advisors often miss obvious opportunities because they are focused only
on immediate liquidity. If the prospect has little in the way of
investable assets but has significant wealth tied up in real estate, a
closely held business or other illiquid assets, the advisor often makes
a note of future potential business and moves on to other, more liquid
prospects. When the financial advisor pursues the prospect after the
liquidity event has occurred, he or she is often surprised to find that
countless other financial advisors have discovered the prospect's
newfound wealth, and now a full-scale beauty pageant is being conducted
for even the smallest piece of business.
A more intelligent way to approach the prospect is for the financial advisor to focus on assisting and advising the illiquid prospect before and during the liquidity-triggering event, and thereby transform from a product purveyor into a trusted financial counselor. By demonstrating knowledge of transfer tax and income tax issues, and understanding the tools that are available to a wealthy but illiquid client to arrange his affairs in an optimal fashion, the financial advisor will have an inside track to invest the client's newfound liquid wealth.
The Estate Freeze Concept
One highly successful technique is to "freeze" the value of an asset before the appreciation is triggered through a sale, IPO or other disposition event. By transferring assets prior to the liquidity event, the client is effectively freezing the value of the asset at its current, low fair market value and gifting the future appreciation out of his or her estate. This also is a key strategy when an older family member wishes to transfer a family enterprise to a younger family member at the lowest possible transfer cost. Sometimes a "down year" in the family business provides a terrific opportunity to transfer the business.
Freeze planning is perfect for the client who is interested in preserving and maximizing wealth for the family and is willing to have less personal wealth. This philosophy requires the client to recognize the confiscatory impact and inevitability of transfer tax (i.e. gift, estate and generation-skipping transfer taxes). The federal estate tax rate is a flat 45% of every dollar above the $2 million exemption applicable to transfers to nonspousal beneficiaries. In states that have retained an estate tax, the combined state and federal rates approach or exceed 50%. Very often clients are transferring some portion of an asset that, when appreciated, would create a level of wealth that is simply not required to maintain the client's desired lifestyle. Put simply, this is planning for financially successful and secure people.
In addition to the obvious advantage of tax minimization, freeze planning also can provide the children, grandchildren and other intended beneficiaries with significant creditor protection by utilizing trusts that are drafted with the proper distribution standards, and to provide an opportunity to pass assets through generations without the imposition of any transfer or estate taxes by proper use of the generation-skipping transfer tax exemption.
What type of assets work best with freeze planning? Closely held businesses that someday may be sold or brought public, a diversified real estate portfolio, hedge fund, private equity or partnership interests (including family partnerships created to accomplish other family goals and incorporated into the family's freeze plan) or any asset that will appreciate significantly in the future are all candidates for freeze planning. A steady cash flow or a near-term liquidity event are both excellent indicators of success with this technique.
A number of techniques are available to freeze assets and shift future appreciation tax free to younger family members or other beneficiaries. Grantor retained annuity trusts (GRATs), grantor retained unitrusts (GRUTs) and various types of partnership freezes are all useful freeze techniques that work well in certain situations. A number of excellent techniques, including charitable lead trusts, accomplish the same goal but provide an immediate benefit to a public charity or the client's own private foundation.
Gift/Sale To A Grantor Trust
The freeze technique that is most effective in the majority of situations, eliminates mortality risk, creates a multigenerational structure and preserves planning flexibility is a gift/sale to a grantor trust.
let's pause a moment to discuss some basics. A grantor trust is a trust
that is treated as if the grantor owns all of its assets, so for income
tax purposes it is indistinct from its grantor. The person who sets up
a grantor trust must report all the income and deductions associated
with the assets in the trust on his or her personal income tax return.
In this context a grantor trust is a trust in which the grantor retains
no beneficial interest-no right to distributions or underlying trust
property- and as a result the trust will be outside of the grantor's
taxable estate immediately.
