As the landscape changes, estate planning opportunities continue to evolve.
The stock market has been particularly volatile this year amid concerns about inflation, potential interest rate increases and the tragic war in Ukraine. This unsettling environment, both generally and with regard to investments, may change the dynamics of estate planning. When interest rates are extremely low, as they remain today, certain techniques may be particularly viable, while others may become more favorable with rising rates—a likely scenario with the newly hawkish tone of the Federal Reserve. For those who feel comfortable making significant gifts, this may be an opportune time to transfer assets to heirs to capitalize on the currently high federal estate and gift tax exemption ($12.06 million per person; $24.12 million per married couple), which is set to sunset in 2026 to its 2017 level of $5.49 million, adjusted for inflation. With that in mind, here are a few strategies that we think may be worth considering—especially for those who have fully utilized their federal exemption.
While Rates Remain Low…
Grantor Retained Annuity Trusts (GRATs)
A GRAT is an irrevocable trust to which the creator (grantor) transfers property and retains an annuity stream for a set term of years (usually two or three), with the remainder passing to heirs (or trusts for their benefit) at minimal or no gift tax cost. It is a technique that is especially attractive for those who have used their exemption or who may be more comfortable giving away growth on an asset than the asset itself.
The funding of the GRAT is considered a gift to the remainder beneficiaries (the heirs). The value of the gift is the initial fair market value of the trust property reduced by the value of the annuity retained by the grantor. GRATs are particularly useful as a wealth transfer technique when interest rates are low because any returns generated above the applicable federal rate (AFR), the IRS assumed growth rate published monthly that is linked to Treasury yields (2.2% in April 2022), will pass to heirs free of gift tax. The lower the AFR, the lower the assumed growth of the trust assets and its remainder, and the lower the assessed value of the gift. By adjusting the term of the trust and annuity payout, it is possible to reduce the deemed gift to nearly zero. Accordingly, a GRAT is typically structured so that the annuity is equal to the value of the property at the time it is transferred to the trust, plus interest calculated using the AFR at the time the trust is funded. Therefore, upon creation of the GRAT, there usually is deemed to be a minimal or no remainder to pass to the heirs—hence, no gift.
GRATs can also be very effective when the assets used to fund them are depressed in value or have high growth potential. In this period of market volatility, there may be opportunities to fund a GRAT when there is a downturn in the market. It may be advantageous to fund a GRAT with a large position in a single stock, a basket of stocks in one industry, or stocks that move in tandem with each other. Otherwise, you could have some stocks appreciate in the GRAT and others decline, canceling each other out and reducing the possibility of having a remainder to pass to your heirs. For this reason, many individuals choose to fund more than one GRAT at a time with different securities.
The appeal of a GRAT in a low-interest-rate, volatile environment is evident in the following sample illustration:
After the market correction resulting from the onset of COVID in March of 2020 (when the 7520 rate was 1.8%), an investor with a large single-stock position that had plummeted in value, and which he believed had significant growth potential, funded a two-year GRAT with 530 shares of the stock valued at $1,890 per share, or $1,001,700 in total. The GRAT was “zeroed out,” as described above, so virtually no gift tax was payable upon funding. Over the two-year period, the investor received back $1,029,755 (the amount he transferred to the trust plus interest) in shares of the stock.1 The stock subsequently recovered, reaching a value of $3,273 per share when the trust terminated in March 2022, and the stock’s appreciation, roughly $725,000, passed to a trust for the investor’s children free of gift taxes.
Regardless of the interest rate, those who have a large position in a security/asset that (1) they believe has appreciation potential, (2) doesn’t throw off dividend income that they rely on, and (3) they don’t plan to sell in the next several years might consider putting that asset into a GRAT. Instead of holding the position in one’s own account, transferring it to a GRAT could allow the appreciation on it to pass to heirs gift tax free.
This technique does have some limitations: It requires a current transfer; the grantor pays all of the income taxes on the assets in the trust just as if the grantor still held them in his or her own name (which can be a benefit if the grantor is comfortable paying them); if the grantor dies before the end of the trust term, some portion or all of the GRAT will be includible in the grantor’s estate (which is why GRAT terms are typically short); and, as with virtually all lifetime gifts, there is carryover basis (i.e., the trust takes on the grantor’s cost basis and there is no step-up in basis).2 However, under current law, your estate may be no worse off than if you had not taken any action, other than setup costs. GRATs take time to prepare, so we suggest drafting paperwork and opening accounts prior to when you contemplate funding them (such as when the stock price hits a designated target).
