Facing down an uncertain election outcome and the possibility of tax reform in 2021, many families started transferring substantial amounts of wealth last year, making large gifts to take advantage of the historically high gift and generation-skipping transfer tax exemptions. Wealthy families were likely concerned these exemptions would be slashed under a Joe Biden presidency.
There’s still uncertainty about tax reform, but nevertheless, some people will still want to consider a number of wealth transfer strategies, including gifts. If clients have already used a significant portion or all of their exemptions, for example, they might want to consider some of these strategies:
1. Gifts
Even if an individual or couple previously used their gift and generation-skipping transfer tax exemptions, they can still make additional gifts outright or in a trust. This strategy has several key characteristics that make it attractive for passing along wealth this year:
• It benefits from the 2021 inflation adjustment amount. The gift and generation-skipping transfer tax exemption amounts are currently indexed for inflation, and for 2021 those exemptions were increased to $11.7 million from $11.58 million in 2020. Accordingly, each individual has an additional $120,000 of gift and generation-skipping transfer tax exemption that can be used this year.
• It includes annual exclusion gifts. Individuals can make certain gifts of up to $15,000 per recipient (it’s $30,000 for married couples), which do not count toward their gift and estate tax exemptions.
• It allows individuals to make direct payments for tuition and medical expenses. Without depleting the annual exclusion or gift and GST tax exemptions, a person can pay for the educational, dental and medical expenses of family members or friends as long as the expense is paid to the providers directly.
2. Grantor Retained Annuity Trust (GRAT)
A GRAT is an irrevocable trust. The grantor makes a gift of property to it while retaining a right to an annual payment (annuity) from the trust for a specified term of years. GRATs can be used for a variety of assets, including concentrated positions and assets expected to appreciate significantly. It has several advantages:
• The right to the annuity is a retained interest that has a value. This value is subtracted from the full value of the transferred property when determining the taxable amount of the gift.
• If the grantor survives the annuity term, any amount remaining in the trust at the end of the term passes to its beneficiaries without additional gift or estate taxes.
• If the grantor dies during the annuity term, the entire value of the trust generally will be included in the grantor’s taxable estate as if the GRAT had never been created.
One of the primary benefits of a grantor retained annuity trust is that it can be structured so that the gift tax value is almost zero, meaning that highly appreciating assets can be transferred to the next generation without creating a taxable gift. This can be particularly attractive if clients have already exhausted their gift tax exemption.
3. A Sale To A Grantor Trust
This strategy takes advantage of the significant differences between the income and transfer tax treatment of irrevocable trusts. The goal of this strategy is to transfer anticipated appreciation of assets at a reduced gift tax cost. It has several advantages:
• In return for the transfer of property, the trust gives the grantor a note, which carries a market rate of interest and usually requires a balloon payment of principal at the end of the note’s term.
• In most instances, the grantor and the grantor trust are treated as the same taxpayer for income tax purposes, but as two separate entities for transfer tax purposes.
• Because the grantor and trust are the same taxpayer for income tax purposes, neither the sale nor the note payments trigger income tax.
• When the note is repaid, the grantor has transferred the appreciation with no tax liability.
This strategy may be especially timely for those who have funded a trust using their gift tax exemption, as this technique typically requires some “seed” funding of the trust before a sale. The ability to lock in current market interest rates, which continue to trend near historical lows, can also significantly benefit the overall transaction.
4. Intra-Family Loans
An individual can make loans to family members at lower rates than commercial lenders without the loan being deemed a gift. This offers several advantages:
• An intra-family loan allows an individual to assist family members financially without incurring additional gift tax.
• A bona fide creditor relationship, including the payment of interest, is established.
• Wealth can be shifted if the loan assets are invested by the borrower and earn a higher return than the required interest rate.
• Interest is paid within the family rather than to a third-party lender.
This can be a good time for the right clients to enter into new intra-family loans or to refinance existing loans since interest rates continue to be very low.
It’s always important to work with qualified professionals when choosing and implementing planning strategies, but it’s even more important this year given the uncertainty of tax reform, retroactive or otherwise. Tax reform could affect all of these planning strategies, and financial advisors might want to consider additional techniques—such as disclaimers, formula gifts and QTIP provisions—to add flexibility and minimize potential gift tax exposure.
Caroline McKay is a senior wealth strategist for CIBC Private Wealth Management in Boston, with 14 years of industry experience. In this role, she is responsible for developing integrated wealth management solutions and providing comprehensive estate and financial planning services to high-net-worth clients.