With a push by the Democratic party, and Democratic Presidential Nominee Joe Biden, to return federal estate taxes to their “historic norms”, taxpayers need to act now before Congress passes legislation that could adversely impact their estates. The historic norms referred to by Joe Biden could mean that the federal estate tax might be lowered down to $3.5 million per taxpayer. Currently, the federal estate and gift tax exemption is set at $11.58 million per taxpayer and is set to increase in 2021 up to $11.7 million per taxpayer. Assets included in a decedent’s estate that exceed the decedent’s remaining exemption available at death ($11.58 million currently) are taxed at a federal rate of 40 percent (with some states, like Minnesota adding an additional state estate tax). Note that Minnesota adds an estate tax of 13-16% on amounts over $3.0 million per taxpayer. However, under current law each asset included in the decedent’s estate receives an income tax basis adjustment so that the asset’s basis equals its fair market value on the date of the decedent’s death. Thus, beneficiaries realize capital gain upon the subsequent sale of an asset only to the extent of the asset’s appreciation since the decedent’s death.
If the election results in a political party change, it might mean not only lower estate and gift tax exemption amounts, but also the end of the longtime taxpayer benefit of stepped-up basis at death. To avoid the negative impact of these potential changes, there are a few wealth transfer strategies it would be prudent to consider before the year-end.
Intrafamily Notes and Sales
In response to the COVID-19/Coronavirus Pandemic, the Federal Reserve lowered the federal interest rates in order to stimulate the economy. As such, wealthy individuals should consider loaning funds or selling one or more income-producing assets, such as an interest in a family business or a rental property, to a family member in exchange for a promissory note that charges interest at the applicable federal rate (the minimum interest required by the government for a transfer to not be considered a gift). In this way, an individual can provide a financial resource to a family member on more flexible terms than a commercial loan. If the investment of the loaned funds or income resulting from the sold assets produces a return greater than the applicable interest rate (e.g. the loaned funds or assets produce 5% of interest and the applicable federal rate is 1.12%), the donor effectively transfers wealth (3.88% in the example just mentioned) to the family members without using the donor’s estate or gift tax exemption.
Swapping Assets to Manage Tax Basis
Assets such as property or financial accounts gifted or transferred to an irrevocable trust do not receive a step-up in income tax basis at the donor’s death. Assets that are gifted instead retain the donor’s basis (referred to as a “carryover basis”), potentially resulting in significant capital gains realization upon the subsequent sale of any appreciated assets. Exercising the trustee’s power to swap assets allows the grantor (the person who donated the assets to the irrevocable trust) to exchange one or more low-basis assets in an existing irrevocable trust for one or more high-basis assets currently owned by and includible in the donor’s estate for estate tax purposes. By doing this, low-basis assets are positioned to receive a basis adjustment upon the grantor’s death, and the capital gains realized upon the sale of any high-basis assets, whether by the trustee of the irrevocable trust or any trust beneficiary who received an asset-in-kind, may be reduced or eliminated.
Illustration: Mike purchased real estate in 2003 for $1 million and gifted the property to his irrevocable trust in 2013 when the property had a fair market value of $5 million. Mike dies in 2020, and the property has a date-of-death value of $11 million. If the trust sells the property soon after Mike’s death for $13 million, the trust would be required to pay capital gains tax (approximately 20%) on $12 million, the difference between the sale price and the purchase price. Let’s say that before Mike died, he utilized the power in his irrevocable trust to swap assets and he exchanged the real estate in the irrevocable trust for stocks and cash having a value equivalent to the fair market value of the real estate on the date of the swap. At Mike’s death, because the property is part of his gross estate, the property receives an adjusted basis of $11 million. If his estate or beneficiaries sell the property for $13 million, they will only pay capital gains tax on $2 million, the difference between the adjusted date-of-death basis and the sale price. Under this scenario, Mike’s estate and beneficiaries avoid paying capital gains tax on $10 million by taking advantage of the power to swap assets.
Grantor Retained Annuity Trusts (GRATs)
Grantor retained annuity trusts (GRATs) are an efficient way for a person to transfer asset appreciation to beneficiaries without using, or using a minimal amount, of the grantor’s gift tax exemption. After the grantor transfers property to the GRAT, and until the expiration of the initial GRAT term, the trustee of the GRAT (often the grantor for the initial term) will pay the grantor an annual annuity amount. The annuity amount is calculated using the applicable federal rate (AFR) as a specified percentage of the initial fair market value of the property transferred to the GRAT. A “zeroed-out GRAT” is intended to result in a remainder interest (the interest that is considered a gift) valued at zero or as close to zero as possible. The grantor’s retained interest terminates after the initial term, and any appreciation on the assets in excess of the annuity amounts passes to the beneficiaries with no gift or estate tax consequences. In other words, if the transferred assets appreciate at a rate greater than the historically low AFR, the GRAT will have succeeded in transferring wealth.
Illustration: Mark creates a GRAT with a three-year term when the applicable federal rate is 0.8 percent. He funds the trust with $1 million and receives annuity payments of $279,400 at the end of the first year, $335,280 at the end of the second year, and $402,336 at the end of the third year. Assume that during the three-year term, the GRAT invested the $1 million and realized a return on investment of 5 percent, or approximately $95,000. Over the term of the GRAT, Mark received a total of $1,017,016 in principal and interest payments and also transferred approximately $95,000 to his beneficiaries with minimal or no impact on his gift tax exemption.
