The COVID-19 pandemic has put the economy in a precarious state, but certain effects of the downturn, such as historically low interest rates and certain provisions of tax reform, make the current environment ideal for re-examining estate plans. The authors highlight several contemporaneous opportunities to protect assets through the use of certain trusts, loans, and asset movements.
The world is in turmoil, but moderately wealthy and high-net-worth individuals should consider planning aggressively to reduce their taxable estates while still maintaining certain benefits of their property. The massive relief effort of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which is likely to be followed by additional efforts, will entail a giant outlay of federal expenditures. The resulting deficit may well be made up by higher taxes on the wealthy (and the not so wealthy) in the near future. How should well-to-do individuals plan in the current environment? What planning techniques might be favored? What recommendations should professional advisors now consider? This article attempts to answer those questions.
Start with the Basics
As of this writing, tens of thousands of Americans have died from the coronavirus disease (COVID-19), and worries over health and safety are acute. Dramatic market declines in a short time have left many investors in financial shock and feeling more financially vulnerable than they have in years. Thus, even though planning makes sense for many, CPAs will have to delicately start the conversation.
Addressing essential estate planning documents with clients who are facing potentially terminal circumstances is nothing new to estate planners. At this juncture, it is critical to inform clients of the importance of making certain that their estate planning documents are in place. There is no doubt that thousands more Americans will die from COVID-19. Educating clients is not capitalizing on a difficult situation, but helping them in a time of need.
Living wills, healthcare proxies, Health Insurance Portability and Accountability Act (HIPAA) releases, powers of attorney, do-not-resuscitate orders, and wills should all be current and reflect the client’s wishes. Even though CPAs do not draft these documents, they are integral members of the estate and tax planning team, and possibly the only member clients might be speaking to right now. Some wealthy individuals may avoid their financial advisors in order to escape hearing realities they might not want to face, so CPAs are in a unique position to encourage clients to address estate planning basics, including non-tax planning. Even well-to-do individuals may feel financially vulnerable, so it is important to make suggestions that will leave clients with sufficient access to their wealth.
An Ideal Planning Window
The coronavirus (COVID-19) pandemic has created a confluence of several significant factors making now an opportune time to plan for estate tax planning:
- The gift and generation-skipping transfer (GST) exemption amounts remain high. These exemptions are, however, temporary and will be cut nearly in half by 2026.
- Whether or not there is a sufficient Democratic sweep of the Senate and White House in November, additional fiscal pressure may lead to the enactment of estate and transfer tax and income tax legislation. The current high exemption amounts may be reduced well before scheduled in 2026. New legislation could bring higher estate tax rates, lower exemptions, loss of step-up in basis on death (or a capital gains tax on death), elimination or reduction in discounts, restriction of grantor retained annuity trusts (GRAT), and more. As indicated, even if the Republicans retain control of the federal government, there may be increased taxes of some kind to pay for the cost of the economic stimulus. One possibility is a value-added tax (VAT), which is like a national sales tax, but it is regressive in nature and would likely be opposed by Democrats.
- Interest rates were already near historic lows, but the Federal Reserve Board’s efforts to bolster the economy have led to reductions that will produce, perhaps, the lowest rates in history for estate planning purposes.
- Valuations of securities have clearly been depressed. Although how long that will remain the case is uncertain, many economists think prices will be further depressed. This has also affected valuation of a wide range of businesses and other properties because of mandatory closures and quarantines, loss of wealth, and other factors. Consider how, in some jurisdictions, landlords will fare when rents are not paid and property owners cannot even begin foreclosures for non-payment. Thus, this is an opportune time to transfer assets out of any wealthy client’s estate.
The above combination represents a scenario that wealthy individuals should consider taking advantage of. Bear in mind, if the Democratic proposals of returning to a $1 million gift exemption and $3.5 million estate tax exemption are enacted, many more taxpayers will have estate tax issues than under current law.
Form or Re-form Grantor Trusts
Democrats have proposed changes that would include, in the settlor’s estate, assets held in a grantor trust at death (or would be subject to gift tax if grantor trust status ends during lifetime). While no one can with certainty predict whether or when this might be enacted, or what the effective date might be if it is, CPAs may wish to recommend proactive action now to address the risk.
Consider how grantor trust status might be “turned off.” First, each of the powers in the trust that caused the trust to be a grantor trust can be renounced. For example, if someone can make a loan to the settlor without adequate security, the trust will be a grantor trust. The trust agreement could give the person holding the loan power the right to renounce that power for herself and for any successor to the power. Similar rights, such as a power of substitution, should also be able to be renamed.