Charitable Lead Annuity Trusts (CLATs)
For those with philanthropic interests, a CLAT is another strategy whose potential benefits are enhanced in a low interest rate environment. CLATs offer the opportunity to combine a charitable gift and a transfer of wealth to heirs at minimal transfer tax cost. A CLAT is a “split-interest” irrevocable trust that pays a charity or charities a fixed annuity for a set term of years at the end of which the remaining trust assets pass to heirs (outright or in trust) free of gift tax, if structured as described below.
As with a GRAT, the funding of the CLAT is a taxable gift of the remainder interest, and the annuity can be structured so that the total annuity payout over the trust term is equal to the initial value of the assets placed in the CLAT, plus interest at the applicable AFR.3 Thus, there is minimal or no gift tax due upon funding the CLAT. As with a GRAT, low interest rates can enhance the opportunity for wealth transfer because any appreciation in excess of the AFR passes at the end of the term to heirs free of gift tax. A significant charitable income tax deduction may be attained if the CLAT is structured in a certain way.4 With appropriate investments, a CLAT can be an effective vehicle to satisfy your philanthropic goals while seeking to capture growth potential for heirs without incurring any gift or estate tax.
Should Rates Rise…
Qualified Personal Residence Trusts (QPRTs)
Just as some techniques are particularly beneficial in a low interest rate environment, others can become more advantageous as interest rates rise. One such technique is a QPRT. A QPRT is a means of transferring property to heirs at a reduced gift tax cost while enabling the donor to capitalize on the currently high federal estate and gift tax exemption with an illiquid asset. As the name implies, a QPRT is a trust to which an individual transfers his home (a primary or secondary residence) and retains the right to live in it for a term of years. At the end of the term, the home passes to the remainder beneficiaries (heirs) either outright or in further trust.
When a QPRT is established, a gift is made to the remainder beneficiaries like in a GRAT. The value of the gift is that of the home minus the current value of the donor’s occupancy, which is determined based on the AFR for the month of transfer. Whereas, in a GRAT, the AFR is used to calculate the value of the remainder interest, in a QPRT, the AFR is used to calculate the grantor’s retained interest—which is the appeal of a QPRT in a rising rate environment. The higher the AFR, the higher the imputed value of the donor’s retained right of occupancy, and the less that is deemed transferred to heirs as a gift. Because the donor retains both the right to live in the home for a period of time and a reversionary interest if she dies within the term, the value of the gift is a fraction of the value of the entire home.
For example, assume a 65-year-old transfers a $1 million home to a QPRT for a 15-year term in April 2022 when the AFR is 2.2%. The donor would be making a current taxable gift of roughly $446,000 to the heirs (representing the right to receive the home in 15 years after the donor’s retained right of occupancy), with the value of the interest retained (based on the AFR) calculated at $554,000—representing a 55.4% discount to the home’s overall value. At the end of the 15-year term, at a hypothetical optimistic growth rate of 5.5%, the property may be valued at approximately $2,232,000, with a potential estate tax savings of $715,000. 5
At the end of the trust term, the home passes to heirs (or a trust for their benefit) at no further gift tax cost, even if the value of the home has increased substantially. At such time, if the donor would like to remain in the home, she will need to enter into a market rate lease with the heirs (or a trust for their benefit), who are the new owners of the property. The rent paid to the heirs represents additional assets that are removed from the donor’s taxable estate. If the donor does not survive the term of the QPRT, the value of the trust at that time will be brought back into her estate—which one should keep in mind when setting the length of the term of the trust. For residents of states with an estate tax but no gift tax, transferring the home to a QPRT may remove the home from their estates for state estate tax purposes if they survive the term.
Charitable Remainder Annuity Trusts (CRATs)
CRATs are a familiar estate planning tool that have had limited use in the recent multiyear period of low interest rates and relatively low capital gains tax rates, but which may be due for a comeback given their appeal when interest rates are higher. A CRAT is an irrevocable “split-interest” trust in which one or more individuals have a beneficial interest for the term of the trust (their lifetime or a term of years) and a charity or charities have the remainder interest.6 CRATs are exempt from income tax (unless they have unrelated business taxable income), making them useful as a diversification tool because the trust can sell holdings without capital gains tax consequences and reinvest the entire proceeds in multiple assets as appropriate. The donor receives a charitable income tax deduction for the actuarial value of the remainder interest passing to charity, which is calculated using the length of the trust term, the individual payout percentage and the AFR for the month the trust is funded or the previous two months. Higher interest rates increase the imputed value of the remainder interest passing to charity, leading to a larger charitable deduction.
If a CRAT is created during lifetime with the donor and/or the donor’s spouse as the initial beneficiaries, no gift tax will be owed. If any other individual is named as a non-charitable beneficiary, the donor will be making a current gift of the actuarial value of that individual’s interest. If a CRAT is created at an individual’s death (through a will or revocable trust), the individual’s estate could receive an estate tax charitable deduction for the actuarial value of the interest passing to charity and the annuity interest would be subject to estate tax if someone other than the individual’s spouse is named as a non-charitable beneficiary.
