michael-rappsThe Wealth Counselor

By Michael P. Rapps

In effective estate planning, the four Ps should be paramount–protection of you, your assets, and your beneficiaries; prosperity, as the correct tools should allow for growth of your property while minimizing taxes; provision of income for you and your heirs; and perpetuity–your legacy can benefit generations to come in an increasingly competitive world. We all want to know that our hard work and sacrifices have not been in vain. Our goal in this series of articles has been to demonstrate that a good estate planner has multiple strategies and tools to meet those objectives and give you the fifth P–peace of mind.

Last week’s article (Level 3, Part 1) explained the role of family limited-liability companies and valuation discounts when there is a projected estate-tax liability that exceeds the life insurance in irrevocable trusts. One of the strategies we discussed was using the federal gift-tax exemption to make lifetime gifts. Sometimes the need arises to make additional gifts but the gift-tax exemption has already been used for other transfers. Our final article in the series examines the other vehicles and techniques available to make the gifts without incurring substantial gift tax.

Before we delve into the details, we’d like to emphasize that we understand estate planning is a complex field and therefore we welcome questions on the topics we’ve covered or any other relevant subjects.

Objective

Mr. Hammer is a knowledgeable and successful investor, age 60. He’s aware of the annual gift-tax exemption of $14,000 per person and has used it to his advantage. He consults his estate-planning attorney, Mr. North, to find out what he can do now that he no longer has that tool available but wishes to make further substantial donations to his spouse and children.

Tool #1: Qualified Personal Residence Trusts. Mr. North suggests that Mr. Hammer transfer his primary or secondary residence to a qualified personal residence trust (QPRT). He’ll retain the right to use the property rent-free for a period of his choosing, following which it will be passed to his children (the beneficiaries named in the trust). IRS tables will be used to calculate the value of his right to remain living there, which will be subtracted from the value of the estate to arrive at the remaining interest. Only this remaining interest would be considered a gift to his children.

Say Mr. Hammer’s vacation home is worth $2,000,000, the assumed interest rate for the month of the gift is 2.2%, and the term is 15 years. The total value of Mr. Hammer’s retained interest would be $1,334,960 and the remaining taxable interest would only be $665,000. If Mr. Hammer survives the 15-year term and the residence appreciates at 5% per annum to $4,157,856, the potential estate-tax savings at a 40% tax rate will be $1,397,126.

Tool #2: Grantor-Retained Annuity Trusts. Mr. North explains that Mr. Hammer could also establish a grantor-retained annuity trust (GRAT). Any asset can be donated to a GRAT, but typically a partnership or LLC interest with good cash flow, or subchapter S shares paying significant dividends are used. (A subchapter S is a form of corporation with a maximum of 100 shareholders providing the benefit of incorporation with the taxation of a partnership.) The GRAT would pay Mr. North a fixed annuity for a specified number of years, following which the trust assets plus appreciation would be passed to his named beneficiaries. Only the value of the remainder interest would be subject to gift tax.

If Mr. Hammer donates $1,000,000 to the GRAT for a 10-year term and retains a 7% annuity interest, he’ll receive $70,000 annually (7% of $1,000,000). If the IRS’s taxable rate (the AFR) for the month of donation is 1.4%, the taxable remainder interest gift would be only $351,016. The gift has a reduced value because the beneficiaries won’t be receiving the property for 10 years. If the assets in the GRAT generate 5% income and 7% growth during the 10 years, there will be $1,915,866 remaining in the trust at the end of the term, which results in a difference of $1,564,850 of taxable transfers (or a tax savings of $625,940 at a 40% tax rate).

Tool #3: Installment Sales to Intentionally Defective Grantor Trusts. Mr. North underlines that this final tool is one of the most popular wealth-transfer vehicles. The grantor creates an irrevocable trust that is designed so s/he owns the assets given to it, receives the income they generate, and pays tax on that income, but the assets don’t form part of his or her estate so no estate tax will be payable by him/her on those assets. The donor is required to gift the estate an amount equal to at least 10% of the value of the assets s/he’ll be selling to the estate. The interest payable on the assets sold to the estate is fixed for the entire term at the lowest rate allowed under the tax law.

If Mr. Hammer had assets worth $10 million available for this type of trust, he would gift 10%, or $1 million, and sell the trust the remaining $9 million. The annual interest payable on the $9 million, assuming a nine-year term and 1.22% interest rate, would be $109,800.

If the assets sold to this type of trust produce a total return (income and appreciation) greater than the interest rate, substantial wealth can be removed from the seller’s gross estate gift- and estate-tax free. The income generated can also be used to cover the interest payments. The assets also usually qualify for valuation discounts due to lack of control or marketability. In addition, repayment of the principal is only required at the end of the specified term.

Disadvantages

Mr. North warns his client of the drawbacks to all three types of trusts: They’re irrevocable, he’ll lose direct ownership of the property at the end of the fixed term, and his heirs will lose the stepped-up basis on appreciated property when he dies (they will have a carryover basis). With qualified personal residence trusts and grantor retained annuity trusts, if he dies during the fixed term, the property contained in the trust will be included in his estate.

Mr. Hammer is pleased to learn from his estate-planning attorney that there are additional ways of gifting assets to his beneficiaries that assure him of continuing income and appreciation on those assets without a total loss of control or incurring significant income taxes or estate taxes. Since he recently had a complete physical examination with excellent results, he’s confident that it’s not too risky to establish trusts with at least a 10-year term.

To recap: In the foundational Level 1 of estate planning, we covered ways of deferring and reducing estate taxes, living trusts, avoidance of probate, establishing powers of attorney for property and health care, and appointing trustees, guardians, and executors.

Level 2 examined the strategies available if a projected estate is larger than the estate-tax exemption, including leveraging the gift-tax exclusion, removing life-insurance proceeds from an estate while retaining their benefit, creating irrevocable life-insurance trusts, and using the tax-free death benefit to provide liquidity to an estate.

Level 3 Part 1 discussed the role of family limited-liability companies and valuation discounts when there is a projected estate-tax liability that exceeds the life insurance contained in the irrevocable trusts covered in Level 2.

Level 3 Part 2 explained how qualified personal residence trusts, grantor retained annuity trusts, and intentionally defective grantor trusts can be established when there is a need to make gifts but the gift tax exemption has already been exhausted.

We hope this series has provided you with increased knowledge about estate planning and underlined the necessity of consulting an experienced estate-planning attorney to meet your goals.

Next week we’ll be providing an additional section on charitable planning, which can be used to zero-out taxes once all the strategies covered in the previous articles have been implemented.

If you have a question regarding estate, asset protection, business succession, or long-term care/Medicaid planning and you would like us to answer it in this column, please submit your question to us by e-mail at info@rappslaw.com (subject “5TJT question”) or visit www.rappslaw.com/contact-us-now. v

Michael P. Rapps is the managing attorney at Rapps & Associates, PLLC, located in Woodmere. His practice focuses on estate, asset-protection, and business-succession planning. He can be reached at mrapps@rappslaw.com or 516-342-3756.

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