Estate Planning in the Time of COVID-19 by Christopher Taarick, JD, LLM
The COVID-19 pandemic has disrupted life as we know it, threatening our physical and financial well-being, potentially for years to come. Just as social distancing and other safer-at-home measures have been implemented to help you protect your health, there are some estate planning strategies you should consider at this time to help you protect your wealth now and into the future.
Even before the COVID-19 crisis, the U.S. tax laws were ripe for tax-efficient estate planning and wealth transfer, thanks to the Tax Cuts and Jobs Act’s (TCJA) doubling of the federal lifetime gift and estate tax exemption in 2018. For 2020, individuals may transfer up to $11.58 million in assets to their heirs during life or at death without incurring federal estate or gift taxes. For married couples filing joint tax returns, the federal estate and gift tax exemption for 2020 is $23.6 million. However, individuals should keep in mind that the TCJA calls for the current exemption to sunset at the end of 2025 and revert to $5 million (indexed for inflation). Moreover, with 2020 being an election year, it is quite possible that a change in the presidential administration will likewise lead to a change in these very generous exemptions and impede any tax-efficient wealth transfer strategies in the future.
The Perfect Storm Emerges
The COVID-19 health crisis has roiled financial markets, causing the value of securities, real estate and business interests to decrease significantly at a time when interest rates are at historic lows. While economic conditions appear bleak, these declines in valuations and interest rates make now an ideal time for tax-efficient estate planning and cost-effective transfers of wealth to future generations.
Generally, you may remove assets from your taxable estate and use up some of your lifetime gift and estate tax exemptions by making outright gifts to family members or to an irrevocable trust for the benefit of your heirs. With depressed stock values, now is a great time to make gifts of low-value stock with high appreciation value, allowing you to use up less of your lifetime gift-tax exemptions and avoid any estate tax on future asset appreciation when you pass away.
Making intrafamily loans can be a simple, yet effective way of shifting wealth to family members. In response to the low-interest rates set by the Federal Reserve Bank, the IRS has reduced the Applicable Federal Rates (AFRs) of interest it allows taxpayers to charge related parties on loans without triggering gift tax consequences. The appropriate AFR depends on the length of the loan. For June 2020, the short-term AFR of 0.18 percent applies to loans shorter than three years, the mid-term AFR of 0.43 percent applies to loans between three and nine years, and the long-term AFR of 1.01 percent applies to loans longer than nine years. As long as the interest you charge is equal to or higher than the current AFR, the transaction will not be treated as a gift subject to gift tax.
Now is also a great time to consider refinancing existing intra-family loans. For example, if you made a $1 million loan to a son or daughter in June 2018, when the long-term AFR was 3.05 percent, your child would save $20,400 a year by refinancing the loan to the June 2020 AFR of 1.01 percent.
Grantor Retained Annuity Trust (GRAT)
A grantor retained annuity trust (GRAT) is an irrevocable trust in which the person funding the trust retains a right to receive over the life of the GRAT the value of his or her initial contribution via qualified annuity interest payments with a rate of return set by the IRS (commonly referred to as the hurdle rate or Section 7520 rate). When the terms of the annuity and GRAT expire, assets remaining in the trust, will pass to the grantor’s intended beneficiaries tax-free. The greater the appreciation of the assets, the greater the tax savings.
When you fund a GRAT with assets that have decreased in value, you remove those assets and their future appreciation from your taxable estate, allowing for greater leverage on estate freezes. Moreover, when transferring minority interests in undervalued businesses to a GRAT, you may be able to apply additional discounts for lack of marketability and lack of control. As the grantor, you may also escape gift tax exposure by approximating the value of the annuity payment to the value of the transferred property at the time of funding, which is referred to as “zeroing out” the GRAT. All appreciation of GRAT asset above the current depressed values and the hurdle rate (which is 0.6 percent for June 2020) will pass to your heirs free of gift taxes. However, if a grantor passes away before all annuity payments are made, the trust may be considered part of the grantor’s estate and subject to estate tax.
As an example of how a GRAT works, consider that in June 2020, Section 7520 rate is 0.6 percent, a grantor transfers $5 million to a zeroed-out GRAT for a fixed term of five years. The grantor retains the right to receive annual annuity payments of $1,018,081 during the five-year term, which is equal to the value of the assets contributed plus a 0.6 percent rate of return. The resulting nominal gift is less than $0.59. Assuming the GRAT earns an annual investment return of 10 percent, at the end of the five-year term, $1,837,063 will be distributed tax-free to the GRAT beneficiaries.
If you have an existing GRAT that decreased in value in the wake of the COVID-19 economic disruption, you may be able to “swap” those assets for cash that you may then use to fund a new GRAT that leverages low interest rates to yield higher future appreciation.
Intentionally Defective Grantor Trusts (IDGT)
An IDGT is an irrevocable trust with provisions that cause the grantor to be treated as the “owner” of the trust for income-tax purposes (i.e. “defective”) but removes the assets contributed to the trust from the grantor’s estate. The “defective” nature of the trust allows the grantor to pay the trust’s income-tax liabilities with non-trust assets, which is essentially an additional tax-free gift to the trust that can continue to grow outside the grantor’s estate for the benefit of trust beneficiaries.
A grantor may fund an IDGT either through outright gifts or an installment sale. While an outright gift of assets would use a portion of the grantor’s estate and gift tax exemption, a properly structured installment sale to an IDGT in exchange for a promissory note (with interest calculated based on the current AFR) would not be considered a gift and; therefore, not use any of the grantor’s estate and gift tax exemption. As long as the assets appreciate in excess of the AFR, the appreciation passes estate tax free to the trust beneficiaries.
Spousal Limited Access Trust (SLAT)
If you are married, you may take advantage of a spousal limited access trust (SLAT) that removes assets from your taxable estate, thereby reducing exposure to estate tax, but allows you to have access to those trust income and principal via distributions made to your spouse while the two of you are still alive.
Charitable Lead Annuity Trust (CLAT)
A charitable lead annuity trust (CLAT) is similar to a GRAT, except that annuity payments based on the IRS’s hurdle rate are made to a charity over a predetermined number of years rather than to the person funding the trust. The donor may receive charitable deductions each year annuity payments are paid to a charity. At the end of the trust’s terms, any remaining trust assets will pass to grantors’ heirs free of gift and estate taxes. CLATS work best in low-interest rate environments because any appreciation above the IRS’s hurdle rate will pass tax free to family members.
About the Author: Christopher Taarick, JD, LLM, is a senior manager of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where he helps private companies and high-net-worth families develop tax-efficient business and estate plans. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or email@example.com.