The grantor retains some minor administrative right-a unilateral right to swap assets with the trust by giving the trustee assets of an equivalent value, for example-and because of that power becomes responsible for all of the trust's taxes, even though the client has no right to distributions. Why is this a good thing? Well, it means that the assets of the trust grow on a tax-free basis because the grantor is picking up its tax tab. It is like a supercharged Roth IRA on a significantly appreciating pool of assets. Wouldn't you like someone to volunteer to pay your taxes? The client's payment of taxes on the trust's income and gains is effectively a tax-free gift to the trust. Remember, a person making a gift (a "donor") can only gift $12,000 per year to each child or other gift recipient under the annual exclusion rules. If the person is married, the couple can gift-split, and up to $24,000 per gift recipient can pass transfer tax free. Any larger gift will reduce the donor's applicable exclusion amount, which either reduces the amount of sophisticated lifetime planning the client can carry out on a tax-free basis or increases the amount of estate taxes that will eventually be due on the client's death.
The sale/gift transaction
contemplated here could produce tax liability far in excess of annual
exclusion gifting limits. Payment of the taxes will be a major economic
benefit for the trust beneficiaries, allowing them to hold onto all
pre-tax income and gains of the trust. Payment of taxes by the grantor
is not a gift because the grantor has a legal obligation to pay them. A
member of the senior generation of the family is reducing his or her
estate by paying taxes, and the younger members of the family that
benefit from the trust are enriched dollar for dollar by the senior
generation's tax payment, which is all accomplished without payment of
A second tax advantage of the grantor trust gift/sale is that a sale by a parent to a child will trigger a capital gains tax, and the type of assets that are best used for this planning typically have a very low basis and therefore would attract significant capital gains taxes on sale. The IRS treats the sale of an asset from the parent to the parent's trust as a non-event. It is the same as the parent selling the asset to himself. No gain is recognized and no tax is due. When a trust is a grantor trust, the grantor can sell assets to it without triggering an immediate capital gains tax-and that's about to become very useful.
Careful drafting may allow the grantor to look to the trust for reimbursement of taxes, and the grantor can always renounce the power that makes the trust taxable to him, there by naming the trust to carry its own taxes. It also is worth mentioning that with certain assets particularly real estate, oil, gas and mineral interests-any tax benefit, such as depreciation, depletion and any tax credits attributable to the transferred asset, still benefit the grantor.
I have seen clients transfer real estate portfolios to grantor trusts, shift significant appreciation to the younger generation transfer tax free, and use the tax attributes of the portfolio to shelter other streams of similar income for decades. This is a powerful technique.
This technique is really pretty simple: (1) Client forms a grantor trust; (2) client gifts 10% of the assets to be transferred to the trust; and (3) client sells assets to the trust in exchange for a promissory note.
In most instances the client should make a small, taxable gift to the trust before entering into the sale. This prevents the IRS from arguing the transaction was a sham. The theory is that no one would sell property to a trust that has no ability to repay the note and no property other than the assets purchased with the loan proceeds to secure the payment. As a rule of thumb, most planners tend to gift 10% of the total value being transferred. If the client has a current grantor trust with significant assets in it, the gift element may not be necessary.
The client sells the remaining 90% of the assets to the trust and does not recognize any gain on the sale because he can't sell something to himself, and as far as the IRS is concerned a grantor trust is just another asset that belongs to a client. The trust will repay the note using either the income generated by the asset transferred or by invading the asset.
The note generated by the sale portion of the transaction can be structured in a commercially reasonable way, and is influenced by the age of the client and the cash flow of the assets sold by the trust.
For an older grantor with an asset that has good cash flow, a fully or partially amortizing note is usually the best choice, with the term of the note often running nine years to qualify the note for the low interest rate typically available under the federal mid-term AFR (4.86% in March 2007). Foregoing of interest would be a taxable gift by the seller. The seller needs to charge interest at a rate that passes as commercially receivable. The AFR is that rate.
For a younger grantor, or for an asset that will appreciate significantly on an eventual sale but which currently lacks steady income-producing characteristics, an "interest only" note with principal ballooning in as many as 30 years may make the most sense. Significant time must be spent running economic models to determine what structure is optimal for a particular client selling a particular asset. When the trust does not have the cash flow to service the note, transferring assets in kind is possible, but transferring a partial interest in real estate or a business requires an appraisal to be sure what you are transferring is equal to the note payment you are making. If the assets were discounted on transfer to the trust, the same discounting principles need to be applied on a like-kind redemption.
