Taxpayers and their advisors often find themselves chopping through the tall grass of complex estate-planning structures and devices when considering alternate ways to transfer wealth. Lost in the weeds is the fact that there are relatively few ways to transfer wealth without paying gift and estate taxes. In this article, we provide an overview of the only four plays in the transfer tax playbook:
• Gifts using gift tax exemption: Taxpayers can transfer future income and appreciation out of the estate by making gifts using their gift tax exemption.
• Leveraged transfers: Taxpayers can use leverage to amplify the amount of future income and appreciation transferred out of the estate.
• Discounts: Taxpayers can structure their gifts or leveraged transfers to take advantage of discounts to create immediate gift and estate tax savings.
• Tax-free gifts: Taxpayers can make tax-free gifts in various forms to deplete the estate without tax risk.
Gift Tax Exemption
After the Tax Cuts and Jobs Act of 2017, individuals now have $10 million (indexed for inflation)1 of transfer tax exemption to use during life and/or at death. Just focusing on the exemption, whether it’s transferred during life or at death makes no difference: There’s no tax on the $10 million either way. The only potential benefits of the gift are: (1) any post-gift income and appreciation is also transferred free of gift and estate taxes, and (2) the exemption is used in case it decreases in the future.
The transfer of assets with the greatest income and appreciation potential is generally considered tax efficient for a taxpayer whose estate is large enough to be subject to estate tax at death. After the taxpayer makes a gift using gift tax exemption, all future income and appreciation from the gifted assets escape gift and estate taxes. If the taxpayer waits until his death to transfer the same assets, only the amount of the taxpayer’s actual remaining estate tax exemption will be sheltered from estate tax.
Example 1: Estate tax benefit of gift using gift exemption. A gift of $10 million of ABC Company stock using a taxpayer’s gift tax exemption would be worth over $32 million after
20 years assuming a 6% annual rate of return, thereby transferring $22 million (the post-gift appreciation) out of the estate without gift or estate tax. Had the taxpayer not made the gift, only $10 million of the total $32 million worth of ABC Company stock in the taxpayer’s estate would have been sheltered from estate tax. As a result, $11 million of estate tax would be charged to the taxpayer’s estate, reducing the total amount left to the beneficiaries to $22 million instead of the $32 million. If the taxpayer’s goal was to leave the beneficiaries $22 million, his estate would need to be at least $44 million before estate taxes to accomplish this goal.
While the tax benefits of gifts using gift tax exemption can be significant, these benefits take time to be realized because the tax savings is based solely on future income and appreciation from the gifted assets. Until these assets begin to generate income and appreciate, taxpayers must weigh the potential estate tax benefit against the loss of a basis adjustment to the gifted asset had the taxpayer kept it.
This “appreciation hurdle” is the aggregate (not annual) appreciation required between the date of the gift and the date of the taxpayer’s death for the estate tax savings to equal the capitals gains tax cost of no basis adjustment.2 No tax benefit will result until this appreciation hurdle is met.
Example 2: Income tax risk of gift using gift exemption. If the $10 million of ABC Company stock had a $0 tax basis, the taxpayer and his family would have an immediate $2 million tax detriment to overcome on making the gift (assuming a 20% capital gains tax rate). This is because the asset would have received a basis adjustment to fair market value had the taxpayer not gifted the asset and it remained in the taxpayer’s estate. Thus, for the taxpayer and his family to overcome the $2 million tax hurdle, the stock must appreciate by about 65% to create an estate tax benefit equal to the capital gains detriment due to the loss of basis adjustment.
Even after the appreciation hurdle is met, the decision whether to retain the assets owned by a grantor trust continues. If a taxpayer has the ability to purchase low basis assets from a grantor trust, the family can benefit from a basis adjustment to the low basis assets at the taxpayer’s death, while the trust can reinvest the high basis sale proceeds to increase the estate tax savings.
The taxpayer must also consider the risk that the gifted assets depreciate after the gift. If the gifted assets decline in value after the gift, then the taxpayer would have transferred the gifted assets with more exemption than the taxpayer’s estate would have needed to shelter the gifted assets had the assets been retained until death.
Using Leverage
The estate tax benefit of gifts using gift tax exemption is also limited by the taxpayer’s available gift tax exemption. That is, taxpayers can only shift the future income and appreciation generated on assets originally worth $10 million (or $11.4 million in 2019 with the inflation adjustment).
To avoid this limitation and amplify the amount that can be transferred, taxpayers can use leverage techniques to increase the amount of future income and appreciation that can be shifted out of the estate. Common leverage techniques include intra-family loans, sales for promissory notes and grantor retained annuity trusts (GRATs).
