While the COVID-19 pandemic has put many businesses on their heels, it’s presented unique opportunities to a few.
Estate planning professionals are thriving, and it’s not because clients have a newfound fear of the Reaper. The pandemic has sent interest rates to rock bottom, while asset values are falling: the stock market is tanking and valuations for many businesses have taken a dive as well. Estate planning attorney Dan Lorenzen notes that while sellers are not apt to accept low asset valuations from third parties, lower valuations are acceptable (and even beneficial) in intra-family transfers. There’s never been a better opportunity for passing assets on to heirs on a tax-advantaged basis.
Moreover, the current estate tax exemption of $11.2 million for single individuals and $22.4 million for couples is set to expire in 2025, and Democratic presidential candidate Joe Biden already has his eye on generational wealth transfers. Under current law, assets that pass directly to heirs benefit from a step-up basis, meaning that heirs receive assets valued at the date of death. Therefore, if the asset is sold immediately, the heir pays little to no capital gains tax. Biden proposes to end the step-up basis and tax assets’ unrealized appreciation at the time of transfer. Not surprisingly, this has the wealthy (and even the merely comfortable) putting estate planning front and center.
In terms of interest rates, the IRS Section 7520 rate (so named after the section of the tax code where it can be found) has fallen to an all-time low of 0.80% in May. For most of the past year, the rate was over 2%. The previous record low, in January 2013, was 1%. Clients taking the opportunity to pass on assets now can lock in the current low rates for years: The IRS rate for 3 to 9-year loans is now 58 basis points, while long-term loans of 20 years or more can be made at 1.15%. There are a number of sophisticated estate planning strategies that can be employed to take advantage of the current amenable circumstances for intra-family transfers.
One of the simplest among these strategies is a straightforward promissory note. Let’s say Grandpa wants to help Johnny and Susie, who are just beginning their careers, financially during his lifetime. He could, of course, give them each $15,000 annually (and the same amount to their spouses and children) under the gift tax exclusion. Better yet, he can lend Johnny and Susie any amount he wishes at the current IRS AFR for long term loans of 1.15%. If the loaned funds are invested, even conservatively, they should generate sufficient returns over the long-term to more than cover the interest payments. Indeed, they can now benefit from the growth potential of the assets. And remember, Grandpa can still gift up to $15,000 annually to cover taxes.
The goal of many strategies is to transfer assets to trusts, either through an outright gift, a loan, or a sale at prices that reflect current depressed valuations. One such strategy is the sale of assets to an intentionally defective grantor trust (IDGT). Why, you ask, would anyone want to create an intentionally defective trust? It’s not as disturbing as it sounds – “intentionally defective” means that it is an irrevocable trust with a purposeful flaw that ensures the grantor will still pay the taxes due on the income generated by the trust during his or her lifetime.
However, for estate tax purposes, the trust assets are not considered part of the grantor’s estate after the transfer to the trust. Typically, the grantor “sells” the assets to the trust in exchange for a promissory note, as gifting the assets would trigger a gift tax. Valuations are depressed at the moment but will likely return to normal levels over the medium to longer term. With the rock bottom level of the IRS AFR rate, the note will pay a very nominal rate of interest. Even assets with modest growth expectations are likely to generate returns exceeding the rate on the note. Moreover, when assets are “sold” to the IDGT, there is no recognition of a capital gain. This is extremely beneficial when assets are highly appreciated.
Beneficiaries of an IDGT are frequently the children or grandchildren of the grantor. With the grantor paying the taxes, he or she is actually passing on extra wealth as the assets appreciate free of tax. It is important to note, though, that the assets owned by the IDGT are for the benefit of the beneficiaries but are not their personal assets. The grantor specifies the way in which trust distributions will be made. The trust can also hold insurance policies on the life of the grantor, and the proceeds of such policies will pass in trust to the beneficiaries.
IDGT’s are a powerful tool in the estate planning arsenal, maximizing the legacy to the next generation while minimizing estate taxes and protecting family assets for future generations. However, given the complexity of trust planning, it’s advisable to see the advice of legal, tax and investment advisors.