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George F. Bearup, J.D. Senior Legal Trust Advisor

29-Jul-19

Non-Taxable Gifts: A Primer

Take-Away: There are principally four ways in which a non-taxable gift can occur. Gifts that use the donor’s federal gift tax exemption. Leveraged gifts. Gifts that use valuation discount strategies. And direct gifts to pay for tuition and medical expenses and annual exclusion gifts. Some of these gift strategies are more effective, or they carry less risk, than others.

Tax-Free Gifts: These lifetime gifts are the easiest to understand and perhaps are the most beneficial since they do not cause a gift tax to be paid and they do not use any of the donor’s federal gift tax exemption. Included in this category are: (i) annual exclusion gifts of $15,000 per donee [IRC 2503(c)]; (ii) direct qualified payments for the donee’s heath or tuition under IRC 2503(e); and (iii) the settlor’s obligation to pay the income tax liability with regard to a grantor trust.

  • Example: A married couple with three children and six grandchildren can make annual exclusion gifts of $270,000 a year (excluding any in-laws as donees.) Over a period of ten years $2.7 million can be removed from the parents’ taxable estate simply by making use of annual exclusion gifts to this large group.
  • Example: The settlor makes a $10 million gift of portfolio stock to a grantor trust. The gifted stock produces a 6% rate of return each year. The trust realizes 20% of unrealized gains per year. After a 20-year grantor trust duration, the settlor will have paid over $4.0 million of income taxes on behalf of the grantor trust, which is gift tax-free, while at the same time reduces the settlor’s taxable estate by $4.0 million. The is equivalent to a gift of $4 million over 20 years gift tax-fee to the trust beneficiaries.

Gift Tax Exemption: The current federal gift tax exemption is $11.4 million per person. If the donor’s federal gift tax exemption is used to protect the gift from taxation, it is best to use assets with the greatest income and appreciation potential, because after the gift, all future income and appreciation from the gifted assets will escape gift and estate taxes. The effectiveness of this gift strategy is directly tied, however, to the time-use-of-money: the longer the gifted assets are permitted to appreciate in value and generate income (outside the donor’s taxable estate) the more dramatic the tax savings from the lifetime gift will be.

  • Appreciation Hurdle: Also balanced against the benefit of this long-term appreciated gift strategy is the loss of an income tax basis adjustment to the gifted assets on the donor’s death. One way to look at this strategy is what is called the appreciation hurdle. It is best described as the aggregate (not annual) appreciation required in the gifted assets between the date of the gift and the date of the donor’s death for the donor’s estate tax savings to equal the capital gains tax cost of no income tax basis adjustment to the gifted assets. No tax benefit will result from the lifetime gift until this appreciation hurdle is met.
  • Example: The donor makes a gift of $10 million of Corp, Inc. Assume the Corp, Inc. stock grows at the rate of 6% a year. After 20 years, the Corp, Inc. stock will be worth $32 million. Therefore, the donor’s  initial gift of $10 million results in $22 million (the post-gift appreciation) of wealth removed from the donor’s taxable estate without any gift or estate tax consequence. Restated, had the donor not made the gift of Corp, Inc. stock, only $10 million of the total $32 million worth of Corp, Inc. stock in the donor’s estate would have been sheltered from federal estate taxation, which means that $11 million of the donor’s estate tax would be charged to the donor’s estate, effectively reducing the total amount left to the donor’s estate beneficiaries to $21 million instead of the $32 million via the lifetime gift of Corp, Inc. stock.
  • Example: If the donor’s basis in the Corp, Inc. stock is $0.00, the donor and his family would have an immediate $2.0 million tax detriment to overcome if the donor makes a lifetime gift of $10 million of Corp Inc. stock. This presumes a 20% capital gain tax rate. The stock would have received an income tax basis adjustment to fair market value had the donor not gifted the Corp, Inc. stock and the stock had remained in the donor’s taxable estate until his death. Consequently, for the donor and his family to overcome the $2 million tax hurdle, the Corp, Inc. stock must appreciated by about 65% to create an estate tax benefit equal to the capital gains detriment due to the loss of the income tax basis adjustment on the donor’s death.

Leveraged Gifts:  While there is an estate tax benefit of a lifetime gift using the donor’s available gift tax exemption, it is limited by that exemption dollar amount. The donor can only shift the future income and appreciation generated on assets originally worth $11.4 million in 2019. To avoid this dollar limitation, and increase the amount that can be transferred, the donor can use leverage techniques to increase the amount of future income and appreciation that can be shifted from the donor’s estate gift-tax-free. These leverage techniques include; (i) intra-family loans; (ii) sales for installment promissory notes;  and (iii) grantor retained annuity trusts (GRATs.) The sale is to a grantor trust in exchange for an installment note is disregarded for income tax purposes. If an intra-family loan is used, the note must bear interest as the applicable federal rate of interest (AFR) which is published by the IRS each month. Consequently, the invested funds from a loan (or installment note for purchased asset by the grantor trust) must only produce investment returns in excess of the AFR for the lender’s (seller’s)family to benefit.

