If estate planning is undertaken in a relatively low interest rate era, as now, then various complex techniques of estate planning structure can save remarkable amounts of taxes.
The current low interest rate environment may lead to estate and gift tax planning opportunities for affluent individuals. The key interest rate used by the IRS for these purposes (the Section 7520 interest rate) can result in tax savings when rates decline and given the likelihood of increased estate and income tax over the next several years, such methods should be seriously considered by those seeking to maintain family wealth for the next generation.
Consider the tax benefits available with these six estate planning techniques:
1. A grantor retained annuity trust (GRAT) enables you to transfer wealth -- often represented by a business interest -- to relatives with little or no estate and gift tax liability. You retain the right to receive fixed annuity payments from the trust for a specified period of years. At the end of the trust term, the remaining assets are distributed to the designated beneficiaries. This is a successful tool when undervalued assets transferred to the trust are expected to appreciate at a rate faster than the Section 7520 assumed rate. At the time the GRAT is created, gift tax is imposed on the remainder interest. Therefore, if appreciation outpaces the interest rate over time, there's no estate tax due on the transfer to beneficiaries.
2. Private annuities With a private annuity, you typically transfer assets to a child in exchange for a promise on his or her to pay fixed payments for the rest of your life. For gift tax purposes, the value of the annuity payments is based on IRS interest rates and life expectancy schedules. If the fair market value of the assets transferred equals the value of the annuity under the valuation tables, there is no gift tax due. The lower the interest rates, the lower the gift tax cost( Under proposed regulations, some tax advantages of private annuities were eliminated for transactions entered into after October 18, 2006. However, transactions before April 17, 2007 may be exempt.)
3. A charitable lead annuity trust (CLAT) may be a viable method for philanthropic taxpayers. With a CLAT, annual annuity payments are distributed to one or more qualified charitable organizations. Then, the remainder passes to beneficiaries such as your children. If the Section 7520 rate is relatively low, the transfer to beneficiaries may avoid estate and gift taxes (or keep them to a minimum). Low rates also increase the charitable deduction.
4. A self-canceling installment note may be used to transfer business assets such as real estate. Typically, you sell appreciated property to a child in exchange for a promise to make periodic payments over a designated period. If properly structured, the self-canceling feature provides termination of the buyer's obligations if the seller does not survive the term of the note. And a low interest rate reduces the payments for the child.
5. An Intentionally Defective Irrevocable Trust (IDIT) A IDIT intentionally is drafted so as to fail in compliance with the tax rules on purpose so the grantor is treated as the trust owner. When the grantor dies, the assets are distributed to trust beneficiaries. Typically, the grantor sells appreciated assets to the IDIT via an installment sale, paying interest equal to the Applicable Federal Rate (AFR). This effectively avoids estate tax when interest rates are low. No taxable gain is realized on the sale because the grantor is the trust owner.
6. Intra-family loans A low interest rate environment is also a good time to arrange intra-family loans to children. Generally, no gift tax consequences result from a loan if you charge interest equal to the AFR for the month the loan is made.
The above techniques all require complex documentation and the good advice of professionals, both tax and legal. The resulting “package” of documents is extensive and nearly incomprehensible for the lay person and can cost the family many thousands of dollars, often more than ten thousand dollars to create. They also require complex structures that often can only be altered with complex methodology or not at all.
So why do them? The only advantage is tax savings and when created correctly the savings can be in the millions of dollars in estate taxes if the estate is large enough. Our basic rule is not to even consider such structures until the estate likely to be confronted exceeds ten million dollars. However, keep in mind that in certain locales, home prices are such that such estates are actually well within the “middle class” range. Every family should thus have these in the back of their minds when considering the type of structures that might be useful. It is to be remembered that absent intelligent planning, upon the second spouse to die, taxes due on an estate of only three or four million dollars nine months after date of death could easily be close to one million dollars. It is a sad but true fact of estate planning that at the moment of grieving, and when a bread winner may have recently died, the family may face taxes of six figures due in cash to the United States government.
Avoiding that legally is one of the goals of good estate planning and in the right circumstances, the above tools may be worthwhile.