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Low interest rates create golden estate planning opportunity
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The recent dip in interest rates has created a golden opportunity to save taxes while giving income-producing assets to your heirs.
You can do this with a “grantor retained annuity trust,” or GRAT. It allows you to continue receiving income from the property for a number of years, and you can then give it to your heirs while dramatically reducing your estate and gift tax.
The amount of taxes you can save is determined by a federal interest rate, known as the “7520 rate.” The lower the rate, the more you can save. And that rate is at one of the lowest points it’s been in many years.
The donor of a GRAT creates a trust and funds it with income-producing assets. The donor then keeps the right to receive a certain amount of income from the trust each year. Generally, the donor gets the same amount each year, but the amount can vary within certain limits.
When the trust expires, the assets go to the beneficiaries of your choice.
Why is this good? Well, let’s say you put $1 million worth of assets into a 10-year GRAT, and at the end of that time the value of the assets has increased to $2 million. If you simply kept the property for 10 years and then gave it to your heirs, you’d be subject to gift tax based on the $2 million. But if you put the assets into a GRAT now, your gift tax is based on the present value, or $1 million.
But even better, that $1 million is further reduced by the present value of the income stream you’ll receive over the 10 years.
And here’s where the 7520 rate comes into play. This is the interest rate the Internal Revenue Service uses to calculate the present value of your income stream. A lower rate is better, because lower rates mean a lower valuation of your total gift for tax purposes.
A variation on the GRAT is a “grantor retained unitrust,” or GRUT. This is the same thing, except that instead of the donor receiving a fixed amount of income each year, the donor instead receives a fixed percentage of the current value of the assets.
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There’s one large drawback to GRATs and GRUTs: If the donor dies before the term of the trust expires, then the trust assets are added back into the donor’ estate, and the tax advantages are lost.
For this reason, choosing the term of the trust requires some thought. The longer the term, the greater the tax savings, but the greater the risk that the donor will pass away and the savings will be lost.
There are several ways to hedge against this risk. One is with “layered GRATs.” For instance, instead of setting up a single 10-year GRAT, a donor could put 10 percent of the assets into a one-year GRAT, 10 percent into a two-year GRAT, and so on until there are 10 GRATs. Then, if the donor died after the fifth year, the family would still get the half the tax benefits of the 10-year GRAT – and the donor could lock in today’s low 7520 rate for all the GRATs.
Another option is “cascading GRATs.” The idea here is that you create a short-term GRAT of two or three years (thus reducing the risk of the donor passing away), and use the annuity payments to create additional short-term GRATs. You would then use the annuities from those GRATs to create further GRATs, and so on.
The advantage is that as the donor ages or becomes ill, he or she can stop creating the GRATs, thus reducing the risk of losing the tax savings. This method will not lock in the current low 7520 rate for all future GRATs, but in some cases it can be the best approach.
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Children who inherit a 401(k) can roll it over into a Roth IRA
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The IRS has given families a little more flexibility in handling 401(k) and pension plans.
According to an IRS announcement, children who inherit a 401(k) or pension plan can now roll it over directly into a Roth IRA.
Before, a spouse who inherited a 401(k) or pension plan could roll it over into a Roth IRA, but this was not true for a beneficiary other than a spouse, such as a child. But now it’s true for any beneficiary.
(In the past, a non-spouse beneficiary could roll over an inherited 401(k) or pension plan into a regular IRA, but not a Roth IRA.)
What this means is that if parents want to leave money in a 401(k) or pension
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plan, rather than rolling it over into an IRA, they can do so without depriving their heirs of the ability to eventually have the money in a Roth IRA.
There are several reasons why a parent might want to leave money in a 401(k) or pension. For example, in some states, assets in a 401(k) or pension are more protected from creditors than assets in an IRA, so doctors or other individuals with significant liability concerns might prefer such an arrangement.
Also, in some states pension payments will not “count” against a person when determining Medicaid eligibility, but distributions from a Roth IRA will.
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Loan to family business could trigger higher estate tax
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From 1997 to 2003, a family could take an estate tax deduction of up to $675,000 if more than half of the estate property consisted of interests in a family business. This law is scheduled to go back into effect in 2011, so it’s wise to be aware of it.
In particular, you should be aware that certain business decisions you make now – such as making personal loans to your company as opposed to capital contributions – could determine whether your heirs can claim the deduction.
A recent case involved the Farnam family, who owned a chain of auto-parts stores in Minnesota, North Dakota and South Dakota. To help grow the company, the family members made a number of loans to the business.
