A market downturn presents numerous opportunities for strategic estate planning. In particular, the wealth transfer techniques discussed here could provide attractive options for making gifts of significant value to your heirs. Due to the complexities of these strategies, you'll need to work with an attorney to discuss their potential rewards and risks, as well as to set appropriate terms and conditions for your portfolio and your family.
Direct Wealth Transfers
Why might now be an opportune time to use a direct wealth transfer to pass assets to a family member or other beneficiary? Due to the market disruption, you may be able to take advantage of the lower market value of your portfolio assets. At the same time, you could benefit from the high gift and estate tax exemption currently in effect if you wish to transfer significant assets.
Many people use either cash or appreciated stock for a direct wealth transfer. In a market downturn, you could pair a direct cash transfer with a tax-loss harvesting strategy. The sale of your depreciated investments would raise cash for the transfer, while also providing a tax benefit. The transfer of appreciated stock could also be advantageous because it would be valued using the market price on the date of the transfer. Thus, you would use less of your lifetime gift and estate tax exemption, and, if the investments rebound, your beneficiaries would enjoy the appreciation. It's important to note, however, that your cost basis will carry over to your beneficiaries. The greater the stock appreciation, the greater may be their responsibility for capital gains taxes when they sell the shares.
The gift and estate tax exemption is currently set at $11 million (adjusted for inflation), courtesy of the 2017 Tax Cuts and Jobs Act (TCJA). But what the TCJA gives it may take away. Per a "sunset" clause in the law, the gift and estate tax exemption is scheduled to revert to $5 million (adjusted for inflation) on January 1, 2026. So, if this high exemption will benefit you, the time window to use it may be limited. Fortunately, if you use the exemption through the end of 2025, the IRS has ruled that your estate will not penalized if the threshold is lower when you die.
With interest rates at historic lows, this may be the perfect time to loan money to family members or to refinance an existing loan. Generally, provided you charge an interest rate equal to the Applicable Federal Rate (AFR), no part of the loan is treated as a gift.
The AFR is determined by the loan duration (short, medium, or long) and by the period for compounding interest (annual, semiannual, quarterly, or monthly). The various AFRs are published monthly by the IRS. In April 2020, the interest rates were:
0.91 percent for short-term loans (three years or less)
0.99 percent for medium-term loans (up to nine years)
1.44 percent for long-term loans (more than nine years)
For comparison, the January 2020 rates were 1.6 percent, 1.69 percent, and 2.07 percent, respectively. In May 2020, it's likely that the AFRs will continue dropping.
As you can see, the savings on interest could really add up for younger-generation family members. And, in these difficult times, the financial assistance might be especially meaningful for those who are dealing with wage decreases or have credit issues. Working with your attorney will help you understand the gift and income tax consequences of any potential loan forgiveness down the road.
Grantor Retained Annuity Trust "GRAT"
A GRAT is an irrevocable trust that allows a significant amount of wealth to be passed to the next generation with little or no gift or estate tax consequences. Accordingly, this strategy is useful if you have already used up your gift and estate tax exemption or plan to use it to shelter other assets. When you establish a GRAT, you transfer whatever amount of assets you desire into the trust. As the trust "grantor," you will receive an annual annuity payment from the trust for a set number of years. When that time period is up, the remaining funds go to the trust beneficiaries. How much is your annuity payment? It is calculated using the original value of the assets you contribute, plus a rate of return called the "section 7520" rate. As with the AFR, the section 7520 rate is determined on a monthly basis by the IRS. Working from this rate, you can set up your annuity payment using one of the following two options:
"Zeroed-out" GRAT. As the trust grantor, you set the annuity payment at the exact amount that will return the original principal and attributed 7520 interest to you over the term of the GRAT. Your goal is that the GRAT's investments will vastly outperform the benchmark of the annuity payments. You will leave any appreciation above the benchmark to your beneficiaries without having to use any of your gift and estate tax exemption.
"Gift" GRAT. With this option, you set the annuity payment to an amount lower than necessary to return the principal and attributed 7520 interest to you. As a result, there will be principal funds remaining in the GRAT, which are recorded as a gift to the trust beneficiaries. As with the zeroed-out GRAT, your hope is that the appreciation of the account's investment will greatly exceed the annuity payments. At the end, everything remaining in the trust passes to the beneficiaries, but only the amount of the recorded gift may count toward your gift and estate tax exemption.
Why might this be a good time to fund a GRAT? There's always the potential benefit of transferring a great deal of wealth with little or no gift and estate tax ramifications. But a depressed market offers additional advantages. During an economic downturn, the section 7520 interest rate is typically lower, which lowers the required payments that must go back to the grantor. (To put this in context, the section 7520 rate for April 2020 is 1.2 percent.) At the same time, the GRAT portfolio established at a low valuation may be ideally positioned for significant growth during a market recovery.
