Advanced Wealth Transfer Strategies

For many individuals, the inflation adjusted gift and estate tax exemption amount of $5.49 million for 2017 is likely to eliminate most, if not all of their potential estate tax liability. But individuals with larger estates, or those who would like to continue receiving income from the assets they ultimately wish to transfer, may need something more. A number of more sophisticated wealth transfer strategies enable you to transfer assets at reduced values for gift and estate tax purposes — often enabling you to remove assets worth well in excess of $5.49 million from your estate without triggering gift or estate taxes. Many of these strategies also provide a predictable income stream. Their interest rate sensitivity makes it advantageous to consider these strategies now, while interest rates are low.

Grantor Retained Annuity Trusts

Grantor retained annuity trusts (GRATs) are an “estate freeze” technique that enable you to remove future appreciation from your taxable estate. They are particularly useful to individuals who have assets that:

• can benefit from a valuation discount, such as a minority stake in a private company,
• may appreciate substantially in value, such as ownership in a company that may be sold or taken public, or
• generate strong cash flow, such as commercial real estate

With a GRAT, you gift property to a trust that makes periodic payments to you. The present value of the payments you receive is taken into consideration in valuing your gift for gift tax purposes. The payments may be “in-kind” (such as a portion of any securities you have gifted) or in cash and, if set at a level that is high enough, they can possibly reduce the value of the gift for gift tax purposes to zero. As long as you outlive the GRAT, when it terminates, any property remaining in the trust passes to the remainder beneficiaries without any additional gift or estate tax consequences.

Example

Kathryn, age 50, is a senior executive at a company that is contemplating going public through an initial public offering (IPO). Several years ago, she used her full gift exemption to establish a trust for her son, but she would like to transfer some of the company stock she owns out of her estate before the IPO.

She sets up a 3-year GRAT that names her son as remainder beneficiary, and contributes shares valued at $10 million. The valuation on the shares includes a 35% discount for lack of marketability and control — placing the value before the discount at $15,384,615. By having the GRAT pay her $3,508,156 each year, she is able to reduce the value of the $10 million gift to zero for gift tax purposes — eliminating the need to pay any federal gift tax.

If the GRAT makes the payments in-kind and the value of the shares increases 10% each year, the GRAT will hold shares with an aggregate market value of $2,612,313 after making the final payment. If the stock goes public at the end of the GRAT’s term at a price that is 10% higher, the GRAT will hold shares valued at $2,873,544.

Sales to Intentionally Defective Grantor Trusts

Selling assets to an intentionally defective grantor trust (IDGT) can be a particularly attractive strategy for leveraging your federal gift and GST exemptions. Similar to a GRAT, an IDGT is useful for transferring assets that

• can benefit from a valuation discount,
• may appreciate substantially in value, or
• generate strong cash flow.

With this strategy, you make an initial taxable “seed gift” to the trust. The trust then purchases additional assets from you that can be valued at up to nine times the value of seed gift by issuing an installment note. If you have not already used your $5.49 million 2017 federal gift tax exemption, the combined gift and sale would enable the trust to acquire assets valued at up to $54.9 million without triggering any federal gift taxes. And, if you are selling a minority stake or transferring ownership in a private company, you may be able to take maximum advantage of any available valuation discount and ultimately transfer even greater value free of federal gift taxes.

In order to avoid federal gift tax consequences, however, the interest rate on the note must be at least as high as the rate set by the IRS, but the note can be structured with a balloon payment to minimize the annual payments. The note can also be refinanced to defer repayment of principal even further, if needed.

It is important to note that the sale of the assets to the trust is not a taxable event. Because the trust is structured to be “intentionally defective” for income, but not gift tax purposes, the sale of the assets to the trust is treated as though it were a sale to yourself. No gain or loss is triggered until the assets are sold to a third party.

Example

Roger, age 60, owns a closely-held business that he believes she can eventually sell for $120 million to a company that could distribute his product more broadly. He recognizes that the $5.49 million federal gift tax exemption provides him with an opportunity to transfer an ownership stake, and the potential price appreciation on it, out of his taxable estate. A valuation firm has told him that the company is worth $90 million based on its current cash flow.

Roger establishes an IDGT, gifts $5 million to the trust and then sells non-voting shares valued at $50 million to the trust. The trust issues a 15-year installment note with an interest rate equal to the IRS mandated rate of 3.0% to finance the purchase of $45 million of the stock. Because the note is structured with a balloon payment, annual payments by the trust are limited to $1,350,000 for the first 14 years, with cash flow from the company being more than adequate to cover the payments.

Although Roger will be taxed on any income earned by the trust assets, he won’t be taxed on the interest payments he receives from the trust and won’t recognize a capital gain on the sale of the shares to the trust. He won’t recognize any capital gain on the transferred shares until they are sold by the trust.

