Wealth Transfer Opportunities with Devalued Assets

March 27, 2020

The COVID-19 pandemic continues to have far-reaching effects which are expected to be felt for months to come, if not longer.  The economy has been hit hard and the stock market has seen a dramatic reduction in value.  Trying to time the market is like trying to catch a falling knife and no one can be sure as to the duration and extent of losses.  Even though gifting may be the last thing on your mind, the current climate presents a unique opportunity for estate planning.

For 2020, a married couple can protect $23.16 million ($11.58 million per individual) in taxable assets from the federal gift and estate tax.  With proper planning, the same amount can often be protected from taxation in the estates of their children as well.  Additionally, the annual gift tax exclusion amount is currently set at $15,000 ($30,000 per couple).

The following are a few techniques to consider: (i) outright gifts, (ii) gifts to dynasty trusts, (iii) gifts to Grantor Retained Annuity Trusts (“GRATs”), (iv) sales to Intentionally Defective Grantor Trusts (“IDGTs”), (v) substitution of trust assets in IDGTs, and (vi) loans to family members.  Each technique is addressed below.

Outright Gifts

Outright gifts are useful.  They are simple and can be completed quickly.  Note, however, such gifts are included in the recipient’s estate for estate tax purposes and do not provide any spousal or creditor protection.

Gifts to Dynasty Trusts

Gifts to dynasty trusts, if structured correctly, have the added effect of removing the gifted property from the beneficiary’s estate.  If proper exemption is allocated to the gift, the future appreciation on the gifted property will not be subject to estate tax on the beneficiary’s death.  Furthermore, the gift will be protected from spouses and creditors.

Example: Jane transfers stock valued at $5 million (assume the stock was valued at $8 million before the crisis) to a trust for the benefit of her son, Bob, and she uses $5 million of her lifetime gift tax exemption.  Five years later, the stock has increased in value to $8 million.  Jane essentially removed $8 million from her estate and only used $5 million of her lifetime exemption.  The trust property (including future appreciation) will be available for Bob’s benefit but will not subject to estate tax on his death and will not be reachable by his creditors or his spouse.

Gifts to GRATs

A GRAT is a trust to which you transfer property and retain the right to receive annual payments for a set period of time.  If the GRAT is “zeroed out,” the remaining property left in the trust at the end of the term will pass to the beneficiaries without using any of your gift tax exemption.  GRATs are perfect when interest rates are low because any appreciation will pass to the beneficiaries tax free.  Starting on April 1, 2020, the interest rate is only 1.2%, which presents a rare opportunity to make transfers while still potentially removing substantial asset appreciation from your estate.

Example: Fred funds a GRAT with $10 million worth of stock and retains the right to receive an annuity payment of approximately $1.318 million annually for 8 years.  Assuming Fred survives for 8 years and the trust principal grows 5% annually, approximately $2.185 million will pass to the trust beneficiaries and Fred will not have used any gift tax exemption.

Sale to an IDGT

With a sale to an IDGT, an asset is sold to a trust in return for a promissory note (after the trust is funded with seed money).  Appreciation on the trust assets in excess of the sale price will pass to the beneficiaries of the trust estate tax free.  As discussed above, effectuating this type of transfer while interest rates are low enables you to pass more assets to your family, as the trust will have to pay less interest on the note.

IDGTs: Substituting of Assets

Oftentimes, the terms of an IDGT provide you with the power to substitute the IDGT’s assets for assets of equivalent value.  Exercising this power can be beneficial if a trust asset is expected to substantially decrease in value.  In that event, you can swap the asset with decreasing value for cash or another asset with increasing value.  As a result, your estate is ultimately reduced (with less property subject to estate tax) and any appreciation on the asset transferred to the IDGT will be removed from your estate for estate tax purposes.

Example: Sally owns real property currently valued at $10 million and expects the property value to increase.  An IDGT created by Sally owns stock also valued at $10 million, but the stock is expected to substantially decline in value.  Sally substitutes her real property for the IDGT’s stock, and dies ten years later when the stock is worth $2 million and the real property is worth $15 million.  Sally’s estate now includes property valued at $2 million while the IDGT, which is not subject to estate tax when Sally dies, has an asset with a value of $15 million.

Note that you should consider the tax basis in the property being substituted, as there could be potential gain or loss when the property is later sold.

In addition to the substitution example discussed above, consider the following scenario: if an IDGT over which you hold a power of substitution owns an asset with a low tax basis, substitute that low basis asset for a high basis asset that you own individually.  Upon your death, your heirs will receive a “step up” in basis in that low basis asset, which will reduce potential capital gain if the asset is later sold.

Transfers to a GRAT, sales to an IDGT, and substitution of IDGT assets remain powerful estate planning techniques, especially where clients no longer have substantial remaining gift tax exemptions to utilize.

Loans to Family Members

Consider making loans to family members or refinancing existing loans to take advantage of the extremely low interest rates (in April, the short term rate will drop to 0.91% and the midterm rate will drop to 0.99%).

As a reminder, on January 1, 2026, the federal estate, gift, and GST tax exemptions are set to revert back to their pre-2018 levels (approximately $5.49 million per individual), as indexed for inflation.  In fact, there is a real possibility that the exemptions will be reduced before 2026 depending on the outcome of the upcoming election.  At this time, we need to assume that the increased exemptions will go back to their previous levels, which means that there is a limited window to take advantage of the increased exemptions.

During this crisis, our main concern is that you and your loved ones remain safe and healthy.  Please feel free to contact us if you would like to discuss any of the above-mentioned techniques with an attorney.  Of course, we remain available to assist you with any other estate planning needs or inquiries, as it may be a prudent time to revisit your current estate plan and make sure that it works for you given the current climate.