Is Your Estate Plan in Order?

The world suddenly changed with the COVID-19 pandemic. We have all had to learn a new skill called social distancing. Millions now work from their homes. Isolation is the new mainstream lifestyle, albeit not by choice. Consequently, any discussion about estate planning seems pretty superfluous in this time of crisis. However, if an individual is optimistic that medical technology will ultimately overcome the coronavirus within a reasonable period, then there are decisions that should be made with regard to existing estate plans in light of the dramatic drop in market values of many assets, the very low interest rate environment and the likelihood that tax rates will increase in order to pay for the government’s multiple stimulus responses. In short, some estate planning strategies might now be exploited to take advantage of prevailing market conditions.

General Considerations: Now is the time when individuals actually do have the time to review their existing estate planning documents. They might even have the inclination to do so in light of the reality that the conoravirus does not discriminate in its victims.

• Review Role Players: Fiduciaries, like patient advocates named under durable powers of attorney for health care, agents named under durable powers of attorney for financial decision-making, funeral representatives, personal representatives named to administer a Will, and a trustee named to administer a revocable Trust all need to be re-evaluated. Those individuals may not be healthy enough, or even available, when called upon to serve in their assigned fiduciary role under an individual’s estate plan. Or, they may be distracted caring for another loved one. Perhaps now is the time to name an institutional fiduciary that is not subject to health and disability risks or other family responsibilities. While it is customary to name a family member to serve in some, or all, of these fiduciary roles, more thought needs to go into that important decision.
• Review Distribution Provisions: Many Will and Trust provisions, or transfer-on-death beneficiary designations, should be revised in light of the dramatic drop in market values. If a fixed dollar amount is to be allocated to a named beneficiary, use of the dollar bequest may no longer make sense. For example, assume that a parent’s Trust provides that upon the parent’s death, the trustee is directed to pay to the parent’s son $500,000, with the balance of the parent’s Trust estate set-aside to be held in trust for the lifetime benefit of the parent’s daughter who is seriously disabled. At the time the parent’s Trust was created the parent’s estate was worth $1.8 million. The parent’s estate is worth $900,000 at the time of his or her death as a result of the market sell-off caused by the pandemic. Under the terms of the parent’s existing Trust, the son will still receive $500,000, but there will only be $400,000 available to fund the trust for the lifetime benefit of the disabled daughter. That is probably not the result the parent wanted or intended. Now would be the time to change the Trust to provide a fraction or percentage allocation to the son, so that an adjusting formula can be used to reflect to the actual size of the decedent’s estate at the time of his or her death.

Planning Opportunities: For more affluent individuals, some basic estate planning strategies might be exploited in the current climate of low market values and very low interest rates caused by the coronavirus, along with the predictable increase in taxes needed to respond to the pandemic.

• Gifts: With current market values low, now is a good time to gift an asset that the donor believes will appreciate with the passage of time. A low value assigned to the gifted asset means that less of the donor’s federal gift tax exemption (currently $11.58 million) will have to be used to shelter that lifetime gift from federal gift taxes. If the gifted asset generates income, that income will be taxed to the donee, not the donor, and thus could be exposed to the donee’s marginally lower federal income tax bracket.
• Intra-Family Loans: The April, 2020 applicable rate of interest (AFR) that is used for many planning strategies and transactions is historically low. The short-term AFR rate for a transaction that is less than three years is 0.91%; the mid-term AFR rate for a transaction between three years and nine years is 0.99%; the long-term AFR rate is only 1.44%. For a loan to a family member, the appropriate AFR rate must be used in order to avoid an implied gift due to a below-market interest rate charged. For example, a grandparent could enter into an 8 year, 11 month loan to a grandchild and charge annual interest on that almost 9 year loan of 0.99% per year. If the grandchild invested those loan proceeds and earned more than 0.99% per year on the investments, the grandparent will have shifted wealth from his or her taxable estate to their grandchild gift tax-free. The outcome is even better if the grandparent is at a marginally higher income tax bracket than their grandchild. While cash is normally the subject of a loan, marketable securities can also be the subject of an intra-family loan.
• GRAT: Special provisions are included in the Tax Code to deal with a lifetime transfer, where the donor retains an interest in the transferred asset. With a grantor retained annuity trust (GRAT) the donor transfers assets to a trust and receives in exchange an annuity stream for a set period of time. At the end of the GRAT term (e.g. two or three years), the remaining assets held in the GRAT then pass to the trust remainder beneficiary. The Tax Code specifies the interest rate that must be used to value the grantor’s retained annuity interest in the GRAT; that value is then subtracted from the value of the asset transferred to the GRAT, and the difference is a currently taxable gift to the GRAT remainder beneficiary. The mandated interest rate for April 2020 is 1.2% (IRC 7520). The lower the interest rate used in this valuation calculation, the larger the value of the retained interest by the grantor, and thus the lower the value of the gifted GRAT remainder interest. For the GRAT to effectively shift wealth gift tax-free, the assets held in the GRAT must grow more than the interest rate that is used to value the remainder interest. Thus, if the transferred assets to the GRAT grow at an annual rate more than 1.2%, that difference in rates will result in the residual assets passing to the remainder beneficiary free of any gift tax.
• QPRT: Just like the GRAT, a qualified personal residence trust (QPRT) functions much like the GRAT, in that a transfer of a personal residence is made to an irrevocable trust where the transferor retains the exclusive use of the residence for a specific number of years. That retained exclusive use of the residence right is also valued using the IRC 7520 rate (1.2% in April 2020). Again, using a low interest rate to value the transferor’s retained exclusive use interest in the QPRT will tend to understate the value of the remainder interest in the QPRT when the transferor’s exclusive use period ends. Like the GRAT, using the lower interest rate to value the transferor’s retained interest will cause a much smaller gift of the remainder interest in the QPRT, thus using less of the transferor’s federal gift tax lifetime exemption.
• Sale to Grantor Trust: A grantor trust under the Tax Code is a trust that has its income taxed to the person who transferred assets to the irrevocable trust. While the trust’s income is taxed to its grantor, the trust’s assets are neither included, nor taxed, in the grantor’s estate at the time of the grantor’s death. Such a trust is often intentionally made a grantor trust by the grantor retaining the right to substitute assets of equivalent value with the trustee. A grantor trust is used to remove an asset from the grantor-transferor’s taxable estate, by selling the asset to the grantor trust in exchange for an installment note. No capital gain is recognized by the grantor on this sale since the grantor is treated the same as the trust for income tax reporting purpose (i.e. it is treated as a sale to oneself). Interest paid on the note by the trustee is treated as paying interest to oneself. In a time when asset values are low, along with low prevailing AFR interest rates, a sale of an asset to a grantor trust carries strong appeal. With a low fair market value asset sold, there is a correspondingly smaller promissory note that will be included in the grantor’s taxable estate at the time of his or her death if the note remains unpaid on that event, which means fewer federal estate taxes paid. With the low AFR interest rate used with regard to the trustee’s promissory note given to the grantor, more wealth will be available to accumulate and be held in the trust, and not subject to estate taxes on the grantor’s death. Such an installment note could also be structured as a self-cancelling installment note, or a private annuity, where there would be no residual value included in the grantor’s estate at the time of his or her death, if the grantor had a better than 50% chance of living at least twelve months after the sale and actually he or she lives eighteen months after the sale.

These are challenging times for all of us. Reviewing existing estate planning documents is a good first step to confirm that the plan in place ‘still works.’ Other planning steps to shift wealth can also be taken to exploit current low fair market values and historically low interest rates.