  • Example:  In June, 2016, the long-term AFR is 2.76%. The donor gifts $10 million of Corp, Inc. to a grantor trust using his gift tax exemption. The donor then sells $50 million of Corp, Inc. stock to the same trust in exchange for an interest-only promissory note with a balloon note payment in 20 years. Assume a 6% rate of return for Corp, Inc. stock for each of those 20 years. The sale of the Corp, Inc. stock to the grantor trust moves an additional $59 million of value out of the donor’s taxable estate after repayment of the grantor trust’s Only $10 million of the donor’s exemption was used for the initial ‘seed gift’ to the grantor trust. For comparison purposes, if the gift-sale of Corp, Inc. stock to the grantor trust had not been used, it would require a taxable estate worth $118 million before federal estate taxes in order to leave $59 million to the donor’s descendants on the donor’s death.
  • Example: The donor transfers Corp, Inc. stock to a grantor retained annuity trust (GRAT). By transferring the stock to a GRAT the donor’s share in the growth of the GRAT’s stock is limited to the IRC 7520 rate which is published monthly by the IRS. The ‘excess return’ that is realized by the GRAT is transferred free of gift and estate taxes to the GRAT’s remainder beneficiaries. However, use of the GRAT also poses the risk that the Corp, Inc. stock declines in value, in contrast to the intra-family loan and sale of stock for a grantor trust’s installment promissory note. With the intra-family loan or sale to the trust could result in a loss to the borrower or trust that purchased the depreciating asset- the grantor trust will owe the full amount of the installment debt, regardless of the stock’s value.

Consequently, GRATs and other debt transactions are both forms of leverage that can amplify the potential transfer tax benefit, but these debt transactions also can amplify the loss if the transferred asset declines in value. Like gifts that use the donor’s gift tax exemption, leveraged transfers can shift future income and appreciation out of the donor’s estate, but to succeed, they must overcome the IRS’ interest rate hurdle. Moreover, leveraged transfers can be used without using the donor’s gift tax exemption so that they are not limited by the donor’s gift tax exemption amount.

Discounted Gifts:  While the prior strategies shift future appreciation and income out of the donor’s estate, they do not deplete the initial corpus of the donor’s estate and they can take significant time to produce the intended transfer tax savings. This wealth shifting process can be accelerated through valuation discounts. Structured discounts can be achieved through: (i) a qualified personal residence trust (QPRT);  or ii) a remainder purchase marital income trust (RPM.) Valuation discounts through the transfer of illiquid and non-controlling interests, e.g. FLPs and FLLCs, can also be effective, but for the ‘red-flags’ they inevitably carry when they are reported on a federal gift tax return. See, Estate of Powell, v Commissioner, 148 T.C. No 18 (May 18, 2017.)

  • Example: In May, 2019, a 55 year old donor transfers her residence to a QPRT. She retains the exclusive use of the residence for 20 years. Her residence is worth $10 million when it is transferred to the QPRT. The IRC 7520 rate for May is 2.8%.  By retaining the right to use the residence for 20 years, the value of the remainder interest in the QPRT transferred to the donor’s children is $4.0 million for gift tax reporting purposes. If the donor survives the 20 years she will have shifted $6.0 million out of her taxable estate. If the residence grows at the rate of 6% a year, at the end of the 20 year exclusive use period, the donor’s children will receive a residence worth $32 million, when the donor only used $4.0 million of her gift tax exemption for that wealth transfer.
  • Example: In May, 2019, [IRC 7520 rate of 2.8%] the donor transfers $10 million of marketable securities to a RPM income trust that pays the donor’s spouse all the income for 20 years, or until the spouse’s death, if sooner. At the same time the donor sell the remainder interest in the RPM, i.e. the right to receive the portfolio and the proceeds from the portfolio at the end of the 20 year term, to an irrevocable children’s trust that is created for the couple’s children’s benefit. The donor’s spouse’s income interest reduces the value of the trust remainder, and consequently, the price that the children’s trust pays for the RPM remainder interest. The children’s trust pays the donor $6.7 million for the right to receive the $10 million portfolio plus all growth generated from the portfolio after the transfer, in 20 years- effectively a 33% discount. If the RPM portfolio appreciates at a 6% annual rate of return, the portfolio will be worth over $32 million after 20 years. However, the RPM income trust requires an initial gift from the donor of $6.7 million.
  • Example: The donor owns a substantial interest in Corp, Inc. Corp, Inc. has a going concern value of $100,000,000. The purchase price for the sale of a 25% non-voting interest in Corp, Inc. is reduced to $17.5 million, rather than $25 million, assuming a 30% valuation discount because the transferred interest is neither controlling nor marketable. The valuation reduction immediately removes $7.5 million from the donor’s estate without using any additional gift tax exemption or having to wait for the Corp, Inc. stock to appreciate in value over the years.

Conclusion: Some of these gift strategies, e.g. annual exclusion gifting, are safe and simple. Other strategies, e.g. lifetime exemption gifts require extended periods of time to permit the transferred asset to grow in value while overcoming the appreciation hurdle. Immediate shifts in wealth using valuation discounts can work well but they bring with them a high level of IRS scrutiny. Other gift strategies, e.g. GRATs,  are successful only if the IRS interest rate hurdle can be beat through the post-transfer appreciation.  The final risk with all of these wealth shifting strategies is that they have targets on their backs with Bernie Sander’s proposed “For the 99%” tax reform bill.