When the founder, Duane Farnam, died, he owned stock in the company, and he also owned notes representing loans he had made to the business. A dispute arose with the IRS over whether the notes were an “interest” in the business.
The reason? If the notes were an interest in the business, then combined with the stock, Farnam’s interest in the business was more than half of his estate, and his heirs could claim the $675,000 deduction. But if they weren’t, then Farnam’s interest in the business was less than half of the estate, and the deduction would be lost.
The U.S. Tax Court sided with the IRS. It said the loans were not an “interest” since they didn’t represent a form of
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ownership or equity in the company. They just represented an obligation to pay.
This is a sad result, since the purpose of the law was to reduce the pressure to sell a family business to pay estate taxes when the founder dies. The Tax Court’s decision makes it more likely that families like the Farnams will have to sell the business they spent their lives creating just to pay off Uncle Sam.
The IRS, by the way, argued that families like the Farnams wouldn’t necessarily have to sell an equity interest in the business. They might be able to pay their tax debt simply by selling the notes.
But that assumes that someone would be willing to buy the notes at a reasonable price. And it also saddles the family with less friendly creditors who are more interested in getting paid than in the long-term welfare of the company.
The bottom line, though, is that if you have a family business, it’s not always possible to separate business decisions from estate-planning decisions. We can help advise you about the implications of your business planning for your estate planning.
Of course, the tax tail shouldn’t wag the business dog, but we can keep you informed of the full effect of your choices, and in some cases we may be able to suggest alternative ways to achieve business results that have better tax consequences for your family.
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Do you want your trust to benefit your heirs’ surviving spouses?
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An heir to the Johnson & Johnson fortune created a trust to benefit four children. The trust was set up so that it would provide money to charity for a period of years, then be distributed to the four children and their spouses.
By the time the distribution came around, one of the children (named Mary) had died. Her third husband, Martin, who was married to her when she died, claimed that he was a “spouse” who was entitled to collect from the trust.
The other children objected, saying that since Mary was dead at the time of the distribution, Martin didn’t qualify as a “spouse.”
The case went to the New Jersey
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Supreme Court, which determined that, in this case, the word “spouse” included a surviving spouse.
This is another good example of why it’s important to be as clear as possible in drafting trust documents.
Many people wonder about all the “legalese” in those documents, when it seems to them that what they intend is obvious. But once a person has passed away, what they wanted isn’t necessarily so obvious, and they can no longer be consulted. So it’s best for the document to be as clear and detailed as possible, to avoid misunderstandings – and lawsuits.
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‘Family LLC’ saves a family $14 million
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A family-owned limited liability company saved a family $14 million in taxes, in the latest ruling from the U.S. Tax Court on this technique.
With a family LLC, parents create a company and fund it with valuable assets. Then they give their children ownership interests in the LLC. Giving these interests triggers less gift tax than giving the underlying assets, because they are “worth” less on the open market. That’s because outside investors would be reluctant to buy a share of a family business that they couldn’t control.
The basic concept is the same for both a family LLC and a family limited partnership, or FLP. The technique works, but only if there’s a genuine business purpose behind the LLC or FLP and it doesn’t exist simply to reduce taxes. Also, the LLC or FLP has to operate as a “real” business. If the parents continue to control all the assets and treat them like they still own them personally, the IRS will be able to claim that the arrangement is a sham.
The recent case involved the widow of the inventor of the heart defibrillator implant. At age 80, she created an LLC and transferred significant assets to it. Some assets were also contributed by three trusts that had previously been established to benefit her three daughters.
Four days before she died unexpectedly, the widow gave a 16 percent interest in the LLC to each of the three daughters’ trusts.
The IRS claimed this was a sham
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transaction that was simply intended to avoid taxes.
But the Tax Court said there were legitimate purposes behind the LLC, including the ability to jointly manage the family’s assets and the desire to pool assets to maximize investment opportunities.
In this case, it helped that the daughters’ trusts had contributed assets initially, because it showed a genuine “pooling” of assets. It also helped that the widow had a long and documented history of urging the daughters to work together to manage investments.
Family LLCs and FLPs can be a great idea, and in the right case they can save a fortune in taxes. But they’re tricky, and they require a commitment to keeping up all the formalities of a business. We’d be happy to discuss whether this is a technique that would work for you.
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This newsletter is designed to keep you up-to-date with changes in the law. For help with these or any other legal issues, please call our firm today.
The information in this newsletter is intended solely for your information. It does not constitute legal advice, and it should not be relied on without a discussion of your specific situation with an attorney.
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