Estate Planning Wealth Transfer in the COVID-19 Environment

We would like to take a moment to emphasize that the current, challenging circumstances perversely present estate planning wealth transfer opportunities. These opportunities result from historically low interest rates, coupled with reduced asset values.

In that regard, the IRS has just announced the Applicable Federal Rates for June, 2020. These are the interest rates that the IRS uses in determining whether the interest being charged is adequate. The newly announced rates are historically low.

This strategic example might be helpful.

The June 2020 rate issued by the IRS for the adequate interest rate to be charged on long term debt (more than 9 years) is 1.01% (that is, the long term Applicable Federal Rate). As such, a long term, interest only, loan could be made to a trust for the benefit of, e.g., one’s spouse and descendants. If the trust invests the loan proceeds at a return that exceeds the 1.01% interest rate, the excess will represent wealth that builds up in the trust for the benefit of the trust beneficiaries, without gift tax, estate tax or generation skipping tax implications. Further, if the trust is structured as a “grantor trust” for income tax purposes, the grantor will pay the income taxes on the income earned by the trust; thereby increasing the tax free accumulation of wealth in the trust while, simultaneously, reducing the grantor’s wealth that might ultimately be subjected to estate taxation.

Additionally, as the federal gift tax exemption is temporarily high - presently $11,580,000 per donor, scheduled to decrease by about 50% after 2025, or sooner depending on political developments – such a loan can become an easy and quick tool for making a gift that utilizes the higher exemption by a cancellation, in whole or in part, of the loan.

The loan proceeds could be invested by the trust in virtually any manner, including by purchasing assets from the grantor. Note that, if the trust is a “grantor trust” (which is disregarded for income tax purposes) such a purchase will not be a taxable event (but, will probably not allow for a tax basis “step-up” at death).

For Example:

Presume that dad is the owner of a business that was worth $50 million prior to the current pandemic. Further presume that, as a result of the economic downturn and uncertainty caused by the pandemic, the business is currently worth $40 million. Dad could loan $10 million to a grantor trust for the benefit of his spouse and descendants, to be repaid in 20 years with interest compounded at 1.01% annually. The trust could use the proceeds to purchase a non-controlling interest in the business (in order for the loan to be respected as bona fide debt, the trust should have some additional capital, which could be gifted to the trust). Presuming that a valuation discount of 37.5% applies for a non-controlling interest, the $10 million could purchase a 40% interest in the business. Further presuming that the reduction in the value of the business is temporary, dad will have effectively removed $10 million from his estate ($20 million in the value of the business in exchange for $10 million in a loan receivable) plus 40% of the future growth in value of the business, plus the cost of income taxes on the share of the income attributable to the trusts share of the business, less the 1.01% annual interest on the loan. If there are no earlier payments, at the end of 20 years, the amount to be repaid on the loan is $12,226,085.32. If, e.g., the trust earns 6% per year (in income and growth), income tax free (as dad is paying the income taxes), on the unreduced and undiscounted value of its 40% interest in the business, the trust would have $64,142,709.44 before its repayment of the loan, and $51,916,624.12 after repayment of the loan – all of which will be free from gift, estate and generation skipping taxes. If the growth of the trust is only 4% per year (income and growth), the trust will still have $43,822,462,86 before repayment of the loan and $31,596,377.54 net of repayment of the loan.

The above is but one example of wealth transfer planning that may be particularly effective in the current environment. There is no way of knowing how long this window of opportunity will last (and, of course, there is no way of confidently predicting future events).  To further discussing wealth transfer planning please contact either Judson M. Stein, Partner and Chair of the Trusts, Estates & Wealth Management Practice Group, via email or Lauren P. Nakachi, Associate in the Trusts, Estates and Wealth Management Practice Group via email or call our office at 973.533.0777.