Second, someone can be granted the right to make any modifications necessary to turn off grantor trust status. For example, a trust protector, acting in a nonfiduciary capacity, may be granted the power to change the federal income tax status of a trust (i.e., to convert the trust into a nongrantor trust). These powers may include the power to prohibit the trustee from paying for life insurance premiums on the life of the grantor or of the grantor’s spouse on policies held in the trust, eliminating the right of any person to loan funds to the grantor without adequate security, the right of any person acting in a nonfiduciary capacity to add a charitable beneficiary, or the right of the grantor to swap or substitute assets in the trust.
If the spouse is a beneficiary, the trust will be a grantor trust. Removing the spouse, however, may not be an acceptable option, so consider adding a requirement that an adverse party must approve any distribution to the spouse.
Consider any negative tax consequences when contemplating turning off grantor trust status, including but not limited to the negative consequences of the loss of power to substitute for the loss of possible basis adjustments, the triggering of gain on negative basis property, or the tax consequences of a sale of assets to the trust by the grantor. It is especially important to keep in mind that if a grantor trust holds a “negative basis” asset (that is, one where debt is greater than remaining income tax basis), gain may be triggered if it becomes a non-grantor trust during the grantor’s lifetime (Revenue Ruling 77-402).
Alternatively, CPAs may want to recommend that clients swap assets out of the GRAT, which has no adverse tax consequences, and re-GRAT them immediately to take advantage of current low values and low interest rates.
GRATs in the Current Environment
GRATs (grantor retained annuity trusts, as described in Treasury Regulations section 25.2702-3) have been a popular planning tool for a long time. With a GRAT, the grantor creates a trust and gifts assets to that trust. The trust must pay an annuity back to the grantor that returns all of the principal of the gift and a specified rate of return. That annuity payment typically reduces the value of the gift to the GRAT to zero or near zero. Any appreciation of assets inside the trust above the required interest payment inherent in the GRAT calculation passes outside the grantor’s estate gift tax free. The application of GRATs in the current environment, however, might be different for several reasons. Those funded with marketable securities that were created in the very recent past may fail due to the dramatic decline in the value of securities. Similarly, GRATs created with business interests hurt by the economic downturn may fail. In these instances, CPAs may want to proactively recommend to clients that the plan is not a failure, but rather the assets merely need to be “re-GRATed” once distributed out of the GRAT as part of the next annuity payment. The grantor might consider selling his remaining annuity to the trust that is the remainder beneficiary of the GRAT (if so structured). Alternatively, CPAs may want to recommend that clients swap assets out of the GRAT, which has no adverse tax consequences, and re-GRAT them immediately to take advantage of current low values and low interest rates.
For individuals who have not used all of their gift and GST exemptions ($11.58 million in 2020), GRATs are not likely to be the optimal planning choice, as they are structured to use little of the current (historically high) exemption. Individuals should first plan to utilize their exemptions and only consider GRATs if they have significant remaining assets.
For clients who may still benefit from using GRATs, the currently low interest rates and stock market and other valuations potentially make transferring assets into a GRAT a valuable estate planning step. If, however, the Democrats gain the Presidency and Senate in the upcoming election, legislation may for all intents and purposes eliminate GRATs. Proposals by Senator Bernie Sanders (IVt.) and Congressman Jimmy Gomez (D-Calif.) have included a minimum taxable gift amount (25% of the value of the assets contributed to the trust) and minimum 10-year term, thus eliminating a common GRAT structure of a short (e.g., two-year) annuity term with a de minimis value of the remainder. The possibility of these restrictions on future GRATs may affect how CPAs might structure GRATs at this time.
A popular application of GRATs has been to use short-term, two-year GRATs and re-GRATing each annuity payment into a new GRAT. This serial or sequential application of GRATs has been called “rolling” or “cascading” GRATs. If new legislation restricts or eliminates GRATs, the opportunity to roll annuity payments into new GRATs might be lost. Therefore, in planning some (but not all) new GRATs, advisors might consider using longer-term GRATs so that, if the ability to re-GRAT is eliminated by future legislative changes, there may be leverage from the use of a longer GRAT to replace the loss of cascading.