A typical sample scenario is as follows: An individual with appreciated publicly traded securities donates them to a CRAT, retains an annuity interest, and receives an income tax charitable deduction for the fair market value of the securities deemed to be passing to charity. The trust sells the securities7 and, because the trust is not required to pay any capital gains tax, the full value of the assets can be reinvested to generate the annual payout amount for the individual. One of the key benefits of a CRAT is that items of income, including capital gains, can be realized income tax free within the trust and do not generate a tax liability until they are distributed to the individual beneficiary. Although the trust is not subject to income tax, the annuity payments received by the individual beneficiary are subject to tax. Accordingly, the capital gains and income taxes are typically deferred—not avoided. The character of the income received by the beneficiary (e.g., ordinary income, long-term capital gain) depends on its character at the trust level.
These are but a few of the estate planning tools that may be available to help you minimize estate and gift taxes over time. We have only summarized the strategies, each of which have specific limitations and requirements. Talking with your advisors is a key first step in assessing whether utilizing any of the strategies discussed in this article would be appropriate for you.8
More Estate Planning Ideas
Have you invested in tangible personal property, such as gold bars or coins, or are you considering doing so? Investing in gold has historically been seen as a safe haven in volatile markets and a long-term hedge against inflation. In some states that have a state estate tax, tangible personal property custodied outside of the state is not subject to state estate tax. For example, if you live in New York (which has a state estate tax) and your gold bars are permanently held in a depository or bank in a state that does not have a state estate tax (e.g., Delaware), the value of those gold bars should not be includible in your estate for New York state estate tax purposes,9 potentially enabling you to avoid state estate tax on that gold. In addition, if you live in Connecticut (which has both a gift and an estate tax) or New York (which has an estate tax and a rule that treats gifts made within three years prior to death as part of your taxable estate), moving the gold to a bank or depository in a state where there is no gift tax (e.g., Delaware) and making the gift there may allow you to give away the gold without the imposition of state gift tax.
Fund Your Revocable Trust
The pandemic has caused many people to be more conscious of their mortality and to want to put their affairs in order. We find that one of the most effective measures to help ensure a smooth transition of management of your assets upon your incapacity or death is to fund a revocable trust—a trust that you establish during your ifetime that is for your benefit.
Although funding a revocable trust does not have any income, estate or gift tax implications in most states, it has some key advantages. For example, if you name an individual or corporate trustee (either to act alone, together with you or as a successor to you), a revocable trust can provide the mechanism for continued management and utilization of your trust assets in the event you become ill, incapacitated or are unavailable because you are traveling. In addition, upon your death the successor trustee can continue to manage your assets without delay and have immediate access to the funds to pay necessary expenses. This can be particularly important if you own assets that may fluctuate significantly in value due to economic or market conditions. In March 2020 at the beginning of COVID, many courts closed for months, causing long delays before wills could be admitted to probate or assets titled in a decedent’s name could be managed. This problem was generally avoided where funded revocable trusts were in place. Revocable trusts are only effective to the extent they are funded, which means that the trust must be properly identified as the owner in account documents.
1The stock can be sold within a GRAT and cash and/or stock may be used to pay the annuity to the grantor.
2 That said, some trusts can be drafted to allow substitution of other assets, typically those with a high basis, to bring the low-basis assets back into the estate, where they can benefit from a step-up.
3 The AFR for the month of the gift or the previous two months can be used when valuing an annuity or unitrust interest for a CLAT and certain other charitable trusts.
4 Each year, the trust gets an income tax deduction for the annual payment to charity to offset the trust’s fiduciary income tax liability. A CLAT can also be structured as a “grantor trust” so that the creator can receive an income tax deduction in the year the trust is established equal to the present value of the interest passing to charity. However, in this scenario, in each year of the trust the creator must include the trust income on her personal income tax return. Under current law, the creator’s payment of the income tax is not treated as a gift to the non-charitable beneficiaries even though it enables the trust to grow on a tax-free basis.
5 Upon a sale there may be a capital gains tax because the donor’s cost basis in the home carries over to the trust. 6 The remainder interest passing to charity must be 10% or greater.
7To preserve the capital gains deferral there cannot be a pre-arranged plan between the donor and trustee to sell the contributed assets.
8 The Biden administration recently released its fiscal year 2023 revenue proposals, some of which, if enacted, could eliminate or substantially reduce the tax benefits of numerous estate planning techniques, including those discussed in this article. At this time, it remains unclear whether any of the proposals will become law. You should discuss the implications of the proposals on your estate planning strategies with your advisors.
9 This has no impact on Federal estate or gift tax.
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