Overview
Appreciation and Inflation: Appreciation and inflation will increase estate taxes upon death. As mentioned earlier, any estate-reducing program is more effective if it includes techniques to shift appreciation and income to a person's intended beneficiaries.
Estate "Freezing": For years, estate planning professionals have developed and implemented estate "freezing" techniques so that the estate tax problem would not get worse. Many of the freezing techniques involved creative structuring of family-owned business entities so that the increasing value of a growing business would shift to the next generation. Some of those techniques were perceived as abusive by the IRS, which persuaded Congress to adopt "anti-freeze" legislation that made the freezing techniques ineffectual. In spite of that, there are still some effective techniques that can be used to shift appreciation and to "freeze" the value of an asset for estate-tax purposes.
Techniques Involving Asset Sales
Installment Sales: By selling an asset to family members on an installment basis, the potential appreciation on the asset is shifted to the family members. This works only if the purchase price is "full and adequate consideration" and the arrangement is properly documented in order to create a legally enforceable obligation. Upon the death of the payee, the unpaid balance of the note is included in his or her taxable estate for estate tax purposes, but the asset that was sold is out of the estate, including its appreciated value. The installment note can be secured by the property sold.
Death Terminating Notes*: Another version of the installment sale employs the use of promissory notes that, by their express terms, expire upon the death of the payee. This type of promissory note has the same advantages as any installment note (including the ability to require security), but in addition to shifting appreciation, the unpaid balance of the note is reduced to zero at death, and there is nothing included in the payee's estate at death. As with any installment note, the purchase price must reflect "full and adequate consideration", but that also means the value of the note must exceed the value of the property being sold. Because the note may expire before the payee receives payments equal to the note's face amount, an additional "premium" must be paid for that feature so that the value of the note is considered adequate to pay for the property. Determining the amount of the "premium" for the death-termination aspect is the primary drawback to this technique. A qualified expert is strongly recommended to make that determination.
*Note: "Death terminating notes" are more often called "self-cancelling installment notes" or "SCINs". The "cancellation" of a debt can have adverse income-tax consequences, so some commentators are advising against the use of that term in the promissory note. This is another example of where form becomes more important than substance, but that is frequently the case when dealing with the federal tax laws.
Private Annuities: A private annuity is a contract that provides for specified payments to the named annuitant during the annuitant's lifetime. This is similar to the death-terminating promissory note, but under a private annuity, the payments never cease so long as the annuitant is alive, even if the annuitant outlives his or her life expectancy. The primary advantage of the private annuity is the fact that the annuity amount can be determined from the IRS valuation tables, eliminating the guess work as to the amount of the periodic payments to be made. Unlike promissory notes used with installment sales, private annuities cannot be secured, putting the annuitant at risk that the payor may become bankrupt.
Retained-Interest Gifts
Grantor Retained Interest Trusts: Most people would like to "have their cake and eat it, too." If possible, people would retain all control and all benefits from an asset up to their death and then have the value of the asset disappear for estate-tax purposes. Unfortunately, federal gift and estate tax laws do not permit this. The general rule is this: "If you give away the tree, you cannot keep the fruit." If you give away only part of the tree, you can keep the fruit only from the part you retain.
Over the years, various trusts (or trust-like arrangements) been devised that allow the grantor of the trust to retain benefits for a specified period of years so that the present value of the gift of the to children is reduced according to the IRS' own valuation tables. The longer the retained-interest period, the lower the value of the remainder interest is. These trusts used to be called "grantor retained income trusts" or "GRITs". Congress has now limited the use of these techniques to a very few specific types of trusts, which I will call "grantor retained interest trusts" (so that we can still talk about them as "GRITs").
If the grantor of a retained-interest trust dies before his or her benefits are terminated under the trust's terms, the asset is subject to estate taxes in his or her estate (and any gift tax paid is credited toward the estate tax). On the other hand, if the grantor outlives his or benefits under the trust, the trust's assets are excluded, and the only transfer-tax cost is the gift tax paid (or the applicable exclusion applied) on the original value of the remainder interest.
While a GRIT can save transfer taxes, there is at least one disadvantage: the lost of the stepped-up basis for income tax purposes. Assets included in a decedent's estate for estate-tax purpose will (under current law) receive a "stepped up" income tax basis equal to the fair market value of the assets at the time of the decedent's death. In other words, all potential capital gain is reduced to zero. If a retained-interest trust is successful, the asset will not be included in the grantor's estate at the time of the grantor's death, so there will be no stepped-up income tax basis; the recipient will have the grantor's original cost basis.
Qualified Personal Residence Trusts (QPRTs)*: A "qualified personal residence trust" or QPRT is a type of GRIT that is still permitted under federal law. A grantor can transfer his or her primary residence or even a qualifying vacation home to the trustee of a QPRT that allows the grantor to reside in the home for a designated period of time. At the end of the designated period, the property passes to designated remainder beneficiaries.
The gift to the trust's remainder beneficiaries is subject to the federal gift tax, but the value of the gift is the present value of the remainder interest, which is determined under the IRS tables after taking into consideration the term of the grantor's retained interest, the grantor's age, and the applicable interest rate published by the IRS monthly.
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If a home worth $500,000 is transferred into a 10-year QPRT, and the remainder interest is valued at 60% of the home’s value, the taxable gift is $300,000. If the grantor survives the term and the home is excluded from the estate, the $200,000 difference could reduce federal transfer tax by $80,000 at the 40% top rate, before accounting for appreciation or other factors.
If the grantor dies before the retained-interest expires, the home is subject to estate taxes, but since any gift taxes paid are credited back, there is no true penalty. The cost of this gamble is the cost of creating and administering the trust.
One psychological drawback to QPRTs is the fact that the grantor no longer has the right to reside in the residence at the end of the term of the grantor's retained interest. In order to remain in the home, the grantor must make fair-market rental payment (according to an agreement negotiated after the term has expired). Of course, the rent paid by the grantor is another good way to make an estate-reducing transfer to the trust's beneficiaries. [The IRS regulations currently prohibit the grantor from purchasing the home before the expiration of the retained-interest term.]
There are a number of technical rules for QPRTs. For example, there are rules governing the possibility that a residence might be sold and a substitute residence purchased. If a substitute residence is not purchased within a specified time limit, the trust must become a grantor retained annuity trust (which is discussed below).
A QPRT can be designed so that at the end of the grantor's term, the residence is transferred to an existing irrevocable life insurance trust (ILIT). When the grantor pays rent to remain in the home, that rent can be used to pay the premiums on the trust-owned life insurance policy or policies. If the ILIT is a grantor trust for federal income-tax purposes, receiving rent will not trigger an income tax.
Grantor Retained Annuity Trusts (GRATs)*: Grantor retained annuity trusts (GRATs) are similar in structure to charitable remainder annuity trusts. GRATs permit the gift of remainder interests that are discounted for gift-tax purposes under the IRS valuation tables. While longer terms produce lower remainder values, even short-term GRATs can produce significant transfer-tax savings. (NOTE: Grantor retained unitrusts (GRUTs) are similar in structure to charitable remainder unitrusts. GRUTs are similar to GRATs in their general purpose, but GRUTs are not considered as effective as GRATs where the trust's assets are expected to appreciate.)
*To download a memo (.pdf) on QPRTs and GRATs, click here.