Rader and Coleman, P.L.

by Stuart A. Rader, Esq. © October 2008
Rader & Coleman Attorneys at Law
2101 NW Boca Raton Boulevard
Boca Raton , Florida 33431
561.368.0545

www. raderandcoleman.com

Down Economy Presents Great Opportunity for Lifetime Estate Planning Transfers

The recent fiasco in the financial and credit markets have resulted in substantially reduced values of investor’s securities portfolios. In October 2008, the Dow Jones Industrials was down over 35% from its high level in October 2007.

There is a silver lining, however, from an estate planning perspective. The depressed economy coupled with low interest rates, presents unique opportunity for high net worth individuals to transfer marketable securities at low values to children and grandchildren. This would allow future growth and appreciation to potentially reduce significantly estate or gift taxes. Instead of focusing on the decreased value of the investment portfolio, the economic conditions present an opportunity to update your estate plan, taking advantage of low interest rates and allowing the future anticipated appreciation to inure to your family’s benefit on an estate and gift tax-free basis.

There are several different techniques available to make present transfers of depressed assets to family members. These techniques include:

• Outright Gifts
• Intra-Family Loans
• Intra-Family Sales
• Sales to Defective Grantor Trusts
• Grantor Retained Annuity Trusts

Estate and Gift Tax Overview. In order to understand these techniques, a brief overview of estate and gift tax principles is required.

· Estate Tax Exemption. The exemption from estate taxes is currently $2 million and increases to $3.5 million in 2009. In absence of future changes in the law, in 2010, there is no estate tax, and in 2011, the estate tax exemption returns to $1 million.

· Gift Tax Exemption. There is a $1 million gift tax exemption on lifetime taxable gifts. Lifetime use of exemption on taxable gifts reduces the estate tax exemption available at death.

· Annual Gift Tax Exclusion. In addition, there is an annual gift tax exclusion of $12,000 per person per donee. This applies to gifts of present interests (as opposed to future interests) and increases to $13,000 in 2009.

· Estate and Gift Tax Rate. The current maximum estate and gift tax rate is 45% and it increases to 55% in 2011 unless the law is changed.

· Basis Rules. Generally, the gift recipient’s basis for a gift is the donor’s cost. This is important for future capital gain reporting purposes. In contrast, the recipient of transfer from a decedent or an estate (for most assets) receives a basis equal to the fair market value at date of death or 6 months thereafter, if elected. The recipient of a gifted or inherited capital asset generally receives a long term capital gain asset. The current capital gain rate is 15% and this is scheduled to increase to 20% in 2011.

· Transfer Taxes. Transfer Taxes refers to estate or gift taxes.

Examples of Techniques.

• Outright Gift. Making an outright gift is the most basic lifetime wealth transfer techniques.

Example. Father (“Dad”) has a net worth of $5 million and had not used any portion of his $1 million gift tax exemption. On October 15, 2008, Dad transfers to his only child (“Son”) 20,000 shares of a growth oriented mutual fund (“Fund”) currently trading at $25 per share. (Six months ago, the Fund was trading at $50 per share). Dad files a gift tax return and reports: a gross gift of $500,000 (20,000 shares of Fund at $25 per share), reduced by the $12,000 annual gift tax exclusion, for a reportable gift of $488,000; no prior taxable gifts, so no gift tax is due; and a $700,000 cost basis for the 20,000 shares of Fund. The gift tax return reduces Dad’s lifetime remaining gift tax exemption to $512,000. Son sells the 20,000 Fund shares on January 15, 2011 when Fund is selling at $45 per share. Son receives $900,000 in proceeds. He recognizes a $200,000 capital gain resulting in $40,000 capital gains tax. (20% x [$900,000 amount realized minus the $700,000 transfer basis]). Dad dies on January 16, 2011.

This outright gift to Son eliminated from Dad’s estate $400,000 in Fund appreciation between October 15, 2008 and January 15, 2011 ($900,000 sale price - $500,000 value at the time of gift). The estate tax savings on $400,000 appreciation is $180,000 at the 45% rate and $220,000 at the 55% rate.

• Intra-Family Loan. Making loans to a family member is another attractive tool in this economy. The Applicable Federal Rate (“AFR”) is a safe harbor interest rate published monthly by the IRS to avoid unintended gift loan treatment of below market loans between related parties. The current AFR is very low. The rates for November 2008 loans paid annually are:

Example. Evan Greedy (“Greedy”) is 29 years old and until recently was a Wall Street mortgage backed securities trader for a company that recently filed for bankruptcy. He is currently unemployed. He earned over $3 million in salary and bonus in 2007. He bought a $4 million cooperative apartment overlooking Central Park with a mortgage of $3.5 million with an adjustable interest rate that increased to 8% last month. The apartment’s current fair market value is under $3 million. Greedy cannot make the mortgage payments and asks his grandmother (“Grandma”) for assistance. Grandma’s municipal bond portfolio decreased in value from $30 million to $23 million (in part, because, she traded a portion of her portfolio with Greedy), but she is a widow, leads a modest lifestyle, and loves Greedy unconditionally. She wants to help Greedy with his current financial crisis, but does not want to give him an outright gift to satisfy the mortgage that results in her (a) using her entire $1.0 million lifetime exemption and (b) paying over $1.1 million in gift taxes (the gift tax on $3.5 million after using the $1 million gift tax exemption). Instead, Grandma offers Greedy a loan that re-finances his existing loan upon very favorable terms: A three year $3.5 million loan at a fixed 1.63% interest rate, paid annually; the principal due at the end of the 3 year period; and no pre-payment penalty. Greedy can afford the annual interest payment of $57,050 on the loan from Grandma, but he cannot afford the $280,000 annual interest expense at the 8% rate on the initial mortgage. Hopefully, before Grandma’s loan is payable in full, the economy will improve and Greedy can sell the co-op at a price greater than the mortgage balance.

