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Archive for April, 2009

This is the Perfect Storm of Estate Planning – Get Prepared!

Thursday, April 16th, 2009

This year, we are in the midst of a “perfect storm” that creates exceptional planning opportunities we are not likely to see again for many years, if ever.  The factors that have come together to create this perfect storm are certainty as to the federal estate tax, significantly reduced asset values, and historically low interest rates.

Take Advantage of Federal Estate Tax Certainty

The prospect for a repeal of the federal estate tax in the foreseeable future is essentially zero and, in South Carolina, there is no state estate tax this year.  Nobody knows whether the Congress and President will agree to a new federal exemption amount or, if they do, what it will be—especially in light of federal spending in the past few months. (Note, however, that if government spending leads to greatly increased inflation, many more individuals will face having taxable estates.)

Because of the virtual certainty that we will continue to have an estate tax, many of us must plan if we wish to avoid paying it.  As the U.S. Supreme Court has said: “Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.  Therefore, if what was done here was what was intended by [the statute], it is of no consequence that it was all an elaborate scheme to get rid of [estate] taxes, as it certainly was.”

Reduced Asset Values Favor Transfer of Wealth

Reduced values for stocks, real estate, and businesses mean that clients can transfer these assets for less today than they could have just a few months ago. For example, if a particular stock declined from $100 per share to $80, now we can transfer 25% more within the $13,000 annual gift tax exclusion (up from $12,000 as of January 1, 2009). In other words, we can now transfer 162.5 shares instead of 130 shares.  Married couples can give twice that amount, or $26,000 per beneficiary, per year (up from $24,000 as of January 1, 2009).  Typically, individuals transfer this amount to children, grandchildren and other close family members.  In addition, reduced real estate and business values mean that we can transfer a larger percentage of these assets now without incurring gift or estate tax by using our $1 million lifetime gift tax exemption.

At the same time, we now have clarity in the law as to the use of the family limited partnership (“FLP”) and family limited liability company (“FLLC”) for asset protection and other purposes. This is a “perfect storm” factor because we can substantially increase the amount of assets we transfer using our annual exclusions and lifetime exemptions by wrapping the assets in an FLP or FLLC and then giving away interests in the FLP or FLLC.  If you are interested in this type of planning, please contact us to discuss it further.

Interest Rates Are At Historic Lows

The March 2009 Applicable Federal Rates (AFRs)—the “safe harbor” interest rates provided by the government for, among other things, intra-family loans—are:

Short-term (not over 3 years) = 0.72%

Mid-term (over 3 but not over 9 years) = 1.94%

Long-term (over 9 years) = 3.52%

These low interest rates make the strategies discussed below even more attractive, particularly if we can transfer interests in an FLP or FLLC that holds depressed value assets.

With these rates, individuals can enter into loans with family members at historically low interest rates (for example, to help start a business, or buy a first or larger home).  Depending upon the amount of the loan and the goals at hand, it may be possible to structure the loan so that annual interest falls within the $13,000 annual gift tax exclusion.  Doing so allows the donor to forgive interest (the beneficiary receives an interest-free loan) such that the donor transfers property to the beneficiary without incurring gift or estate tax.

Over the past 100 years, a U.S. bull market has always followed a bear market.  Selling depressed assets to a trust for a child or grandchild in return for a long-term installment note at today’s historically low interest rates can be an effective way to “freeze” the current asset values in your estate and have the recovery in asset value that comes in the bull market escape exposure to estate taxation for at least a full generation.

How does the trust obtain the ability to purchase the assets?  One common way is by making a gift to the trust followed by the trust purchasing the assets using an interest-bearing promissory note (with terms similar to a financing transaction with a third-party lender) at or above the minimum interest rate established by the IRS: the current AFR.  We are glad to assist the family in making these transactions.

Grantor Trusts

A “grantor” trust contains certain provisions defined by the Internal Revenue Code.  Interestingly, what makes a trust a grantor trust for income taxes is defined by one part of the Internal Revenue Code and what makes a trust a grantor trust for gift and estate taxes is defined by an entirely separate part of the Internal Revenue Code—and the rules don’t match.  Therefore, with careful design, an irrevocable trust can be made to be a grantor trust for income tax purposes yet not be a grantor trust for gift and estate tax purposes. By using this long-standing wrinkle in the Internal Revenue Code, the strategies for transfers of assets by gifts and sales to trusts discussed above can all be virtually “supercharged.”  Making the recipient trust a grantor trust for income tax purposes but not for estate tax purposes produces tax-free compounding of income in the trust and estate depletion for the donor through his paying taxes on that same income.  And paying those taxes is not an additional gift to the trust.

When Is A Sale Not A Sale?

Under the Internal Revenue Code, when an individual sells an asset she must pay income tax on the amount above her “basis” in the property.  In its most simplified sense, basis is the amount the individual paid for an asset when he purchased it; or if she received it by gift, it is her donor’s basis in the property.  A typical sale of appreciated property thus causes imposition of income tax.

However, the IRS treats a grantor trust for income tax purposes as being a mere extension of the donor.  And since one cannot “sell” property to oneself, the IRS ignores (for income tax purposes) a sale to such a grantor trust.  The donor simply continues to report all items of income, realized gain or loss and deduction from income associated with the assets of the grantor trust on his or her individual income tax return.

