Advisors will often recommend establishing a family limited partnership or limited liability company, transferring assets to the entity and giving the client a limited ownership interest in it. This limited interest should be entitled to a valuation discount. The client will retain it until he or she dies or transfers the ownership interest to lower generation heirs at its discounted value, thereby saving gift taxes. Clients should be aware, however, that such structures should have a significant and independent reason for being other than for their tax advantages. Otherwise, the values may be challenged by the Internal Revenue Service.
Another popular technique for transferring assets that are expected to appreciate significantly in the future is a sale to a grantor trust (also sometimes referred to as an intentionally defective grantor trust). This is an irrevocable trust in which the grantor retains a power that will cause the income of the trust to be taxed to the grantor without the assets of the trust being included in the grantor’s gross estate for federal estate tax purposes. A sale to a grantor trust of an asset expected to appreciate in the future is a widely used estate planning technique to freeze the value of the client’s estate.
This technique involves a four-step process:
First, the client sets up an irrevocable grantor trust for the benefit of his heirs.
Then the client funds the trust with 10% of the amount to eventually be transferred to it. This is a taxable gift that can be offset by using some of the client’s $11,580,000 exemption.
Next, the client sells an appreciating asset to the grantor trust in return for a promissory note. The appreciating asset is now in the trust. The client holds the promissory note. Since the value of the promissory note is fixed and will not appreciate, the client has frozen the value of his or her estate at the note’s value. The appreciating asset, meanwhile, is out of the client’s estate.
The IRS has ruled that transactions between the client and grantor trust are not subject to income tax recognition, so the sale of the appreciating asset to the trust is not a taxable event. Since the income of the grantor trust is taxed to the client, the client reduces his estate by the amount of income tax he pays on the trust income. Meanwhile, the trust is able to grow without the income tax burden.
The final step is that the client pays the note off over time, preferably before he or she dies.
Charitable planning. Clients interested in planned giving have a number of choices. Many high-net-worth clients would like to establish and make charitable gifts to their own private foundations. Gifts to a private foundation are generally subject to more restrictive limitations for purposes of the income tax deduction and are also subject to certain penalty taxes if not administered properly. Given the complexity of the rules applicable to private foundations, high-net-worth clients might favor establishing a donor-advised fund instead.
These are funds established at a public charity, such as a community foundation, university, hospital or another charitable organization. The donor-advised fund is a public charity, allowing for higher limitations for an income tax deduction. The fund will do the administrative work involving the charitable giving, from making the charitable gift to filing the applicable tax returns. In donating to a donor-advised fund, the client gives up legal control over the assets but retains advisory privileges over which charities receive the donation. In effect, the donor-advised fund is a simplified version of a private foundation.