The Perfect Storm Exists for Estate Planning: Low Interest Rates & Depressed Values
By Ed Townsend, CPA
Given today’s valuation environment, interest rates and available tax planning techniques, many tax planners have described this time period as “The Perfect Storm” to make family transfers. With the scheduled repeal of estate and generation-skipping taxes in January 2010, every business owner or wealthy investor should review their estate planning while opportunities still exist. Summarized below are some estate planning concepts that are currently available today.
Whether transferring closely-held business interest or investment assets to family members, current rules favor the use of flow-thru entities such as limited liability corporations (“LLCs”) or Subchapter-S Corporations, (“S-Corp”), coupled with transfers to a grantor trust.
Grantor trusts are used due to the significantly different tax treatment they receive under our income tax and gift tax rules. For income tax purposes, the grantor of the grantor trust is the deemed owner of the trust assets so he continues to report the income from S-Corp stock or LLC units, even though the stock or units are owned by the trust. However, the transfer is a completed transfer for gift tax purposes.
When LLC units or S-Corp stock is transferred to a grantor trust in exchange for an annuity for a fixed period of years, (such as in a GRAT transaction), the normal income tax rules for an exchange of assets for an annuity are ignored and the grantor continues to pay income tax on the LLC or S-Corp income as if he never transferred ownership to the grantor trust. However, for gift tax purposes, the transfer is complete and the grantor has made a gift to a family member for the difference between the present value of the annuity payments to be received over the value of assets transferred by the grantor to the grantor trust.
Given today’s lower asset values and the historic low interest rates a zero out (no gift) GRAT is not unusual. An important factor in achieving these results is that an LLC or S-Corp is not subject to income tax and the income tax on the LLC or S-Corp income is paid by the shareholder/grantor. Thus, tax distribution to the grantor trust that would normally be used to pay income taxes by the shareholders can be used by the grantor trust to pay the trust annuity payments and the grantor can then use the annuity payments to pay the tax on the LLC or S-Corp income on the assets owned by the trust.
The same basic rules summarized above apply to the installment sale of S-Corp stock or LLC units to a grantor trust. For income tax purposes, no sale has incurred but for gift tax purposes the sale is recognized and any difference between the value of the stock or units sold and the sales price would result in a gift.
An advantage common to both GRAT and sale transaction is that the grantor can retain control by transferring only non-voting S-Corp stock or LLC units. Even if the IRS challenges the valuation of assets transferred to a zero-out (no gift) GRAT, no taxable gift can occur, (only a change in the annuity amount). However, if the assets were sold to a grantor trust, a taxable gift may occur if the IRS is successful in increasing the value of the property sold. Finally, the most significant disadvantage of a GRAT is that the grantor must survive the GRAT term or the transferred assets are included in the grantors estate.
In summary, given today’s valuation environment, interest rates and available tax planning techniques, many tax planners have described today’s time period as, “The Perfect Storm” to make family transfers. But the time may be short as the new administration will make changes to our current estate and gift system that could eliminate or restrict many current tax planning techniques.
For additional information, contact Edward Townsend, Tax Partner at etownsend@wiss.com or 973-994-9400.
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