Estate Planning Strategies in the Wake of COVID-19

Although the economy has faltered during this COVID-19 pandemic, wealth transfer continues to grow. This article outlines a few of the estate planning techniques to make the best out of these trying times.

by Lois Tilton and William Friedman
Unique opportunities for estate planning brought on by such factors as the decline in value and volatility in certain sectors of the market

Unique opportunities for estate planning brought on by such factors as the decline in value and volatility in certain sectors of the market

I. Introduction – As we are well into the second half of 2020, the COVID-19 pandemic has created unprecedented economic hardship and uncertainty. While acknowledging and not minimizing the difficult circumstances in which many Americans now find themselves, we can look through the practitioner’s lens to also see unique opportunities for estate planning brought on by such factors as the decline in value and volatility in certain sectors of the market, including real estate and other asset classes, and historically low interest rates. By taking advantage of this unique set of circumstances, careful planning can achieve significant estate and gift tax savings. Lower market values can increase the benefit of a gift or sale of property, allowing the transfer of more property while using less of an individual’s estate, gift, and generation-skipping transfer (GST) tax exemption, currently $11.58M per individual in 2020 and scheduled to be reduced by half in 2026. Lower interest rates also make certain estate planning strategies more attractive. The following is an overview of favorable strategies in the current environment.

II. Grantor Retained Annuity Trust (GRAT) – A GRAT can be an effective strategy for transferring assets to designated beneficiaries without using gift tax exemption or paying transfer taxes. A grantor creates a GRAT by irrevocably transferring assets to the trust. The trust makes annual annuity payments to the grantor for a set time period and then distributes any remaining assets to the designated remaindermen, often one or more follow-on trusts. The gift tax value of the remainder interest, and therefore the value of the grantor’s gift at the time the GRAT is formed, is determined by reference to a rate known as the “7520 rate.” Prescribed by the Internal Revenue Service (IRS), the 7520 rate is published monthly and is based on prevailing interest rates. It is possible to structure a GRAT such that the value of the remainder interest is zero, meaning that the grantor is deemed to have made no taxable gift when funding the GRAT. This is known as a “zeroed-out GRAT.” If the GRAT property grows at a rate in excess of the 7520 rate, the excess will pass to the remainder beneficiaries free of gift tax. In August 2020, the 7520 rate is historically low at 0.4%, meaning that by exceeding an annual growth rate of 0.4%, the GRAT would be successful.

There is little downside to a zeroed-out GRAT strategy: if the trust property appreciates at or below the 7520 rate, the GRAT simply pays all of the trust property to the grantor and terminates. The grantor must survive the term of the GRAT, which makes shorter-term GRATs a lower risk than longer-term GRATs. If the grantor dies during the GRAT term, the trust property will be included in the grantor’s estate. If the grantor wishes the remainder interest to be exempt from GST tax, exemption is allocated to the GRAT property at the time the remainder is paid using the then-current value of the remainder.

III. Gifts and Sales to an Intentionally Defective Grantor Trust (IDGT) – An IDGT is a trust that, when properly drafted, represents a completed gift for gift and estate tax purposes and an incomplete gift for income tax purposes upon funding. Solely for income tax purposes, the grantor is still the owner of the trust property. This means the grantor is responsible for income taxes on the trust, but more importantly, transfers, including sales, have no income tax consequences to the grantor—there is no gain recognition.

Popular types of IDGTs are spousal lifetime access trusts (SLATs), which permit the spouse to be a beneficiary, and trusts for children and descendants, often referred to as dynasty trusts. If an individual has not used the full exemption amount now is a good time to consider making gifts of property with a depressed value to one or more IDGTs. For those who don’t have any or enough exemption to use, a sale to an IDGT for fair market value would not subject the property to estate, gift, or GST tax, and would not trigger income tax gain; however, property owned by a trust generally would not qualify for an income tax basis step-up on the grantor’s death.

In a typical sale to an IDGT the grantor will, if necessary, make a gift to the trust of seed money—generally no less than 10% of the value of the sales price. Lower asset values could mean a smaller seed gift is needed if the trust does not already hold enough assets. The sales price would reflect the lower value of the asset being sold. The trust can give the grantor a note with interest equal to or greater than the Applicable Federal Rate (AFR) published by the IRS each month. In August 2020, the AFR is 0.17% for loans with a term of less than three years, 0.41% for loans with a term of three to nine years, and 1.12% for loans with a term of greater than nine years. At lower rates, the note will be paid back with fewer trust assets and less addition (in the form of interest) to the grantor’s estate. Hopefully the assets will eventually appreciate, and the appreciation will be removed from the grantor’s estate.

IV. Charitable Lead Trust (CLT) – A CLT offers a tax-advantaged way to make a present gift to charity and a future gift to noncharitable beneficiaries. A grantor creates a CLT by irrevocably transferring assets to a trust. The trust makes annual distributions, in the form of either an annuity or a unitrust amount, to charity (thereby qualifying for an income and gift tax charitable deduction) for a set time period and then terminates, at which time the remaining assets in the trust are distributed to the noncharitable beneficiaries. As with a GRAT, the value of the remainder interest in a CLT is based on the 7520 rate, meaning that the value of the grantor’s gift to the remainderman when the CLT is formed is deemed to be less when interest rates are low. If the CLT property grows at a rate in excess of the 7520 rate, the excess will pass to the remainder beneficiaries free of gift tax.

A CLT can be structured so that the grantor personally receives the full income tax charitable deduction in the year in which the CLT is funded. As with a GRAT, a properly structured CLT can be zeroed out. However, unlike a GRAT, a CLT may lead to adverse income tax results if the CLT is unable to make its annual payment to charity.

V. Intra-Family Loans – A loan made to family members, or to a trust for their benefit, at a below-market interest rate generally will be recharacterized as a gift from the lender to the borrower. So long as a loan pays interest at a rate equal to or greater than the AFR, however, the loan will generally not be viewed as a gift. A taxpayer could, then, make a loan to a child or grandchild in August of 2020, paying interest at 1.12% annually for a term of 10 years, without paying gift tax or using gift tax exclusion. The borrower could invest those funds, earning a potentially much greater return over the term of the loan and retaining that increase in value when the loan is repaid after a decade. If the loan was made to an IDGT, the grantor, who is treated as the owner of trust property for income tax purposes, would not even have interest income. Existing intra-family notes could also be refinanced to take advantage of lower rates, provided that some consideration was offered to the lender (a refinancing fee, shorter term, increased principal payments, etc.) in exchange for the refinancing to avoid an unintended gift.

VI. Allocation of GST Exemption to Existing Nonexempt Trusts – The GST tax generally applies at a rate of 40% to transfers by individuals to transferees who are two or more generations below that of the transferor. Grantors of existing trusts that are subject to GST tax may wish to allocate their GST exemption to make such trusts partly or wholly GST exempt. GST exemption must be allocated to property held by an existing trust based on its value at the time of the allocation. This can be a particularly effective strategy in the current market, with GST exemption amounts at historic highs ($11,580,000 per individual in 2020, scheduled to decrease by half after 2025) and asset values depressed.

VII. Conclusion – Practitioners should reach out to clients to review their existing plans and discuss with them the unique opportunities that are available to reduce gift, estate, and GST taxes. Clients may benefit from this unprecedented estate planning environment, leveraging one or more of the strategies discussed above into significant tax savings.

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Lois Tilton

Partner at Perkins Coie

Lois Tilton is a partner in the New York office of Perkins Coie.

William Friedman

Counsel at Perkins Coie

William Friedman is counsel in the Seattle office of Perkins Coie.