When are depressed values, low crediting rates and tax law changes good news? The answer is when you are trying to move family wealth without experiencing gift and estate taxes. In a rare sign of the times, lawyers, trust officers and financial advisors are generally in agreement that conditions are ideal for wealthy families to transfer wealth. Driving the call to action by advisors is an unusual set of economic conditions coupled with the possibility of tax law changes.
Reduced values for stocks, real estate and closely held businesses also mean reduced values for gift taxes. The lower the value of the asset, the more the donor can give under the $1 million lifetime federal gift tax exemption.
Consider Simon, who wants to transfer some of his family-owned business stock to his children. If Simon had gifted shares in his stock last year when the value was at $50 per share, under the $1 million gift exemption 20,000 shares could have been passed gift tax free. Because of the adverse economic environment, Simon's company stock is currently valued at only $30 per share. If he makes the gift currently, 33,333 shares can be passed tax free. Assuming the value of the stock will recover, transferring in this depressed economy means a substantial amount of potential appreciation can be passed on to the children without gift taxes.
This advantage is compounded by the fact that closely held business interests are being heavily discounted for valuation purposes. Appraisers are finding that in this low liquidity economic environment, it has become a buyer's market. The affect is that in valuing the shares for the gift tax purposes, Simon's appraisers will likely include a significant discount to reflect the poor environment for business sales.
Sizeable discounts for private businesses and real estate can apply for reasons beyond economic conditions. Wealthy taxpayers and their advisors have long battled the IRS over discounts for lack of marketability, lack of control and a list of arcane limitations that reduce the value of the asset. Using various restrictions and limitations in the structuring of the transfer, the sought for result is that the tax value of the asset is substantially lowered.
Typically placed in an LLC or Family Limited Partnership, in some cases asset values are slashed by more than half their full fair market value. The IRS on occasion successfully challenges the size of these discounts, but in other cases the tax court has sided with the taxpayer. In general, these discounts can significantly lower valuations for gift and estate tax purposes as long as they are not excessive.
A low interest rate environment is another factor that can make this an ideal time for intergenerational transfers of wealth. Simon may want to pass on additional wealth but has exhausted his lifetime gift exemption. Instead of gifting, he can lend assets.
For example, he makes a nine-year interest-only loan to his children of a minority interest in his business. Taking advantage of the depressed stock value and sizeable discounts available under current law, the effective true return on the stock is 8%. As long as Simon charges his children no less than the applicable federal rate of interest (AFR), the loan will not be treated as a gift. Using the June 2009 AFR of 2.25%, the children only have to pay Simon $22,500 each year for the nine-year loan period. If the actual return on the stock at 8% is $80,000, the positive arbitrage for the children is $66,500 per year, a total of nearly $600,000 over the period of the loan. This is $600,000 of appreciation that will never be subjected to gift or estate tax for Simon.
Although this loan transaction demonstrates the opportunity available because of low interest rates, advisors for many wealthy families are using sophisticated techniques to even further enhance the leverage. For example, Simon's advisors may suggest he use his annual gift tax exclusion ($13,000 per child) to gift the annual interest payment to the children. This means more wealth stays with the children.
Further, Simon could transfer the assets to a grantor trust instead of directly to the children, causing the income tax liability to remain taxable to Simon. These two techniques will further enhance how much wealth and appreciation remains with the children free of transfer taxes.
Simon might also consider gifting using a Grantor Retained Annuity Trust (GRAT). This popular estate planning technique, most notably used by the Walton family to transfer Walmart stock, effectively lowers the gift tax value of the transfer to nearly zero, plus it avoids any requirements for a loan pay back. The cumulative effect of all these techniques is Simon's family can avoid gift taxes while he is alive, freeze the value of much of the family business for estate tax when he dies and retain more wealth for the succeeding generations.
The fact is even with these techniques Simon's estate may still have estate taxes to pay at a 45% top estate tax rate. These taxes can substantially cut into the family's wealth. Life insurance has of late been recognized by advisors as an attractive sponge to soak up much of the remaining estate tax liability. By holding a guaranteed death benefit insurance contract outside of the estate in a trust, money is available to pay estate taxes without being subjected to estate taxes itself.
For example, the grantor trust that is holding Simon's gifted stock for his children might also purchase life insurance on Simon's life. The death benefit would be available to pay off the loan if and when Simon dies, plus it could help pay any remaining estate taxes. How does the trust afford the premium? Recall that there is a positive arbitrage between what the trust is earning on the stock (8%) and what it has to pay back to Simon in interest (2.25%). This positive cash flow plus other gifts from Simon generate the money for premium payments. Even if the stock is not particularly liquid, in this low interest rate environment there are both commercial and private lending techniques that can help fund the life insurance purchase.
As the economy improves, asset values may go up. Improved earnings, better credit availability and more buyers can all lead to enhanced valuations in appraisals. Interest rates, currently at historical lows, seem certain to go up eventually.
Perhaps most pressing of all is the state of future gift and estate tax rules. There is a general belief in the advisory community that sizeable gift and estate liabilities will remain for wealthy families. What is not as clear is whether some of the favorable techniques described above will be curtailed or ended by tax legislation. Particularly in the area of discounting and GRATs, both the administration and Congress have indicated an interest in taking a closer look at these planning opportunities for the wealthy.
Simon and other wealthy individuals may not be happy with the state of the economy and the affect it has had on their wealth. They may have suffered real losses, and be unsure about how to recover lost wealth. However, for those individuals and families seeking to move wealth to future generations, there is a pretty side to this ugly economy. Now may be the time to move wealth while avoiding gift and estate taxes.
Steve Parrish, JD, CLU, ChFC, RHU, is a consultant with the Principal Financial Group in Des Moines, Iowa. He can be reached at 515-235-6120.