Private Client

Action Item: This is the second installment of our Annual Estate Planning Newsletter, and focuses on specific gift and generation-skipping transfer ("GST") tax matters. We urge you to review this installment to ensure that your 2016 estate and tax planning is in order.

1. Annual Gift Program. A lifetime gift-giving program could reduce overall transfer tax costs considerably. By receiving lifetime gifts, donees will benefit from all future appreciation of and income generated by the transferred property free of transfer taxes. This year, every individual may transfer cash or other property worth $14,000 (or $28,000 for married couples) to each of as many donees as the donor selects without incurring any gift or later estate tax. An inflation adjustment applies when that adjustment would increase the annual exclusion amount by $1,000 (e.g., to $14,000 in 2013). Donors may make these gifts (known as "annual exclusion" gifts) outright or via custodianships or trusts, although careful planning is needed if trusts are to be used. For example, it is very important to assure that any trust for a grandchild contains special provisions so that gifts made to that trust are exempt from the GST tax (discussed in paragraph 3 below). In addition, no gift taxes are imposed if you pay a donee's tuition or medical expenses (payments must be made directly to the school or health care provider), and you may prepay tuition under certain circumstances.
   
   Even if a gift is not "tax-free" as described above, if your aggregate gifts do not exceed the $5,450,000 lifetime gift tax exemption amount (or $10,900,000 for married couples), no gift tax will be payable at the time of the gift. Taxable gifts in excess of the $5,450,000 lifetime exemption will accelerate transfer tax payment, but an overall tax savings may result because your gift tax dollars generally will not be subject to estate taxes at death. Paying gift taxes now, however, may result in an unnecessary tax payment if estate taxes would not be payable at death under new legislation; the possibility of estate tax repeal should be considered. Certain valuation advantages (such as "minority" discounts) that might be unavailable at death often are possible under current law in connection with lifetime gifts. Finally, the relatively low interest rates still in effect make this a very good time to loan funds to younger generations, and may make certain types of gifts via trust particularly attractive as described in paragraph 2 below.
2. Low Interest Rate Gift Planning. While you still have all of 2016 to take advantage of increased annual exclusion gifts ($14,000 per donee) and the increased lifetime gift tax exemption (now $5,450,000 per taxpayer), we recommend that you not wait too long to take advantage of the current low interest rate gift opportunities for a number of reasons, including the advantage that once a gift is made, any future appreciation of the transferred property and any future income generated thereby will escape transfer taxes.
   
   In addition, future legislation could limit your gift planning opportunities. Proposed changes that have been discussed in the past and that are likely to be discussed again include (i) eliminating "discounts" for closely-held business and real estate interests; (ii) prohibiting short-term (e.g., two-year) Grantor Retained Annuity Trusts ("GRATs"); and (iii) limiting the benefits of "defective grantor trusts" and long-term "dynasty" trusts. None of these changes were enacted in the recent legislation, but for those in a position to do so, we strongly recommend that you take advantage of your gift tax planning opportunities sooner rather than later, after considering the impact of your gifts on your donees.
   
   Low Interest Rates
   On or about the 20th of each month, the Internal Revenue Service issues its "Applicable Federal Rates" ("AFRs") that are applicable for many federal income tax purposes for the following month. These minimum interest rates are a key component in many estate planning strategies, and lower rates provide significant opportunities to shift wealth to junior generations. The AFRs for January and February 2016 are very low (even after the Federal Open Market Committee raised interest rates for the first time since 2006): the February rate for a loan of less than three years ("short-term") is a mere 0.81%; the rate for a loan of between three and ten years ("mid-term")is only 1.82%; and the rate for a loan of ten or more years ("long- term") is 2.62%.
   
   The rates for short-term and mid-term loans may rise significantly later this year. You therefore may wish to take one or more of the following opportunities now:
   Transfers to GRATs
   By way of brief background, a GRAT is another statutorily sanctioned type of trust (similar to a CLAT) whereby you (the "grantor") transfer property to the trust but retain the right to receive specified payments (annuity) from the trust for a specified number of years, after which the GRAT property is distributed to your donees. The payments are often structured so that, after accounting for the 7520 Rate of return on the property transferred into the GRAT, the present value of the payments you are to receive will equal the value of the property you transferred into the GRAT. When the annuity payments are structured in this manner, the GRAT is often said to be "zeroed- out" because your donees' remainder interest has no value for gift tax purposes; thus, no gift tax is payable and no gift tax exemption is used in connection with your funding of the GRAT. To the extent that the investment return on the GRAT property exceeds the 7520 Rate, value will remain in the GRAT after all annuity payments are made, thereby effecting a tax-free gift of the excess return (provided you survive the GRAT term). Accordingly, to the extent that the investment return of a GRAT established in January or February exceeds 2.2%, there will be a tax-free transfer of assets to the ultimate beneficiaries of the GRAT (typically your children).
   
