Estate Planning Opportunities During Down Markets

Turning lemons into lemonade

The sudden and overwhelming effects of COVID-19 have been challenging for us all. We’ve had to make drastic lifestyle changes as we practice social distancing and self-isolate inside our homes. As a result, the market has experienced a severe downturn, and it’s natural to feel helpless during this time. However, much can be done for those who wish to protect their wealth. In fact, the current economic climate actually presents a number of opportunities to limit estate tax exposure.

Currently, each individual can transfer up to $11.58 million (through lifetime gifts or at death) without incurring estate or gift tax. Married couples can transfer double that. Any excess assets transferred are taxed at a flat 40% rate. Admittedly, under today’s estate and gift tax exemption, many people will be able to transfer their entire estate tax-free. However, those with assets less than $11.58 million should not shy away from estate planning, as they may eventually have taxable estates. At the end of 2025, the exemption is set to decrease to around $6 million per person. Additionally, with the upcoming presidential election, there’s a possibility that the exemption will be reduced sooner and could be even lower than $6 million. Thus, it’s best to maximize the benefits of the current exemption before any changes are made.

The present economic state creates an extra incentive to act immediately. As always, you should make sure that you have basic estate plans in place — living trusts, powers of attorney and health care directives — and that such plans are up to date. However, because of depressed asset values and low federal rates due to the impact of COVID-19, now is an opportune time for wealth transfer planning as well.

Direct gifts

If you own assets that have greatly declined in value, such as stock shares or real estate, you may consider giving them away now. If you are concerned about asset protection or a beneficiary’s ability to manage such assets, you can make the gift to a trust held for his or her benefit. Making such a gift at this time will allow you to use less of the exemption amount than you would have used before the economic decline. The value of these assets will likely appreciate over time, and any future growth on these assets will occur outside of your taxable estate.

Grantor Retained Annuity Trusts

If you do not want to make direct gifts because you want to preserve your exemption or because you need to use some of the assets for spending needs, you might choose to freeze the value of your assets instead with a grantor retained annuity trust (GRAT). A GRAT allows you to gift assets to a trust in exchange for an annuity equal to the value of the transferred assets, which will be paid out during the term of the trust. Any appreciation on the assets above a certain interest rate set by the IRS (“7520 Rate”), can be transferred tax-free to friends or family through a trust held for their benefit, and the growth on the assets will be excluded from your taxable estate.

The 7520 Rate in May is 0.8%, down from 1.2% in April. Due to the low rate, reduced asset values, and the likelihood that the market will recover over time, there’s a good possibility that appreciated assets will pass to your loved ones tax-free. However, in the event that the assets continue to diminish in value during the term of the trust, the assets will simply be returned to you at the end of the term — a “win-tie” scenario.

Please note that if you are planning to transfer assets to multiple generations, a GRAT is not recommended. GRATs are effective for one generation but cannot pass to the next generation (i.e., grandchildren) on a tax-advantaged basis.

Sales to a Defective Grantor Trust

Another popular estate planning technique involves selling highly appreciable assets to one or more defective grantor trusts (DGT) held for the benefit of friends or family members. A DGT has special terms that allow its assets to be excluded from the grantor’s estate for estate tax purposes but treat the assets as owned by the grantor for income tax purposes. Thus, grantors will pay income tax on any gain earned by the trust (a tax-free gift), while the beneficiary enjoys the appreciated assets tax-free. Importantly, the “sale” of assets to the DGT is not a taxable event — no gain is triggered — and the DGT will retain the grantor’s basis in the transferred asset.

Usually, if the sale is made to a newly formed DGT, a small cash gift (typically 10% of the transfer value) will be used to fund the trust. The appreciable assets are then sold to the trust in exchange for a low-interest promissory note. The interest rate for such note is set by referring to the Applicable Federal Rates (AFRs), which are the minimum interest rates that the IRS allows for private loans. The May 2020 AFR for a nine-year note is 0.58%, down from 0.99% in April. With these extremely low rates, the sale will be even more effective if completed during this time.

Because this transaction is primarily a sale, the transferor can leverage the gift tax exemption using a smaller portion of exemption equal to only a fraction of the transfer value. Selling the assets during a time when values are extremely low increases the likelihood that appreciating assets will pass to the beneficiary free of gift and estate tax. In addition, the DGT can be set up to pass through multiple generations. The trust term may be limited in some states, but a grantor may also consider setting up a DGT outside their home state to take advantage of dynasty trusts that can last in perpetuity.

Refinancing intrafamily loans

With AFRs at historic lows, it’s a good time to re-examine any outstanding loans with family or friends. Refinancing a loan is fairly simple and can have significant benefits. First, if the interest rate on the loan is higher than the current AFR, you can lower the interest rate, thus reducing the financial burden on the borrower. In addition, if the balance is coming due in the near future, refinancing the loan will allow you to extend the due date and give the borrower more time to repay. The borrower may think about offering some consideration in exchange for the lender’s agreement to refinance to a lower interest rate to ensure the refinance is viewed as an arm’s-length business transaction.

Sweeter long-term potential

Although today’s market volatility may leave a sour taste in your mouth, the down markets clearly open doors to some sweet estate planning strategies. Before getting started, reach out to your wealth manager or estate planning attorney to discuss your specific circumstances and how to best attain your desired estate planning goals.

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