Since the transaction is structured as a loan, Grandma preserves her entire gift tax exemption or her estate tax exemption. The technique allows Grandma to assist Greedy, but without reducing the exemption available to her estate and other beneficiaries that include other grandchildren who she loves unconditionally.

Intra-Family Sale. The Intra-Family Sale involves the transfer of assets from one family member to another with a low interest loan provided by the seller senior family member.

Example. Using the same fact pattern in the Outright Gift example, instead of gifting the 20,000 Fund shares trading at $25 per share for a total of $500,000 to Son, Dad sold them to Son for $500,000, with a $12,000 down payment and 15 year installment note for $488,000. The primary terms of the unsecured installment note are: fixed interest at the AFR 4.29% (since the loan is longer than nine years); interest paid annually; and no prepayment penalty. Dad does not have to file a gift tax return reporting the $500,000 transfer so his gift tax and estate tax exemption are not reduced. If the Fund outperforms the 4.29% interest rate, there is a tax-free transfer of wealth. When Son sells the Fund for $900,000 on January 15, 2011, there is a pre-income tax gain of $400,000 or 80%, which significantly outperformed the 4.29% interest rate. Son deposits the proceeds into his personal bank account. He will need to keep a cash reserve of $40,000 to pay the capital gains tax (20% tax on $200,000 gain). He is not required to pay off the installment loan upon the sale of the Fund, as it is an unsecured installment note with 12 years remaining until maturity. After Dad’s death, on January 16, 2011, Dad’s estate tax has an unreduced estate tax exemption and owns a note receivable with a balance of $488,000.

The advantages of the Intra-Family Sale over the Outright Gift are that: Dad is not required to file a gift tax return; he does not have to reduce his lifetime gift tax exemption; and his estate may be entitled to a 10-15% discount on the principal value of the note because it is not investment grade and for an interest rate that is below market rates.

Sale to Defective Grantor Trust. The sale to a Defective Grantor Trust is variation on the Intra-Family Sale. A Defective Grantor Trust (“DGT”) is a trust that holds assets that are completed gifts to the DGT for gift tax purposes, but incomplete for income tax purposes because of certain powers the Grantor retains, such as the power in a non-fiduciary capacity to substitute property of equivalent value.

Example. Assume the same facts as the Intra-Family Sale, except that:

• Instead of the Son being purchaser, Son as Trustee of a DGT for the benefit of Son is the purchaser.
• Dad initially funds the DGT with $12,000 (in a way that qualified for the annual gift tax exclusion) and then sells the 20,000 shares of Fund worth $500,000 to the DGT in consideration for $12,000 in cash and a 15 year installment note for $488,000 on the same terms as the Note in the Intra-Family Sale Example.

The advantages of the Sale to the DGT over the Intra-Family Sale are:

• The assets of the DGT are protected from the claims of any of Son’s creditors, including a spouse in a divorce; and

• During Dad’s lifetime, he remains responsible for the payment of all income taxes for the DGT’s assets owned , including:

• The dividends on Fund DGT receives during his lifetime;
• The capital gain of $200,000 incurred one day prior to Dad’s death. (Dad’s estate is responsible to pay the capital gains tax liability on his final personal income tax return, which will be an estate tax deduction on Dad’s estate tax return); and

• Dad’s payment of the income taxes is essentially a tax free gift that allows the DGT assets to compound without any income tax liability; therefore, $400,000 is transferred transfer tax free and is not reduced by the $40,000 capital gain tax liability that Son incurs under the Intra-Family Sale).

Grantor Retained Annuity Trust (“GRAT”). The GRAT is another interest rate sensitive tool that works best in a low interest rate environment when funded with assets likely to appreciate in the future. The interest or discount rate applicable to GRATs in November 2008 is 3.6%.

Example. Dad transfers the 20,000 shares of Fund on November 1, 2008 with a market value of $25 per share. He elects a three year term paying an annuity of 35.76154% per year. The annuity to Dad may be paid in-kind with Fund shares. Son is the sole remainder beneficiary of the GRAT and at the end of the three year term receives the remaining GRAT property. There is a minimal gift upon creation. Dad survives until November 15, 2011. The Fund is worth $900,000 on November 1, 2011. The GRAT is a grantor trust so Dad pays all of the income tax consequences during the three year term. The remainder is $323,845.36 and it passes to Son transfer tax free. The GRAT is summarized as follows:

If Dad had died during the 3 year term, the transaction fails and the 20,000 shares of Fund are included in Dad’s taxable estate at the $900,000 value.

Comparison. The different techniques described in this article are compared below.

Conclusion. These examples demonstrate that there are powerful estate planning opportunities in this economy. The combination of the depressed marketable securities values and low interest rates provide individuals with a choice of techniques to transfer wealth and future appreciation to the next generation(s) in a tax efficient manner. Individuals and families with estates that are likely to be subject to significant estate tax in the future, that concentrate their attention on using one or more of the lifetime estate planning techniques discussed will likely save their families significant future estate taxes.