Using longer GRATs—e.g., a ladder of six-, eight-, and ten-year GRATs—however, does present new planning challenges. Longer-term GRATs create greater risk that the grantor might die during the GRAT term, resulting in estate inclusion. In addition, different approaches may be necessary for longer-term GRATs in terms of locking in a large gain inside a GRAT, often referred to as “immunization.” If there is a large increase in the value of the asset inside a GRAT, the grantor might swap or buy that asset out for cash, and the GRAT would hold that new asset or cash until its term expires. This locks in the gain outside the client’s estate in case the value of the original asset declines. With a two-year GRAT, there is limited cost to holding cash in a GRAT for the remainder of the term; however, if a ten-year GRAT is immunized in year three, holding cash for seven more years is not likely to be palatable. Instead, more sophisticated asset allocation or hedging strategies will be necessary to permit some investment returns while limiting downside risk to retain the locked-in gain.
As an alternative to a single GRAT structure, CPAs may consider a series of GRATs, each holding a different asset class. Ideally, the dollars involved would be sufficient that each GRAT could hold a different asset class. Ordinarily, a single GRAT can be characterized as a “heads the taxpayer wins, tails the taxpayer does not lose” proposition. If a GRAT succeeds, the increase in value above the Internal Revenue Code (IRC) section 7520 rate is removed from the taxpayer’s estate; if it fails, the assets are merely returned to the taxpayer or her estate. Thus, if a single GRAT with a diversified portfolio is used, the winners and losers offset each other, which is not optimal as a GRAT planning technique. Especially with the incredible uncertainty in the current market environment, it may make sense for individuals to consider making GRATs more granular (e.g., one GRAT for each similar asset class) so that if different market segments recover at a different rate, the benefit will not be offset by money-losing GRAT investments. If, in contrast, a diversified portfolio is gifted to a GRAT, the winners offset the losers, reducing the potential benefits of the GRAT technique. If a single stock, however, is contributed to a GRAT, the winners will be bigger and the losers less consequential. When a GRAT fails as a result of the asset not appreciating, the asset is just returned to the grantor’s estate and little or no gift exemption will have been sacrificed.
If historic patterns of eventual market recovery hold true, a simple loan to an irrevocable trust that can be used to invest in equities at the depressed values may provide a valuable estate transfer technique.
There is another application of GRATs that may have an interesting application in the current environment: the very long–term GRAT. To understand the potential benefits of a very long–term GRAT, CPAs need to understand how the amount included in the decedent’s estate is determined when the individual dies before the end of the GRAT term. Many people incorrectly assume that the entire GRAT principal is included in the settlor’s estate when the settlor dies before the end of the GRAT term. In fact, the law requires taking the required periodic annuity payment and dividing it by the then-applicable IRC section 7520 rates on the date of death to determine the amount included in the decedent’s gross estate. If interest rates are substantially higher when the settlor dies than when the GRAT was created, an amount less than the full value of the GRAT will almost certainly be included in the grantor’s gross estate. With interest rates currently at near historic lows, it seems likely that interest rates will be substantially higher when the grantor dies.
If rates do substantially increase before the grantor dies, she can sell the remaining annuity payments for the amount determined in the calculation above. A very long–term GRAT thus can prove to be a winning estate transfer strategy even if the grantor dies during the GRAT term.
With historically low interest rates, a common and simple wealth transfer technique for an individual is to make a low interest loan to a trust, family member, or family entity, which can then invest the assets to seek a greater return. If historic patterns of eventual market recovery hold true, a simple loan to an irrevocable trust that can be used to invest in equities at the depressed values (or, perhaps, purchase real estate of business assets) may provide a valuable estate transfer technique. Of course, clients must understand the risk and uncertainties of market performance (Diana S.C. Zeydel, “Estate Planning in a Low Interest Rate Environment,” Estate Planning, July 2009). As all CPAs are aware, it is imperative that all the formalities of the loan be adhered to. Many individuals are often sloppy in their implementation and maintenance of family loan transactions.
CPAs should ensure that clients hire counsel to create and document a proper intrafamily loan, secure the loan if advisable and appropriate, be certain that the terms are arm’s-length in nature (other than the low interest rate permitted to be used), and appropriately delineate the parties to the loan transaction. The loan document should be in writing and signed by the parties. Interest should be paid ideally on a regular basis, although there are alternatives to consider. The transaction should be treated as a loan by both parties and reported as such on each party’s respective income tax return, as well as any books and records. If the loan is between the taxpayer and a grantor trust, however, no reporting for income tax purposes is necessary.