Installment Sales of Income Producing Assets to an Irrevocable Trust
This strategy is similar to an intrafamily sale. However, the income-producing assets are sold to an existing irrevocable trust instead of directly to a family member. In addition to selling the assets, the donor also seeds the irrevocable trust with assets worth at least 10 percent of the assets being sold to the trust. The seed money is used to demonstrate to the Internal Revenue Service (IRS) that the trust has assets of its own and that the installment sale is a bona fide sale. Without the seed money, the IRS could recharacterize the transaction as a transfer of the assets with a retained interest instead of a bona fide sale, which would result in the very negative outcome of the entire interest in the assets being includible in the donor’s taxable estate. This strategy not only allows donors to pass appreciation to their beneficiaries with limited estate and gift tax implications, but also gives donors the opportunity to maximize their remaining gift and generation-skipping transfer tax exemptions if the assets sold to the trust warrant a valuation discount.
Example: Lisa owns 100 percent of a family business worth $100 million. She gifts $80,000 to her irrevocable trust as seed money. The trustee of the irrevocable trust purchases a $1 million dollar interest in the family business from Lisa for $800,000 in return for an installment note with interest calculated using the applicable federal rate. It can be argued that the trustee paid $800,000 for a $1 million interest because the interest is a minority interest in a family business and therefore only worth $800,000. A discount is justified because a minority interest does not give the owner much, if any, control over the family business, and a prudent investor would not pay full price for the minority interest. Under this scenario, Lisa has removed $200,000, and any growth on the $1 million dollar interest, from her taxable gross estate while only using $80,000 of her federal estate and gift tax exemption.
Spousal Lifetime Access Trusts (SLATs)
With the threat of a lowered estate and gift tax exemption amount, a spousal lifetime access trust (SLAT) allows individuals to lock in the current, historic high exemption amounts to avoid adverse estate tax consequences at death. The grantor transfers/gifts an amount up to the grantor’s available gift tax exemption (currently up to $11.58 million) into the SLAT. Because the gift tax exemption is used, the value of the assets in the SLAT is excluded from the gross estates of both the grantor and grantor’s spouse. An independent trustee administers the SLAT for the benefit of the grantor’s beneficiaries. In addition to the grantor’s spouse, the beneficiaries can be any person or entity including children, friends, family members, or charities. The grantor’s spouse may also execute a similar (but not identical—due to the reciprocal trust doctrine) SLAT for the grantor’s benefit. The SLAT allows the appreciation of the assets to avoid federal estate tax and, in most cases, the assets held in the SLAT are generally protected from creditor claims. Because the SLAT provides protection against both federal estate tax and claims of creditors, it is a powerful tool that can be used to transfer wealth to multiple generations of beneficiaries.
Illustration: Michelle and Steve are married, and they are concerned about a potential decrease in the estate and gift tax exemption amount in the upcoming years. As such, Michelle executes a SLAT and funds it with $11.58 million in assets. Michelle’s SLAT names Steve and their three children as beneficiaries and designates their friend Dirk as a trustee. Steve creates and funds a similar (but not identical) trust with $11.58 million that names Michelle, their three children, and his nephew as beneficiaries and designates Nice Community Bank as a corporate trustee (among other differences between the trust structures). Michelle and Steve both die in the same year when the estate and gift tax exemption is only $6.58 million per person. Even though they have gifted more than the $6.58 million exemption in place at their deaths, the IRS has indicated that it will not punish taxpayers with a “clawback” provision that pulls transferred assets back into the taxpayer’s taxable estate. As a result, Michelle and Steve have saved a total of $4 million in estate taxes assuming a 40 percent estate tax rate at the time of their deaths.
To download a one page chart showing a summary of all of the above strategies, please click here.
Consult with an Experienced Minnesota Estate Planning Attorney
If you are concerned that the upcoming election will negatively impact your estate, or the legacy you wish to leave for your family, we encourage you to schedule a meeting with us as soon as you are able since some of the strategies outlined above may not be as impactful (and might not be available) if there are any changes in Washington this November. By scheduling a free consultation, we can review your estate plan and recommend changes and improvements to protect you from potential future changes in legislation. Call our office today at (952) 658-6503 or click here to send us a message to schedule a free initial consultation.
Zach Wiegand is a Minnesota probate attorney and estate planning attorney and the owner of Gold Leaf Estate Planning, LLC. Gold Leaf Estate Planning is an estate planning law firm that also handles probate and trust administration in Minnesota. We serve the Twin Cities metropolitan area with a focus on estate planning for clients in Burnsville, Eagan, Savage, Prior Lake, Lakeville, Apple Valley, Eden Prairie, Farmington, Rosemount, and the South Metro as well as clients in Woodbury, Lake Elmo, Maplewood, Oakdale, St. Paul and the East Metro. Our firm has offices in both Burnsville and Woodbury (Lake Elmo). The firm also handles probate in Dakota County, Washington County, Scott County, Hennepin County, and Ramsey County and most other counties in the Twin Cities Metro area. Zach has been named a Super Lawyer – Rising Star for 2017, 2018, 2019 and 2020. In addition, Zach is a member of the Society of Financial Service Professionals, the Twin Cities Estate Planning Council, and WealthCounsel – a national organization of estate planning attorneys dedicated to practice excellence. You can contact Zach via e-mail at firstname.lastname@example.org or by calling (952) 658-6503. Gold Leaf Estate Planning is located in Burnsville at 3000 County Road 42 W., Suite 310, Burnsville, MN 55337 and in Woodbury/Lake Elmo at 8653 Eagle Point Boulevard, Lake Elmo, MN 55042.