In the case of both intra-family loans and sales of assets for promissory notes, these transactions will be disregarded for income tax purposes if the taxpayer enters into the transaction with a grantor trust. Because the notes must only bear interest at the applicable federal rate (AFR) published by the Internal Revenue Service each month,3 the invested funds (from a loan) or purchased assets (from a sale) must only produce investment returns in excess of the AFR for the family to benefit.
Example 3: Estate tax benefit of leveraged sale. In addition to gifting $10 million of ABC Company stock to a grantor trust for his children, if a taxpayer also sold $50 million of stock to the trust in exchange for an interest-only promissory note with a balloon payment, the estate tax benefit dramatically increases. Assuming the same 6% rate of return and 20-year period as in the prior examples, the sale moves an additional $59 million of value out of the estate after repayment of the promissory note (assuming a 2.76% interest rate, which is the long-term AFR for June 2019) without using any of the taxpayer’s gift tax exemption. By comparison, it would require an estate worth over $118 million before estate taxes to leave
$59 million to the taxpayer’s descendants at death.
Likewise, GRATs generally accomplish the same objectives without using gift tax exemption or triggering gift tax. By transferring assets to a GRAT, the taxpayer’s share in the growth of the GRAT’s assets is limited to the Internal Revenue Code Section 7520 rate published monthly by the IRS, and the “excess” return realized by the GRAT is transferred free of gift and estate taxes.
However, GRATs accomplish this without risk of loss to the remaindermen if the assets decline in value, whereas intra-family loans and sales of assets for promissory notes could result in a loss to the trust and backwards estate planning because the trust owes the full amount of the debt regardless of the investment return. As such, GRATs and debt transactions are both forms of leverage that can amplify the potential transfer tax benefit, but debt transactions also amplify the loss if assets decline in value.
Thus, like gifts using the gift tax exemption, leveraged transfers can shift future income and appreciation out of the estate (albeit with an interest rate hurdle for the leveraged transfers). However, the leveraged techniques can accomplish this without using or being limited to the taxpayer’s gift tax exemption. And, unlike a transfer sheltered by gift/estate tax exemption, leveraged transfers must be undertaken during life, or the opportunity is lost.
Using Discounts to Deplete the Estate
While the foregoing methods shift future appreciation and income out of the estate, they don’t deplete the initial corpus of the estate and could take significant time to produce any tax savings at all. To speed up the process and immediately deplete the estate, taxpayers can structure their gifts and leveraged transfers in a manner that takes advantage of valuation discounts.
Discounts can be obtained based on the structure of a particular transfer. Qualified personal residence trusts (QPRTs) and remainder purchase marital (RPM) income trusts are examples of trust structures that create discounted transfer opportunities.4
Examples 4 and 5: Statutory “time value” discounts.
QPRT. A 55-year-old taxpayer transfers his residence to a QPRT and retains the right to use the residence rent-free for 20 years, after which the residences passes to a trust for the taxpayer’s children. The residence is valued at $10 million on the date of the transfer. By retaining the right to use the residence for 20 years, the value of the remainder interest transferred to the trust for the taxpayer’s children is reduced to approximately $4 million for gift tax purposes (assuming a 2.8% IRC Section 7520 rate, which is the rate for May 2019), thereby shifting $6 million out of the estate if the taxpayer survives the 20-year term. If the residence appreciates at a 6% rate, the trust for the taxpayer’s children will receive a $32 million asset after 20 years by the taxpayer using only $4 million of gift tax exemption.
RPM income trust. A taxpayer transfers a $10 million portfolio of marketable securities to a RPM income trust that pays the taxpayer’s spouse all the income for 20 years or until the spouse’s death if sooner. Simultaneously, the taxpayer sells the remainder interest (that is, the right to receive the portfolio and the proceeds therefrom at the end of the 20-year term) to an irrevocable trust for his children.
The spouse’s income interest reduces the value of the remainder and thus the price the irrevocable trust pays for the remainder interest. Assuming a 2.8% Section 7520 rate (the rate for May 2019), the irrevocable trust would pay the taxpayer approximately $6.7 million for the right to receive the $10 million of assets plus all growth generated from such assets after the transaction date, in 20 years—effectively a 33% discount. At a higher Section 7520 rate, this discount would be greater.
If the portfolio appreciates at a 6% rate of return, the portfolio will be worth over $32 million after 20 years. This is the same net transfer as the $10 million gift example above, but the RPM income trust required an initial gift of $6.7 million.