Refinancing Intrafamily Loans
The dramatic decline in interest rates provides an opportunity for practitioners to review prior transactions to determine whether or not notes can be renegotiated with a lower interest rate. This situation can arise in many family planning scenarios. If a large client sold a family business interest to a grantor trust using an installment note, it may be possible to reduce the interest rate on that note, resulting in greater value in the buying trust. Lowering the interest rate will also reduce the value of the lender’s estate. Refinancing an existing loan at a lower interest rate could be useful for cash flow planning and in certain transactions might reduce the negative income tax impact of interest payments that may not be deductible by the payor or may be taxable to the payee.
One might argue that a change in interest rate could be viewed as a gift in a family context, but there is a strong counterargument that this is not the case. If the loan does not prohibit pre-payment, the borrower can simply renegotiate with the lender on the basis of saying, “I will not repay this loan unless you agree to refinance at a lower rate.” According to other commentators, it may be feasible to renegotiate the terms of a note without triggering gift tax consequences, especially if the lender receives other benefits, such as a shortened payment term or additional collateral (Jonathan G. Blattmachr, Bridget J. Crawford, and Elisabeth O. Madden, “How Low Can You Go? Some Consequences of Substituting a Lower AFR Note for a Higher AFR Note,” Journal of Taxation, July 2008, https://bit.ly/2zw6guL).
The current, historically high GST exemption provides a planning opportunity for many individuals to make a late allocation of GST exemption to trusts to which GST was not allocated when the gifts were previously made.
Note Sales to IDGTs
A commonly used planning technique has been to create an “intentionally defective” grantor trust (IDGT) and sell assets to that trust. The reduction in asset values due to the current economic situation makes it an ideal time to transfer assets out of a wealthy client’s estate to an irrevocable trust. The historically high interest rates make the payments due on the installment notes almost nothing; this enhances the leverage in the value of the overall wealth shifting technique. Note sales are particularly important to consider because, as mentioned above, some proposals would effectively eliminate the use of grantor trusts for estate tax planning purposes; in addition, discounts may be eliminated, and there may be other restrictions enacted that will hinder or prevent this planning technique. While there is certainly no assurance that a transaction to sell assets to a grantor trust today will be grandfathered under future estate tax legislation, it may prove worthwhile to at least try to secure the benefits of this technique now. CPAs might caution clients, perhaps even in writing, that the effective date of future legislation cannot be known and may adversely affect any current planning and discuss the use of the exemption before a sale.
Late Allocation of GST Exemption
Many taxpayers will never use all of their GST exemption. Individuals often are fearful, given recent market and economic turmoil, of making any asset transfers. For some, this may be an opportune time to shore up and improve existing trust planning, even if no further transfers are made. The current, historically high GST exemption provides a planning opportunity for many individuals to make a late allocation of GST exemption to trusts to which GST was not allocated when the gifts were previously made. The effects of the recent stock market decline on assets held in the trust may also provide an opportunity to make those late allocations when the amount of GST exemption necessary to provide a trust with, for example, a zero-inclusion ratio is much lower.
Short Sale to Grantor Trust
With the current market volatility, there may be an opportunity for individuals to shift further value out of their estates into grantor trusts. Individuals may wish to consider making a short sale to a grantor trust that is structured as a completed gift trust and thus out of their estate. In such a sale, the individual sells shares of stock that it does not own to the grantor trust; if the stock goes down, the trust pays less for the share. This could be done in the other direction as well, for example, if the grantor trust believes a stock it holds will decline in value.
As mentioned at the beginning of this article, many individuals may feel financially vulnerable in the current environment, which may cause them to hesitate to act even in cases where their assets no longer benefit them. But there are arrangements that can alleviate such concerns, such as having two spouses create nonreciprocal trusts for each other, creating a domestic asset protection trust (DAPT) for the client in a jurisdiction (such as Alaska, Nevada, or one of 17 other states) that protects such trusts from claims of creditors of the grantor, creating a hybrid DAPT where the client is later added as a beneficiary, or creating a “special power of appointment trust.” (For more details, see Abigail O’Connor, Mitchell Gans, and Jonathan Blattmachr, “SPATs: A Flexible Asset Protection Alternative to DAPTS,” Estate Planning, February 2019.)
Many individuals may be shell-shocked by health fears and economic woes, but these times may prove to be an ideal and final chance for wealthy individuals to secure certain estate planning benefits. CPAs should be proactive in opening up a dialogue with their clients about the current opportunities.