Originally published October 20, 2010
Keywords: estate planning, gift tax, generation-skipping transfer tax, GST, Grantor trusts, GRAT, annuity
Many have referred to this period as a "perfect storm" for estate planning. That is due to the generally low value of many assets, low interest rates, the historically low gift tax rate and the repeal of the generation-skipping transfer tax (GST). There is some uncertainty as to the possibility of retroactive changes to the transfer tax laws, but at this writing retroactive changes—or indeed any changes that might be effective before the end of 2010—appear unlikely. The estate planning techniques described below are based on current tax laws, which are subject to change at any time.
Substantial Gifts to Children and Grandchildren. You should consider making large gifts to children and grandchildren, even if that may mean paying a gift tax. Currently, the gift tax rate is at an all-time low of 35 percent. In addition, if you make a gift directly to a grandchild this year, that gift will not be subject to the additional GST tax, which is repealed for 2010 only. In the past, that tax has been imposed at a rate of 45 percent to 55 percent and is scheduled to be 55 percent in 2011. Generally, any gifts you make now (plus all the appreciation) will be out of your estate at your death and not subject to the estate tax (also scheduled to be 55 percent starting in 2011).
GRATs. A grantor retained annuity trust (GRAT) would enable you to make a gift to your children without incurring gift taxes or using your gift tax exemption. With a GRAT, you would transfer assets you expect to appreciate to a trust which would pay you an annuity for a term of years. The annuity is calculated so that the present value of the annuity is equal to the value of assets you transfer to the GRAT. If you are living at the end of the term of years, the assets pass to your children (or to trusts for them) without any gift taxes. Essentially, you have transferred the appreciation on the assets to your children with no gift tax. For example, assume you transfer an asset with a value of $1 million to a four-year GRAT and retain the right to receive back an annuity of about $250,000 per year for four years. If that $1 million asset has appreciated at a rate of 10 percent per year, your children would receive approximately $265,000 at the end of the four-year period. This would be the result even though you had not paid any gift taxes or used any of your gift tax exemption.
Sales to Grantor Trusts. Another very effective technique is to establish a grantor trust for the benefit of your descendants, which means that you are responsible for paying the income taxes on the income earned by the trust assets. This enables the trust assets to grow income tax-free for the benefit of your children and grandchildren. Also, the grantor trust status allows you to sell assets to the trust without having any income tax effects. Typically, the assets are sold in exchange for a promissory note that bears a very low rate of interest as announced monthly by the IRS, with the assumption that the trust assets will grow at a higher rate. Another example might help. Assume you sell an asset with a value of $1 million to a grantor trust in exchange for a nine-year promissory note bearing an interest rate of 1.75 percent. If that $1 million asset has appreciated at a rate of 10 percent per year for those nine years, after you are paid back the interest and principal on the note, the grantor trust for the benefit of your children and grandchildren would hold assets with a value of approximately $1 million at the end of the nine-year period. Again, this would be the result even though you had not paid any gift taxes or used any of your gift tax exemption.
Valuation. Any transfer by you to your children, grandchildren, to GRATs or to grantor trusts will be enhanced if the transfer is of assets to which a valuation discount could be applied, such as closely-held stock or other non-marketable or restricted assets. Many families choose to establish limited partnerships to pool their investment assets and typically those partnership interests can be discounted. For example, if you make a gift of a 10 percent interest in a limited partnership that has an aggregate value of $10 million, then the value of your gift for gift tax purposes should not be $1 million but more likely will be in the range of $650,000 to $750,000.
2010 is an optimum time to make these kinds of transfers. That is because of the perfect storm referenced earlier: generally low values for many asset classes, low interest rates and the low gift tax rate. Further, the tax laws are uncertain, and there may be more legislative changes before the end of 2010. There have been proposals to bring back 2009 estate, gift and generation-skipping laws, and there has been legislation proposed that would prohibit tax-free GRATs as well as eliminate discounting for intra-family transfers.
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