It's important to keep in mind that using a GRAT involves downsides. If you die during the term of the GRAT, the remaining assets will be transferred back into your taxable estate and pass to your beneficiaries pursuant to your other estate planning documents. But the chief risk is the possibility that a GRAT will "fail." In fact, depending on the terms and timing, many existing GRATs may fail in 2020.
Essentially, a failure occurs when the trust doesn't experience growth above the applicable 7520 rate. In these cases, at the end of the term, the trust returns the remaining assets to the grantor and terminates with nothing left to distribute to the beneficiaries. Assuming you would have made similar investment choices as you did in your GRAT, your financial position would not be substantially different from the time you set up the GRAT. You would, however, have incurred costs to set up and administer the trust. And years would be lost that could have been devoted to a different estate planning strategy.
Another downside to consider is the potential capital gains tax liability for your beneficiaries. If all goes according to your plan and the GRAT performs well, the assets received by your beneficiaries may include substantial appreciation. Depending on how the annuity payments are managed, the cost basis from the start of the investment period may be low. Your beneficiaries will be responsible for capital gains taxes based on the carryover cost basis.
Family Limited Partnerships (FLPs)
FLPs operate with general partners who manage the business and limited partners who benefit from the proceeds. Typically, parents or grandparents contribute investment assets, real estate, or other business interests to an FLP. Serving as general partners, they slowly transfer partnership interests as gifts to their heirs. Often, the gifting process is executed over many years to stay within the annual gift tax exclusion of $15,000 per year, per person.
In a depressed market, the valuation reduction of an FLP can be useful in two ways. As with a zeroed-out GRAT, once an FLP interest is transferred to your beneficiaries, the future growth of that interest is outside of your estate. You're also able to transfer a larger percentage of the partnership interests to the next generation using the $15,000 per beneficiary annual gift tax exclusion cap. So, using an FLP in a depressed market may allow you to transfer a larger percentage of your interests (with all its potential for future growth) while using little or none of your lifetime gift and estate tax exemption.
Other Trust Planning
While GRATs are the most common wealth transfer trust, other trusts may be used for specific circumstances. These include the qualified personal residence trust (QPRT) and the nonspecialized irrevocable trust.
QPRT. Each QPRT is limited to holding one residence, and each individual can have a maximum of two QPRTs. Many people use a QPRT to hold a vacation home, although it's also possible to transfer a primary residence into a QPRT. The features of a QPRT are nearly identical to those of a gift GRAT. The value of the gift is calculated using the value of the residence transferred, the applicable section 7520 rate, and the duration of the QPRT. In contrast to the gift GRAT, however, you do not receive any annuity payment back from the trust or any return of an interest in the residence.
Thus, transferring a vacation home to a QPRT in a depressed market offers the same double benefit as a GRAT does. The section 7520 rate will be lower due to the overall market depression, and the value of the property is also likely to be depressed. Together, these factors would lower the value of the gift to the QPRT. As a consequence, you would need to use less of the lifetime gift and estate tax exemption to make the transfer. Provided that you survive the term of the QPRT, all appreciation in the property transfers free of taxes to the trust beneficiaries.
Nonspecialized irrevocable trust. You may find that a nonspecialized irrevocable trust provides the most flexibility for transferring wealth amid the current economic uncertainty. This type of trust allows for extensive customization. For instance, you might choose to maintain the trust as a "grantor trust" for tax purposes. With this option, the grantor covers the taxes on any income, dividends, and capital gains, rather than having the trust pay these costs. Accordingly, asset growth is maximized for your beneficiaries. A nonspecialized irrevocable trust can be drafted to allow for future contributions or to include provisions that will benefit you in the future.
Reviewing Your Estate Plan
During times of great economic upheaval, it's prudent to review your estate plan. You may need to update standard estate planning documents, such as a revocable grantor trust or your last will and testament. Make time to meet with your attorney to discuss general estate planning in conjunction with any wealth transfer strategies that might be beneficial. An attorney's assistance is necessary to ensure that your estate plan is up-to-date with current regulations, including new laws such as the SECURE Act.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer. ©Copyright 2020 Commonwealth Financial Network® Sara Romaine is a financial advisor at Blue Hills Wealth Management. BHWM is located at 300 Crown Colony Drive, Quincy MA. Sara can be reached at 617-471-6800 or firstname.lastname@example.org. Securities and advisory services offered through Commonwealth Financial Network, Member, FINRA/SIPC a registered investment advisor. Fixed insurance products and services and College Planning services offered by Blue Hills Wealth Management and College Funding Solutions are separate and unrelated to Commonwealth.