Grantor Retained Annuity Trusts

Another strategy aided by low interest rates is the Grantor Retained Annuity Trust (“GRAT”). GRATs are a type of irrevocable trust specifically authorized by the IRS regulations interpreting the Internal Revenue Code. They permit you to make a lifetime gift of assets to an irrevocable trust in exchange for a fixed payment stream for a specified term of years.  At the end of the term of years, after making the final payment to the donor, the balance of the GRAT property, if any (the “remainder interest”), transfers to the beneficiaries of your choice—typically children or grandchildren. The IRS published interest rates at the time of the transfer determine the gift for federal gift tax purposes. This “Section 7520 rate” is 120% of the mid-term AFR (2.4% for GRATs established in March 2009). Critically, this rate does not take into consideration any future appreciation in the value of the property, and therefore the trust maker can reduce the value of the gift to as low as zero.

During the term of years the GRAT must pay the donor a set amount at set intervals, which can be no less frequently than annually. The term of years and the amount of the payments are fixed at the time the trust maker establishes the GRAT. During the term of years of the GRAT, the donor can be the GRAT’s sole trustee or a co-trustee with complete control over all decisions of the GRAT and the assets in the GRAT. Alternatively, the GRAT can appoint a financial advisor to manage GRAT assets.

A GRAT is a “heads you win, tails you tie.” win for everyone.   If the performance of the assets in the GRAT exceeds the 7520 rate, the excess value is transferred without estate or gift tax. If the performance of the assets in the GRAT equals or falls below the 7520 rate, the donor gets all the GRAT assets back.

Despite these difficult economic times, there are many reasons why we should plan now rather than wait until we have more economic certainty. Furthermore, for those who may be subject to federal or state estate tax, a “perfect storm” creates a once-in-a-lifetime opportunity to accomplish unique planning goals and objectives.  Please contact us so that we can assist you during this opportunity.

Taxpayer Certainty and Relief Act of 2009 – Estate tax bill proposed

Friday, April 3rd, 2009

This just in:

Sen. Max Baucus has introduced a bill in the Senate that would make the 2009 estate tax level permanent and reunify the estate and gift taxes. As you might remember, under current law, the top rate for all three taxes is 45%, and the exemption is $3.5 million for individuals. In 2010, the current law would eliminate the estate tax and the generation-skipping transfer and cut the gift tax rate to 35%, but, in 2011, the estate, generation-skipping transfer, and gift taxes are scheduled to return to pre-2001 levels, with an exemption of $1 million, a 55% top rate, and a 5% surtax on large estates.

In addition to making the 2009 estate tax level of $3.5 million permanent, the new bill, the Taxpayer Certainty and Relief Act of 2009, would allow portability of the exemption for spouses, eliminating the need to segregate assets of a spouse at the first death into a Credit Shelter or Bypass Trust in order to use both spouses exemptions.  It has been said that we can expect a bill to pass by August of this year. 

Another provision would increase the amount available under the special use valuation revaluation to equal the estate tax exemption.

Other provisions in the Baucus bill deal with ordinary income taxes. Under current law, ordinary income tax rates are imposed at 10%, 15%, 25%, 28%, 33% and 35%. These tax rates expire at the end of 2010. The Baucus bill would make permanent the 10%, 25% and 28% tax rates. The 15% tax rate is already permanent law.  It would also make permanent the reduced tax rate on capital gains and dividends for taxpayers in the 10%, 15%, 25% and 28% brackets.  A 2003 tax bill created a new tax rate of 15% (5% for low-and middle-income taxpayers, going to 0% in 2008) for dividends.  Before the passage of the 2003 bill, dividends were taxed at ordinary income rates. The 2003 bill also reduced the capital gains tax rate from 20% (10% for low- and middle-income taxpayers) to 15% (5% for low- and middle-income taxpayers, going to 0% in 2008). These reduced tax rates originally were set to expire at the end of 2008, but they were extended until the end of 2010 in the Tax Increase Prevention and Reconciliation Act of 2005.

Other provisions in the bill deal with ordinary income taxes. Under current law, ordinary income tax rates are imposed at 10%, 15%, 25%, 28%, 33% and 35%. These tax rates expire at the end of 2010. The Baucus bill would make permanent the 10%, 25% and 28% tax rates.  The 15% tax rate is already permanent law. This bill would make permanent the reduced tax rate on capital gains and dividends for taxpayers in the 10%, 15%, 25% and 28% brackets.

As you might remember, a 2003 tax bill created a new tax rate of 15% (5% for low-and middle-income taxpayers, going to 0% in 2008) for dividends.   Before the passage of the 2003 bill, dividends were taxed at ordinary income rates. The 2003 bill also reduced the capital gains tax rate from 20% (10% for low- and middle-income taxpayers) to 15% (5% for low- and middle-income taxpayers, going to 0% in 2008). These reduced tax rates originally were set to expire at the end of 2008, but they were extended until the end of 2010 in the Tax Increase Prevention and Reconciliation Act of 2005.

Stay tuned to see what amendments the Republicans will propose and for the final passage.