Three years later, when the company is sold for $120 million, the trust repays the $45 million outstanding on the note and is left with $21,666,667 in cash.¹ Roger receives a combined $98,333,333 from the sale of his remaining 44.4% stake in the company and the repayment of the $45 million note.² He uses a portion of those funds to pay the tax on the capital gain triggered by the sale of the company. The strategy enables him to transfer over $21.6 million in value to his children over a three-year period by using just $5 million of his $5.49 million gift tax exemption.

Given the amount of assets that can be transferred to an IDGT without triggering federal gift taxes, it is often advantageous to allocate your GST exemption to the gift to the extent practical. This enables the trust to make tax-free distributions to grandchildren and future generations.

Establishing the IDGT in a state such as Delaware that does not limit the duration of a trust can help you extend the term of the trust and its ability to provide tax-free payments to future generations.

Sale to an IDGT is often an advantageous way to leverage your gift tax exemption and remove appreciation from your taxable estate, while continuing to receive income from the transferred assets. IDGTs also offer greater flexibility than GRATs — the term can be much longer because there is no requirement that you outlive the IDGT, the repayment schedule can use a balloon structure, and the note can be repaid at any time. The minimum interest rate on the note is mandated by the IRS and varies with the note’s term. Current low interest rates make a sale to an IDGT an attractive alternative for anyone who is interested in removing future appreciation from their taxable estate.

Qualified Personal Residence Trusts

For individuals with a primary residence or vacation home that they would like to leave to family members, a qualified personal residence trust (QPRT) can be a useful strategy for transferring ownership in a tax-advantaged manner. With a QPRT, you transfer a personal residence to a trust, but retain the right to occupy it for a fixed period. At the end of the period, ownership passes to your designated beneficiaries. Although the transfer to the trust is a taxable gift, the value for federal gift tax purposes is reduced by your “retained interest” — the value assigned to your ability to use the residence during the stated term. As a result, the amount of the taxable gift is generally well below the fair market value of the home. And, you can use any remaining lifetime gift tax exemption amount to offset some, or all, of the federal gift tax.

Example

Linda, age 60, transfers her vacation home, valued at $2 million, to a qualified personal residence trust set up to last 10 years. Over that period, the home appreciates 2% a year. When the trust ends, it’s worth $2,437,989, and the ownership of the home is transferred to Linda’s daughter. Assuming an IRS mandated interest rate of 3.0%, Linda can potentially realize estate tax savings of nearly $466,916.³

What about gift tax? Linda’s top gift tax rate would be 40%. If Linda gave her home to her daughter outright, the value of the transfer for gift tax purposes would be $2,000,000. If she had already used her $5.49 million lifetime gift tax exemption, she would have to pay $800,000 in gift tax.

In contrast, gifting the home in trust with the right to live in the residence for ten years reduces the taxable value of her gift to $1,270,700. As a result, the maximum amount of federal gift tax that Linda would have to pay would be $508,280 — a savings of over $291,720.

It’s important to remember that from a legal perspective, you are giving away your home. The trust can provide a degree of flexibility, but your overall control over the residence is effectively terminated when the trust term ends. You do have the ability to include a provision in the trust agreement that allows you to continue living in the residence after the term ends, but you must pay fair market rent to the new owner in order to avoid adverse tax consequences. Should you fail to survive the trust term, the value of the residence would be included in your estate. You should avoid using a QPRT on any property that has an outstanding mortgage as mortgage payments would be considered additional gifts to the trust.

Charitable Lead Annuity Trusts

Individuals who are interested in philanthropy and who would like to transfer assets to beneficiaries at a reduced valuation for gift tax purposes may find a charitable lead annuity trust (CLAT) useful. With a CLAT, you gift assets to a trust that makes annual payments to charities of your choice for a designated period. The present value of the charitable payments is taken into consideration when calculating the gift tax value of the assets you transfer to the CLAT. At the end of the trust’s term, any assets remaining in the trust pass to your designated remainder beneficiaries without triggering any additional federal gift or estate taxes. A low discount rate coupled with a high payout rate can substantially reduce the gift tax value of the remainder interest.

Example

Carlos would like to leave a portion of his securities portfolio to his son, but has already used his lifetime gift exemption. He creates a CLAT with $5 million worth of appreciating securities and names his son as the remainder beneficiary. The CLAT will pay his favorite charity $200,000 a year for 15 years for a total contribution of $3,000,000. If the IRS mandated discount rate is 3.0%, the charitable payments will reduce the taxable value of his gift to the trust to just $2,612,420. Assuming the trust earns an annual return of 7.5%, at the end of the 15-year term, the assets remaining in the CLAT that will pass to his son will be worth $9,570,714.

If Carlos still has $1,500,000 of his lifetime gift tax exemption remaining how much could he transfer to the trust without triggering gift taxes? If he increases the annual charitable payments to $293,500, the taxable value of the portfolio will be reduced to just under $1,500,000 for federal gift tax purposes and his son will receive the $7,128,647 remaining when the trust terminates without triggering additional federal gift or estate taxes.