Discounts can also be obtained based on the particular asset transferred. For instance, the gift tax value of a minority interest in a closely held corporation or in a family limited partnership can be reduced for lack of control and marketability.
Example 6: Valuation discounts. Assuming ABC Company has a going concern value of $200 million, the purchase price for the sale of a 25% non-voting interest could be reduced to
$35 million rather than $50 million assuming a 30% discount. This valuation reduction immediately removes $15 million from the estate without using any additional gift tax exemption or having to wait for the stock to appreciate.
However, the use of valuation discounts isn’t without risk. The IRS frequently challenges valuation discounts, and recent events shine a light on the increased weaponry that the IRS may use to attack these transactions.
• In August 2016, the Treasury Department issued proposed regulations under IRC Section 2704 in an attempt to attack valuation discounts for family-controlled entities. While these regulations were later withdrawn, they would have served as a significant weapon for the IRS to combat valuation discounts.
• In May 2017, the IRS achieved a major victory in its effort to thwart discounts applied to the transfer of limited partnership interests with the Tax Court’s decision in Estate of Nancy H. Powell v. Commissioner,5 which extended the application of IRC Section 2036(a)(2) to decedents owning only limited partnership interests in certain family limited partnerships.
Even if discounts apply, the IRS may challenge the amount of the discount. If the IRS is successful in claiming that the transferred assets are worth more than the value reported on the gift tax return (for example, because the discount was too high), additional tax, interest and penalties could be imposed. For that reason, it’s important to obtain a professional appraisal and consider methods to transfer the assets with reduced gift tax risk, such as the use of formula gifts and disclaimers.
Tax-Free Gifts
Various forms of tax-free gifts (that is, gifts that don’t trigger gift tax and don’t use gift tax exemption) can be made to deplete the estate. These include annual exclusion gifts, qualified payments for health or education expenses and payment of grantor trust taxes.
While tax-free gifts are unlikely to create the large, immediate estate tax benefit that discounts provide, they can significantly diminish the estate over time. For example, a married taxpayer with three children and six grandchildren can make annual exclusion gifts totaling $270,000 per year, or $2.7 million over 10 years, without any tax risk or complexity. The taxpayer can also pay for his grandchildren’s pre-school, elementary, high school, college and graduate school tuition free of gift taxes, as well as their medical expenses.
Another tax-free gift is a taxpayer’s payment of income taxes attributable to income generated from a grantor trust. Structuring irrevocable trusts as grantor trusts enables taxpayers to pay the income tax attributable to the trust assets, allowing the trust assets to grow tax free (as well as to enter into the leveraged techniques described above without income tax consequence). This payment of the trust’s income taxes is an indirect tax-free gift to the beneficiaries, which will compound over time to transfer significant wealth and deplete the estate. In fact, this compounding benefit is so powerful that it’s important for the grantor-taxpayer to retain the ability to “turn off” grantor trust status if the payment of taxes begins to deplete the estate too much or quickly.
Example 7: Impact of grantor trust taxes. Assume the $10 million gift in Example 1 was a portfolio of stocks that continues to produce a 6% rate of return and that the trust realizes 20% of unrealized gains per year. Over the 20-year period, the taxpayer may pay over $4 million of income taxes on behalf of the trust, which is a tax-free gift by the taxpayer that reduces the taxpayer’s estate. If the portfolio generates 1% of income per year, this total rises to over $6 million for the 20-year period (assuming a combined federal and state 40% ordinary income tax rate). As the taxpayer engages in additional wealth transfers (for example, sales for promissory notes), this income tax figure will continue to increase.
Endnotes
1. For purposes of this article, $10 million will be used as the federal estate and gift tax exemption amount and 50% as the combined federal and state estate tax rate.
2. See David A. Handler and Patricia H. Ring, “Lifetime Transfers of Appreciating Assets: When Does it Pay?” Trusts & Estates (January 2018).
3. Internal Revenue Code Section 7872(e).
4. See David A. Handler and Deborah V. Dunn, “RPM Trusts: Turning the Tables on Chapter 14,” Trusts & Estates (July 2000); David A. Handler and Deborah V. Dunn, “RPM Annuity Trusts: A ‘Great’ Alternative,” Special Supplement to Lawyers Weekly USA (Jan. 24, 2004), at p. 1; David A. Handler and Deborah V. Dunn, “GRATs and RPM Annuity Trusts: A Comparison,” Tax Management Estate, Gifts and Trust Journal, Vol. 29, No. 4 (July 8, 2004).
5. Estate of Nancy H. Powell v. Commissioner, 148 T.C. No. 18 (May 18, 2017).