It’s said that every dark cloud has a silver lining, and even the COVID-19 pandemic has managed to engender one benefit.
Namely, the combination of plummeting interest rates with a volatile equity market has led to an unprecedented opportunity for transferring assets to the next generation tax free.
Prior to the pandemic, interest rates were already low. In addition, the 2017 Tax Cuts and Jobs Act (TCJA), which came into force in 2018, increased the estate tax exemption. In 2020, the exemption is $11.58 million for single individuals and $22.8 million for married couples, with annual indexation for inflation. However, the law extends only through 2025. With the federal estate tax rate of 40%, TCJA was a welcome piece of legislation for many wealthy Americans.
While the pandemic has driven interest rates about as far down as they can go, there is also the concern that a Democratic victory in the upcoming election could spell the end of the generous estate tax exemption. Moreover, the massive amount of pandemic-related stimulus spending by the government will create a significant deficit, increasing pressure to raise taxes. The confluence of these factors has led to significantly increased demand for estate planning services. Carl Waldman, a Westlake, California-based estate attorney, said that clients with significant net worth are extremely motivated to undertake planning right now, and his schedule is packed.
Waldman notes that against the backdrop of rock bottom interest rates, gyrating stock prices and economic uncertainty, there is also concern regarding how real estate and business valuations will be affected by the pandemic. He’s focusing on strategies that leverage these factors and reduce valuations on assets, fractionalizing ownership through various entities, for example a family-controlled LLC, and then selling or gifting interests in the entity to a trust, with the asset moved outside of the estate of the grantor.
One favored strategy for larger estates is the grantor retained annuity trust (GRAT), which makes it possible for clients to transfer wealth to heirs while retaining the current value of assets and paying sharply reduced gift and estate taxes. In order to take advantage of this estate planning technique, an individual, hereafter known as the Grantor, establishes an irrevocable trust (a trust that cannot be terminated by the grantor once it’s created) for a specified number of years. The Grantor transfers assets to this trust and receives an annuity payment at the end of each year that the trust exists.
The assets held in the GRAT (stock or other non-cash assets) may be used to make the annuity payment. This annuity payment can be level or graduated, but increases cannot exceed 120% of the prior years’ payment. The payment can be specified in dollar terms, or as a percentage of the assets held in trust. At the end of the trust term the assets remaining in the GRAT are passed on to the trust beneficiary free from tax liability.
When the GRAT is created, the Grantor is considered to be making a taxable gift to the beneficiary, and the Grantor pays the tax at that time. The value of this gift is calculated by subtracting the present value of the total annuity payments from the fair market value of the assets contributed to the GRAT. The present value of the annuity payments is calculated by using an interest rate provided by the Internal Revenue Service, the §7520 rate. As of today, May 15, 2020, the rate is at an all-time low of 0.80%, a drastic 73% reduction from three months ago. Interest rates are inversely proportional to present value, so as the rate falls the present value of the annuity rises. Maximizing the present value of the annuity can significantly reduce the taxable value of the gift, in some cases reducing it to zero.
However, for the trust to have transferable value, the total rate of return generated by the trust assets must be greater than the IRS designated interest rate used to value the annuity. Therefore, investment performance will drive the value of this estate planning technique.
You’ll recall that the trust is created for a certain period. If the Grantor dies before the trust period is up, the trust assets will revert to the Grantor’s taxable estate. However, the estate will not bear any additional tax liability. It will simply be as though the trust were never created.
You will also recall that the assets in the trust will be generating a return. The Grantor will be responsible for paying the income tax due on all income earned by the trust over the trust period – whether or not that income is distributed. For the GRAT to be an effective estate planning strategy, the trust assets must generate a total return that exceeds the IRS-designated return. The current rate of 0.8% is certainly not a high hurdle to clear. If the assets don’t generate an adequate return, there will not be sufficient appreciation on the trust assets to pass on to the beneficiary. If this is the case, the effort to create the GRAT will have been for naught.
Since none of us can predict the future, and sometimes things happen that we don’t count on. The Grantor who established the GRAT obviously expects to survive the trust period, but one should always prepare for the unexpected – the speeding bus, the global pandemic… Therefore, a smart move is to purchase life insurance to hedge against this risk. The policy should pay out the estimated tax liability or, better yet, the value of the asset(s) in trust. If the asset is increasing in value, it’s better to have more rather than less insurance. The incremental cost is not that great, considering the magnitude of the potential tax liability.
In today’s pandemic environment, many assets may be at low valuations. If undervalued assets are expected to appreciate significantly, the appreciation can be transferred on a tax-advantaged basis while the current value is retained for the individual who wishes to make a gift. Take advantage of the silver lining while you can.