Make sure that the grantor allocates a portion of his or her generation-skipping transfer tax exemption to the gift to the trust so the trust and all its future growth will be exempt from generation-skipping transfer tax. This will allow the assets to re-main in a creditor-protected vehicle, which passes the economic benefit from generation to generation without the imposition of confiscatory estate and gift taxes, preserving the entirety of the trust assets for the next generation and avoiding a 50% tax.
Assume you gift $500,000 to a grantor trust and sell $4.5 million in stocks and bonds to the trust in exchange for a nine year, self-amortizing note at a time when the AFR is 4.86%. The total transfer is $5 million. If the assets appreciate at 10% at the end of nine years you will have received a total of $5.66 million in note payments and there will still be $3.245 million in the trust. Without this planning there would be an additional $3.2 million in your estate. Through this planning you saved $1.6 million of estate taxes. What's more, the entire amount is exempt from the GST Tax, meaning it can pass to your grandchildren without incurring a second level of taxation at 45%. If we look ahead another ten years, using the same investment assumptions, the trust will have grown to about $8.42 million-all of which will pass without further transfer taxes.
Family Limited Partnerships
As efficient as a sale to a grantor trust is, it is possible to add even more leverage to the transaction by using a family limited partnership (FLP) or limited liability company (LLC), or re- capitalizing an "S" corporation with voting and nonvoting stock. An FLP is simply a limited partnership owned by members of a single family or trusts for the benefit of that family. An FLP has two types of ownership, the general partnership (GP) interest and the limited partnership (LP) interest. A general partner controls the daily operation of the partnership and is personally liable for any debts of the partnership. A limited partner is prohibited from participating in the management of the partnership and is not personally liable for partnership debts. Similarly, an LLC or "S" corporation may be structured with voting and nonvoting interests. Although in general no member will share liability for the LLC's debts, nonvoting members will be prevented from having a say in most LLC management decisions.
The sale to the grantor trust must be for "fair market value." The gift tax system defines fair market value as what a hypothetical willing buyer would pay to a hypothetical willing seller, both having full knowledge of all relevant facts and neither being under any compulsion to act. Under this definition an LP interest or a nonvoting LLC or "S" corporation interest is not very valuable. Compared to the pro rata value of the underlying property, a discount should be taken for the lack of control a limited partner or nonvoting member or shareholder has and the absence of a ready market for the transfer of such an interest. For example, if an FLP owns 100 shares of XYZ Company, the owner of a 1% LP interest in the FLP should not be treated as if he owns one share of XYZ Company. After all, he has no say in whether to keep or sell the XYZ shares, no access to any dividends XYZ Company might make and it is extremely unlikely that anyone who wanted to buy XYZ shares would buy his LP interest instead of trying to acquire the XYZ shares directly. In short, a "willing buyer" wouldn't pay the pro rata value of the interest. The actual discount varies, but appraisers generally report anywhere from 30% to 50%, depending on the nature of the assets and certain other factors.
If instead of transferring $5 million of undiscounted assets, as we did in the last example, we transferred a 99% LP interest in a limited partnership that owned $5 million in assets, the result would be a little different. Assuming a 40% discount, the 10% gift to the grantor trust, in this case a 9.9% LP interest, would only be worth $297,000. The sale price would not be $4.5 million, it would be $2.67 million. As a result, at the end of nine years total note payments would have been only $3.36 million and the trust would retain assets worth $6.60 million at the end of nine years. By adding the FLP more than twice as much property was retained in the trust and more than twice as much estate tax was avoided.
A gift/sale to a grantor trust has both income and transfer tax advantages. Creating a pot of money that can pass through generations within the family without triggering gift, estate or generation skipping transfer taxes is attractive for most financially successful families. Once the illiquid asset is monetized, the financial advisor who had the wisdom to help the family garner the benefits of grantor trust planning will have a significant opportunity to manage the newly liquid wealth.