grandchildren or to another trust for their benefit;
  • If President Trump wins, grantor continues to hold the note. When the grantor dies holding the unpaid promissory note, the note’s value will be discounted to reflect the fair market value of the note (a long-term 20-year note that only pays 1.01% a year in interest; )
  • If grantor is married, grantor gifts a fractional interest in the promissory note to a lifetime QTIP marital deduction trust for his wife; on grantor’s death, the note will be discounted to reflect its fair market value (discount #1) and the fractional interest in the promissory note held by the grantor at death will be discounted a second time (discount #2).

Conclusion: While the pandemic continue to rage through our country, estate planning is top of mind for many Americans. Many have started to plan their estates. With the Presidential election upon us, that migh alsot warrant expediting their planning in anticipation of a change in tax laws.