Robert J. Kolasa, Ltd.
Estate Planner, CPA & Former IRS Attorney
Advanced Tax Planing
Families with significant assets should consider advanced estate planning strategies in addition to conventional estate tax planning in their living trusts. Failing to plan may mean that substantial family assets will end up with the IRS and state taxing authorities.
We regularly assist affluent families with sophisticated planning strategies as Intentionally Defective Grantor Trusts ("IDGTs"), Grantor Retained Annuity Trusts (“GRATS”), Qualified Personal Residence Trusts (“QPRTs), Generation Skipping Trusts (“Dynasty Trusts”), Irrevocable Life Insurance Trusts (“ILITs”), Family Limited Partnerships (“FLPs”) and a wide range of charitable gifting techniques to reduce Federal and Illinois estate taxes.
Intentionally Defective Grantor Trusts (“IDGTs”)
The Intentionally Defective Grantor Trust (the “IDGT”) is a great tool for estate tax and asset protection planning. An IDGT is a trust that not only moves assets outside of the creator of the trust’s taxable estate, but also makes the assets no longer owned by the trust creator (i.e., grantor) for asset protection purposes. Because the grantor no longer owns the assets, all future appreciation and growth of the assets occurs in the trust, outside of the grantor’s taxable estate, and out of the reach of predatory creditors. In essence the trust is used to “freeze” the grantor's estate.
A common transaction is for the grantor to sell assets with high appreciation potential to the IDGT. Since the IDGT is a grantor trust for income tax purposes, no gain or loss is realized on the sales transaction. Yet, the sale is a bona fide sale for transfer tax purposes resulting in assets being transferred to the IDGT in exchange for a promissory note. Post gift growth in the transferred assets is retained by the IDGT, which is outside of the grantor's taxable estate, thereby avoiding estate taxes. Often discount valuation strategies can be also employed to value the transferred assets at less than their liquidation value, resulting in additional estate tax savings.
An IDGT sale can viewed as a technique which freezes the estate tax value of transferred assets to their discounted value as of the date of transfer to trust. In effect, the grantor trades an appreciating asset (marketable securities or nonvoting business shares) to the trust for a non-appreciating asset (the promissory note). The grantor still controls the business since voting control is maintained, even if the IDGT buys all of the nonvoting shares. Upon the death of the grantor, the company’s appreciated value passes to beneficiaries free of federal estate tax, and the estate may pay income taxes on the note’s unappreciated value (although some commentators insist that this too can be avoided).
The Obama administration proposes to eliminate this technique and the IRS is selectively attacking such transactions, although IDGTs remain a staple of advanced estate tax planning.
Grantor Retained Annuity Trusts (GRATS)
A Grantor Retained Annuity Trust (“GRAT”) is one of the estate planning techniques based primarily on interest rate assumptions. Clients create GRATs with assets that are likely to earn more than the IRS assumed interest rate (i.e., Code Section 7520 interest) during the GRAT term, in an effort to pass the appreciation in the assets to trust beneficiaries free of gift and estate tax. GRATS are currently one of the most powerful and tax efficient wealth transfer tools for assets which may explode in value after trust contribution. In a successful GRAT, transferred trust assets increase in value with most of the growth escaping estate taxes altogether.
The Obama administration proposes to eliminate limit this technique or impose a minimum 10-year term for GRATS (this would bar “zeroed-out” GRATs). If such proposal ever passed, GRATS would become less attractive for wealthy investors. We will have to wait and see.
Qualified Personal Residence Trusts (QPRTs)
Our homes are often our most valuable assets and hence one of the largest components of our taxable estate. A Qualified Personal Residence Trust or a QPRT (pronounced “cue-pert”) allows you to give away your residence or vacation home at a great discount, freeze its value for estate tax purposes, and still retain the option to live in it after the gift.
Here's how it works: You transfer the title to your residence to the QPRT (usually for the benefit of your family members), reserving the right to live in the house for a specified number of years. If you live to the end of the specified period, the residence (as well as any appreciation in its value since the transfer) passes to your children or other beneficiaries free of any estate or gift taxes. After the end of the specified period, you may continue to live in the home but you must pay rent to your family or designated beneficiary in order to avoid inclusion of the residence in your estate. This payment of rent is equivalent to a tax free gift as it serves to further reduce the value of your taxable estate, though the rent income does have income tax consequences for your family (although practitioners sometimes take the position that such rent income is nontaxable).
If you die before the end of the period, the full value of the residence will be included in your estate for estate tax purposes, though in most cases you are no worse off than you would have been had you not established a QPRT. An added benefit of the QPRT is that it also serves as an excellent asset/creditor protection vehicle since you no longer technically own the property once the trust is established the residence transferred to the QPRT.
Irrevocable Life Insurance Trusts (ILITs)
There is a common misconception that life insurance proceeds are not subject to estate taxes. While the proceeds are received by your loved ones free of any income taxes, they are countable as part of your taxable estate and therefore family members may lose about half of its value to estate taxes.
An Irrevocable Life Insurance Trust is created specifically for the purpose of owning your life insurance policy. A properly established and administered trust holds the policy outside of your estate and keeps the proceeds from being taxable to your estate. The proceeds from the insurance policy can then be used to provide your estate with the liquidity to pay estate taxes, pay off debts, pay final expenses and provide income to a surviving spouse or children. Once your trust is established, you use your annual gift tax exclusion to make cash gifts to your trust. The cash is counted as a gift to the trust beneficiaries with such cash retained in trust to pay the premiums on the life insurance policy.
There are many options available when setting up an ILIT. For example, ILITs can be structured to provide income to a surviving spouse with the remainder going to your children from a previous marriage. You can also provide for distribution of a limited amount of the insurance proceeds over a period of time to a financially irresponsible or disabled child.
Discounted Family Limited Partnerships (“FLPs”) and Limited Liability Companies ("LLCs")
FLPs and LLCs are favorite gift discounting mechanisms available in the estate planner's quiver. Often the main advantages of forming these entities relate to estate/gift tax savings and asset protection. FLPs and LLCs may allow you to retain effective control over transferred assets even though they are excluded from your taxable estate. Once the entity is established and funded, membership shares are gifted to family members.
The above plan accomplishes several estate planning objectives simultaneously:
First, the value of each limited partnership/LLC interest which is gifted decreases the value of your taxable estate and, consequently, any tax heirs would have to pay upon your death. The gifts can be made using the annual gift tax exclusion to avoid paying gift taxes on the transfer, although larger gifts may be made to the extent of the available gift/estate tax exclusion amount, which is $5.43 million in 2015.
Second, the value of the partnership interests transferred to beneficiaries can be far less than the corresponding value of the assets in the entity. Since limited partners do not have the ability to direct or control the day-to-day operation of the entity, a minority discount can be applied to reduce the value of the interests which you are gifting.
Furthermore, because the limited partnership/LLC is a closely-held entity and not publicly-traded, a discount can be applied based upon the lack of marketability of the transferred interests. This allows you to leverage the entity as a vehicle to transfer more wealth to your beneficiaries, while retaining control of the underlying assets.
Lastly, a properly-structured limited partnership/LLC can have creditor protection characteristics. A creditor who gets a judgment against the entity is typically not be successful in forcing the entity to liquidate and disgorge assets to creditors.
For the last ten years there have been concerns that Congress may soon abolish the tax discounts available to FLPs and LLCs. The IRS has also, with limited success, been winning cases questioning the economic substance of discount entities holding marketable securities. These factors should be taken into account. Discount planning should probably not be recommended for those who are weak of heart or unwilling to pay the attendant professional fees.