Wednesday, May 14, 2014

Estate Planning: Mechanisms for Large Lifetime Non-Cash Gifts

Making lifetime taxable gifts is an invaluable estate planning strategy for a high net worth family. These strategies can range from utilizing the annual exclusion strategically to more complicated strategies involving GRATs, Intentionally Defective Grantor Trusts, installment sales, and plenty of other context-dependent alternatives. For a high net worth family, the advantages of these strategies will almost always outweigh the disadvantages because their cumulative net worths far exceed the unified credit amount and because losing the use of the cash that might be necessary in paying gift tax for a certain period of time will likely not have a meaningful effect on their financial condition. In the current market, the rate of return available for that cash is not so high as to make the loss of that liquidity a very important consideration. The other potential disadvantage to consider is the fact that testamentary gifts have a stepped-up income tax basis whereas lifetime gifts retain the donor's basis. For a high net worth family with responsible children, there would seem to be no foreseeable problems with regard to mismanagement of any lifetime gifts by their children or any problems with regard to dis-incentivizing their children to work because they are all for the most part successful, motivated, and responsible from the information that has been provided to us.

The best option for the X family to make gifts in one of the following manners. I provide a brief explanation of each option and the mechanics and advantages of each. The ideal option, though, is the intentionally defective grantor trust with the appropriate and optimal allocation of lifetime gift and GST exemption. This option is best because it will keep all future appreciation out of the estate, thereby saving a ton of money at death. It is even possible to fully fund the childrens’ inheritance during the parents' lifetime. The intentionally defective grantor trust is the best option because it has the best risk profile legally and economically speaking and allows the most flexibility and efficiency (especially in terms of GST planning).

a. GRAT -

A GRAT is an irrevocable trust to which a donor contributes assets (can be company stock, cash, or any number of other financial interests) but retains the right to receive an annuity for a specified term. The remainder of the trust property passes to the remainder beneficiaries chosen by the donor (in this, case, the children). As long as some very specific IRS (§2702) and Treasury regulations are strictly adhered to, the GRAT would let the parents transfer property (such as their Company stock) at a negligible gift tax cost because that gift tax cost is calculated by the FMV of the property transferred to the GRAT minus the present value of the retained annuity payment right. Structured properly, the trust instrument makes this amount is as close to zero as possible. A critical consideration here beyond the drafting of the instrument is how long of a term we choose for the parents'' GRAT; if the parents' don't survive the specified term, the result will not quite be punitive, but will return us back to the status quo estate tax circumstances. A 5-year term seems reasonable, but we'll need to have some slightly more sensitive conversations with the parents about their health should we choose to go this route. Because of the strict rules related to a GRAT and possible complications that could be caused by company stock, the GRAT might not be the most flexible or best option here. For instance, if the Company goes public and the Board decides to issue a dividend, that dividend cannot accrue to the trust without jeopardizing its status. A GRAT works best when the trust term is structured to capture the immense upturn in value in the company (company's) stock and exceed the §7520 rate. Usually, we would only fund a GRAT with a single asset instead of a mix of assets (or create multiple GRATs holding each asset). Also, GST cannot be allocated to the GRAT at the time of its creation, so the beneficiaries shouldn't be grandchildren.

b. Installment Sale -

The installment sale option is a strategy by which parentswould transfer title to their property in exchange for a promissory note that stipulates a payment schedule over a certain length of time. Regarding the company stock interest, timing would be important in the execution of this option because a sale of a marketable security cannot be reported on an installment basis (losing the tax benefit of the entire scheme).

Like the GRAT option, if the seller dies before the note is paid, the note will be included in the seller's estate and taxed accordingly at its FMV. Valuation of the property appropriately is extremely important in order to avoid unintended gift tax consequences and having the IRS re-characterize the transaction in a most unpleasant and most unfavorable way. There is also the possibility that other trust assets would be liable on the promissory note involved if the primary asset (Company stock) declines in value.

c. IDGT -

The Intentionally Defective Grantor Trust strategy, which I would recommend, combines all of the benefits of the aforementioned options while retaining more flexibility in estate planning. An Intentionally Defective Grantor trusts involves some aspects of the installment sale strategy, but will allows the parents'' to sell their property to the trust without any negative income tax implications (regardless of whether grantor is a beneficiary himself/herself or receives any benefit from it). Of course, just as in the installment sale explanation above, the installment note involved would have to be regarded by the IRS as having the indicia of genuine debt. The IDGT should hold some assets other than the purchased property in order to have a source for note payments other than income from the purchased property to avoid complications. In order to maximally take advantage of the possible upside in their company stock, their basic QTIP plan should include the creation of multiple separate QSTTs for the children. The children should be appropriately advised of the requirement that they elect for those trusts to qualify as QSTTs.


Note: Nothing on this blog should be construed as legal advice. Rather, it is a discussion of various mechanisms that might achieve a particular end from a non-lawyer source. This is merely for comparative purposes, not advisory. This advice should not be relied on as expert knowledge in any way.