   Intra-Family Loans
   As a result of the historically low interest rates, it's also a good time to loan money to younger family members. As noted above, the minimum interest rate in February for a loan of up to three years is 0.81%, and loans between three and ten years carry a minimum interest rate of only 1.82%. To the extent that the loan recipients are able to invest the borrowed funds and generate a return greater than the minimum interest rate, wealth will have been successfully transferred without any gift tax.
   
   For example, if a loan of $1,000,000 were made for three years at 0.75%, and if the borrower invests that $1,000,000 in an investment earning 5% after taxes, the excess after three years of $127,500 will have been transferred to the borrower free of gift tax.
   
   Finally, if you currently hold an outstanding promissory note that has an interest rate significantly higher than current interest rates, you can refinance that note now to generate additional cash for your donee and reduce your taxable income.
   
   "Defective" Grantor Trusts
   Instead of making loans or gifts directly to family members, a more effective option is to make loans or gifts to a "defective grantor trust" for their benefit. A "defective grantor trust" is a type of trust in which all income is taxable to you individually, even though that income inures solely to the benefit of the trust beneficiaries. This in effect permits additional "gifts" to the beneficiaries (in an amount equal to the income tax) without your being considered to have made any further taxable gifts.
   
   Similarly, it may also be appropriate to sell assets to a "defective grantor trust" in exchange for a promissory note. No taxable gain is recognized by reason of that sale, and no taxable income is recognized by reason of your interest receipts. If the assets that are sold to the trust generate income or appreciate at a rate that exceeds the currently low minimum interest rate, wealth will inure to the benefit of the next generation without the imposition of gift tax.
   
   Possible Disadvantages
   Once you make a gift, you of course lose access to that property. You should not give away property if you may need it someday, although you should be able to borrow funds from the gift trusts that you have established. If paying additional income taxes by reason of a "defective" grantor trust later becomes burdensome, you can release the "defective" feature to eliminate the imposition of future income taxes.
   
   The recipient's income tax basis in property received by gift generally is the donor's basis; thus, gifts of high-basis property are more tax-efficient. If you have created a "defective grantor trust" with low basis assets, you later can exchange cash or higher basis assets tax-free for the low basis asset originally given to that trust. The IRS intends to provide guidance to determine whether the basis of an asset in a "defective grantor trust" is adjusted to fair market value at the donor's death, even though those assets are not subject to estate tax.
   
   Finally, if the property loses value after the gift, you will have used more exemption by making the gift than would be used at your death
   1. establish a GRAT;
   2. make "intra-family" loans to your children or grandchildren, or to trusts for their benefit;
   3. "refinance" existing intra-family loans that bear higher interest rates; and
   4. if you have philanthropic goals, consider the following:
      
      (A) Estate tax savings. A charitable lead annuity trust ("CLAT") is a statutorily sanctioned trust that lasts for a specified number of years and provides for specified amounts to be distributed each year to charity during the CLAT term. Any growth in the CLAT assets in excess of the IRS specified rate (the "7520 Rate," which is 2.2% for January and February) passes to the non- charitable remainder beneficiaries (e.g., your children) at termination of the CLAT, free of gift or estate tax; and
      
      (B) Income tax savings. A gift to charity of a "remainder interest" in a personal residence or farm produces better results with lower interest rates. Because your retained use of the realty is equivalent to a retained income stream, the lower the interest rate, the less your retained interest is deemed to be worth (and correspondingly, the more your charitable gift is worth), so your charitable contribution deduction is greater. For example, a donor age 70 who contributes the "remainder interest" in a $1,000,000 residence not subject to a mortgage to charity in January or February (2.2% 7520 Rate) will be entitled to an income tax deduction of approximately $700,000 (rather than $450,000 at a 6% 7520 Rate).
3. GST Tax. The GST tax generally imposes an additional transfer tax (at the 40% estate tax rate) on property transferred to grandchildren and other younger beneficiaries by lifetime gift or at death, and whether outright or via trust. Certain techniques are available to avoid or substantially reduce this GST tax. One technique involves making "tax-free" gifts as described in paragraph 1 above via an "annual exclusion" gift program to grandchildren (either outright or via trust) and by paying a grandchild's tuition and medical expenses (remember, direct payments to the school or health care provider are required). Another technique involves use of your lifetime GST exemption to establish a "dynasty" trust (which can invest in life insurance policies or other property) to enable a substantial amount of property to pass to grandchildren, great-grandchildren, and later generations free of any estate or GST tax. The GST exemption for 2016 is the same as the unified $5,450,000 estate and gift tax exemptions. Whereas use of the gift and estate tax "exemptions" is automatic, use of the GST exemption is elective. In view of the voluntary GST exemption allocation rules, we generally recommend that clients who make gifts to trusts from which a grandchild or other younger beneficiary may receive distributions file gift tax returns (even if not required) in order to specifically elect whether to allocate or not allocate GST exemption to those trusts.
4. Regulatory Notice. We are providing this letter and the enclosure as a commentary on current legal issues as a service to our clients and friends; neither should be considered legal advice, which depends on the unique facts of each situation. Receipt of this letter and the enclosure does not establish an attorney-client relationship.