By carefully planning and managing your giving through a CLAT, you can effectively reduce or even eliminate the federal gift tax liability on assets transferred to beneficiaries. This makes it an effective strategy for transferring appreciating assets if you have already utilized all or a portion of your lifetime gift tax exemption and are making, or plan on making gifts to charity.

Intra-Family Loans

Intra-family loans offer an additional way to transfer future appreciation on assets without triggering gift taxes. With this strategy, you loan money to another family member, typically an adult child or grandchild, enabling him/her to purchase assets. The borrower agrees in writing to repay the principal plus interest at a rate equal to the IRS mandated rate in effect when the loan is made — a rate that is typically lower than the rates on commercial loans.

Because you are loaning and not gifting the money, a properly structured intra-family loan is not subject to gift tax, and any appreciation on assets purchased with the loan remains outside of your estate for estate tax purposes. You might also have the ability to reduce overall family income tax, since any income produced by the assets purchased with the loan proceeds will be taxable to the borrower — typically a child or grandchild, who may be in a lower income tax bracket than you are. However, you must include the interest payments you receive in your taxable income, so this is a benefit only to the extent that the income produced by the assets is greater than the interest paid.

Some families find intra-family loans an effective way to encourage younger family members to become actively engaged in and learn about investing. An intra-family loan allows the borrower to retain any income generated in excess of the loan rate, giving them incentive to become more knowledgeable about markets and skilled in their investment selections.

Example

Alex, age 72, is interested in encouraging his 21-year-old granddaughter to take a more active interest in investing. He loans Sarah $500,000 in exchange for a Note that requires her to pay interest at the 3.0% annual rate established by the IRS and repay the principal at the end of the 5-year term. If Sarah’s investments appreciate 7.5% annually, she will have $130,689 left after making the interest and principal payments on the Note. Alex will have to recognize the annual interest payments as income and Sarah will have to recognize any annual income from the portfolio in excess of the annual interest payment.

Private Annuities

Private annuities offer another potential way to transfer assets without gift tax consequences. Assets are sold in exchange for a private annuity — a promise to make periodic payments for the remainder of the seller’s life. As long as the present value of the expected annuity payments under IRS valuation tables equals the fair market value of the assets, the transaction is free of federal gift tax consequences. This enables the seller to remove the assets, together with any subsequent appreciation on them, from his or her taxable estate. The amount actually paid depends on the length of time the seller lives.

Example

Edna is a 65-year-old widow with an actuarial life expectancy of 19.5 years. Due to some recent significant health concerns, Edna does not expect to live to the age of 85. With that in mind, she decides to transfer $1,000,000 worth of securities to her daughter, Melissa. In exchange for the securities, Melissa agrees to pay Edna an annuity of $77,259 per year, representing the fair market value of the shares calculated using an assumed IRS mandated interest rate of 3.0%.

Eight years later, Edna dies. Assuming that the securities have an average annual return of 7.5%, and that Melissa paid the annuity (a total of $618,072) from other assets, at the end of the eight years, the shares owned by Melissa will be worth $1,783,478. As for the transfer tax consequences, the transfer is free of both federal gift and estate tax.

With a private annuity, the seller recognizes a gain on the sale of the property. As a result, it may be advantageous to sell securities that have a cost basis close to the current market value. By selling the asset to a grantor trust, the seller may be able to avoid recognition of a gain on the sale. Each year for income tax purposes, the seller must also recognize the portion of the annual payment that is not allocated to the gain on the sale or to return of basis. However, the purchaser is not able to deduct the corresponding amount as implied interest. Because the present value of the annuity payments is higher when the IRS mandated rate is low, the economic benefits of a private annuity are typically more attractive when interest rates are low.

Summary

Although the $5.49 million federal gift and GST tax exemptions provide an opportunity for many individuals to eliminate most if not all of their potential estate tax liability, individuals with larger taxable estates may find some of these more advanced wealth transfer techniques useful in minimizing gift and estate taxes. The interest rate sensitivity of many of these strategies, combined with the current tax environment make it especially advantageous to consider these strategies now, while interest rates are low.

Choosing an appropriate strategy, however, depends on your individual needs and goals as well as the nature of the assets you may wish to transfer. Your private wealth advisor, along with an experienced wealth strategist from our Wealth Structuring Group, would be pleased to meet with you, your attorney and other advisors to help assess the various alternatives and discuss how they may benefit you, your family and future generations.

If a trust is decided upon, your private wealth advisor and wealth structuring specialist will introduce experienced trust professionals from U.S. Trust.⁴ As one of the nation’s leading trust organizations, U.S. Trust brings deep fiduciary knowledge as well as experience managing a wide range of sophisticated trusts. Your team of Merrill Lynch and U.S. Trust® professionals will work with you and your tax and legal advisors from concept through implementation.