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updated: 9/21/2017 10:37 AM

The calm before reform: Wealth transfer strategies in an uncertain tax environment

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By Elizabeth McKillip, Miranda Morgan, Shelby Anderson
Ice Miller attorneys

President Trump and House Republicans have released separate tax reform plans aimed at simplifying the tax code. Both plans call for the repeal of the federal estate tax; however, details on how the repeal will be implemented are limited. Trump's plan also proposes to eliminate the "stepped up basis" by which a beneficiary's basis in an inherited asset is equal to the fair market value of the asset as of the decedent's date of death. With Republicans controlling less than 60 seats in the Senate, the permanence of any estate tax repeal remains in question. While the uncertainty of tax reform has put a chill on gifting strategies that will cause the donor to pay gift tax, there are a number of wealth transfer strategies that are worth considering to slow the growth of a taxable estate, even in the midst of tax reform.

Annual Exclusion Gifts: The annual federal gift tax exclusion allows individuals to gift up to $14,000 ($28,000 for married couples) per recipient in 2017 without incurring gift tax or utilizing gift tax exemption. These gifts may be made directly to the recipients (children, grandchildren, or others), to 529 plans, or to trusts that qualify the contributions as "present interest gifts." In addition to annual exclusion gifts, individuals may make unlimited gifts, without incurring gift tax or utilizing gift tax exemption, in the form of direct payments of tuition or medical expenses made directly to the educational institution or medical provider. Even with reform on the horizon, annual exclusion gifts and direct medical and educational gifts remain effective tools to transfer wealth from one generation to the next and to potentially shift income producing assets to recipients in a lower income tax bracket.

Intra-Family Loans: An intrafamily loan is a strategy that takes advantage of the low interest rate environment to transfer wealth between generations without utilizing gift tax exemption. The transaction is structured as a loan (often from a parent or grandparent) to the borrower (often a child or grandchild). The goal is for the borrowed funds to earn income and appreciate in the hands of the borrower at a rate higher than the rate of interest on the loan. Intrafamily loans must be carefully structured to ensure they are recognized as loans (as opposed to gifts) by the IRS. Among other requirements, the interest on the loan must be set at a rate equal to or above the applicable federal rate. The short-term applicable federal rate for August 2017, assuming annual interest payments, is 1.29 percent, while the midterm and long-term rates for the same period are 1.95 percent and 2.58 percent respectively. With rates still low and indications that rates may rise in the future, intrafamily loans remain a valuable strategy to transfer wealth without utilizing gift tax exemption.

Granter Retained Annuity Trusts: The granter retained annuity trust ("GRAT") is a strategy to freeze the value of the granter's taxable estate and avoid transfer tax on future appreciation. When the trust is established, two property interests are created -- the granter retains a right to receive annuity payments (defined as a percentage of the fair market value of the trust assets) for a period of two years or more, and remainder beneficiaries named by the granter (typically the granter's children or trusts for their benefit) receive the right to any remaining trust property at the end of the annuity term. The goal of the GRAT is for assets in the trust to appreciate at a rate higher than the IRS' defined rate of return. Assume, for example, a properly drafted GRAT with a two-year term funded with assets valued at $2,000,000. Using the August 2017 federal rate of 2.4 percent and an assumed annual investment return of 6.0 percent, approximately $112,706 would be left in the GRAT for the remainder beneficiaries at the end of the two-year period. With the applicable federal rates still low and indications that rates may rise, GRANTS remain a valuable strategy to transfer wealth without utilizing gift tax exemption.

Installment Sales: Similar to GRANTS, an installment sale to an irrevocable granter trust is a strategy to freeze the value of the granter's taxable estate and avoid transfer tax on future appreciation. The granter creates an irrevocable trust and sells the assets to the trust, taking a promissory note for the purchase price. No gift tax is incurred on the assets sold to the irrevocable trust, so long as the sales price reflects the fair market value of the assets. Further, the trust's granter trust status for income tax purposes ensures no capital gain is recognized upon the sale. The granter receives principal and interest payments on the promissory note, and the property remaining in the trust upon repayment of the note is administered according to the trust's terms (often for the benefit of the granter's children). This strategy is most effective with income producing assets, including closely held business interests and assets that are expected to appreciate in value. In 2016, the IRS proposed regulations (known as the 2704 Regulations) which may limit valuation discounts (e.g. lack of marketability and lack of control) on transfers of closely held business interests. Accordingly, now may be an ideal time to consider transfers of closely held businesses interests as the regulations continue to be assessed.

Charitable Contributions: Both tax reform plans call for an increase to the personal income tax standard deduction. For some, this will mean that taking the standard deduction will be more beneficial than itemizing deductions. Additionally, both plans call for a reduction in the top income tax rate. Accordingly, charitable contributions in 2017 may result in a greater reduction of taxable income than in post-reform years. Charitable contributions may be made directly to the charity of choice or can be made through other gift vehicles, such as donor-advised funds and private foundations. Donor-advised funds and private foundations allow donors to recognize an immediate income tax deduction for the charitable contribution, while retaining certain advisory rights in the administration of the gifted funds.

These strategies represent only a few of the tools for wealth transfers in an uncertain tax environment. If you have questions about these strategies or how the tax reform legislation may impact your estate plan, please contact Elizabeth McKillip, Miranda MorganShelby Anderson or another attorney in the Trusts and Estate Group at Ice Miller.

• This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.