United States: The Window Of Opportunity May Be Closing - Top Estate Planning Strategies To Consider (Now)

As noted in the recent article by Gideon Rothschild, certain gifting strategies may be seriously curtailed or eliminated in the coming months. While we can't be certain whether (and to what extent) these proposals will become law, under the circumstances there are several proactive planning techniques that we would encourage you to consider, including (i) creating perpetual "dynasty" trusts, (ii) establishing grantor retained annuity trusts (GRATs) and (iii) making intra-family loans.

Dynasty Trusts

For individuals seeking to utilize some or all of their remaining lifetime estate/gift tax exemption, a common strategy is to gift assets that are likely to appreciate in value to an irrevocable trust for the benefit of children and more remote descendants. This is often referred to as a classic "dynasty trust." The gifted assets will be removed from the donor's estate for tax purposes. In addition, the property will also be shielded by the powerful protections offered by this trust structure against potential future creditors (including marital claims).

Over the past year, the COVID-19 crisis has led to depressed values across many different asset classes. This has created a temporary opportunity for individuals to transfer wealth to a dynasty trust for the benefit of future generations at a considerably lower cost than pre-pandemic values. Assuming that values will recover and continue to grow over time, any future appreciation on assets gifted to the trust will escape the transfer tax system as well.

Still, many clients may be uncomfortable making larger gifts without retaining some access to the transferred property. There are several options that can help in this regard, including the following variations to a typical dynasty trust.

Spousal Lifetime Access Trusts

One approach for a married couple is to gift assets to an irrevocable trust wherein the grantor's spouse is named as a discretionary beneficiary. This type of trust is sometimes referred to as a spousal lifetime access trust or a "SLAT". This type of trust can provide the grantor with indirect access to future distributions of income or principal, so long as the couple remains married and the grantor's spouse is living.

Self-Settled Spendthrift Trusts

Clients who are not married, or those who wish to retain more direct access to the gifted property, might instead consider a self-settled spendthrift trust, which is allowable under the laws of several states. Under this type of trust, the grantor can be named as a discretionary beneficiary and the trust assets might still be excluded from his or her taxable estate. For clients seeking to achieve maximum creditor protection, this approach may not be advisable. However, there are alternative techniques, involving special powers and retained controls, which can be built into a trust to achieve significant protection and maximum flexibility with respect to the gifted property.

To protect against the relatively small possibility of a retroactive reduction to the estate/gift tax exemption effective as of January 1, 2021, there are contingency provisions that can be built into the trust as well. This includes language that would allow for the "unwinding" of a gift to the extent of any tax exposure.

Grantor Retained Annuity Trusts

A GRAT is a mechanism for transferring the appreciation of an asset to beneficiaries gift-tax free. Assets are transferred to an irrevocable trust in exchange for the right to receive fixed annuity payments for a specified term of years. Unlike in the case of the other trust structures discussed above, the value of assets transferred to a GRAT need not be limited to the lifetime gift tax exemption and, if the value of assets transferred to a GRAT is changed in the event of an IRS audit, there should remain little or no gift tax consequence.

A GRAT is effective if it is funded with assets that appreciate in value over and above the 7520 Rate (oftentimes referred to as the "Hurdle Rate"). For example, one might consider gifting shares in a closely held corporation or a percentage interest in a limited liability company which may be currently undervalued, or has the potential for significant future growth. This technique is particularly attractive in light of the current low interest rate environment. The Hurdle Rate for transfers made in May 2021 is 1.2%. To the extent that property transferred to the GRAT has an annualized return of more than the Hurdle Rate, any excess appreciation on the transferred property remaining at the end of the GRAT term will result in a tax free gift for the benefit of the trust remainder beneficiaries.

If assets decline in value, the grantor will simply get back the property that was transferred to the GRAT and be no worse off. If, however, the grantor dies during the GRAT term, some or all of the trust property could nevertheless be includable in their estate. While a longer GRAT term could mean greater appreciation and increased tax savings, this should be weighed against the grantor's mortality risk.

Low Interest Rate Loans

Another attractive option is a sale, rather than a gift, of an asset (such as non-voting shares in a company), to an irrevocable grantor trust in exchange for a promissory note. With a sale, the asset is removed from the grantor's taxable estate and is substituted with a stream of income. Since the grantor is treated as the owner of the trust for income tax purposes, there is no income tax consequence to the grantor. Any appreciation following the sale in excess of the Applicable Federal Rate ("AFR") will remain in the trust free from estate and gift tax. This method has become increasingly popular while interest rates are at historic lows. (Those who previously engaged in such sale transactions may also want to consider taking advantage of low rates by either refinancing an existing loan or forgiving some or all of the note up to their remaining gift tax exemption.)

In comparison to a GRAT, there is no mortality risk with the sales approach. While asset valuations could be subject to challenge by the IRS in the event that the sale transaction is audited, there are several ways to mitigate this possible risk.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.