Important Update: IRS issued “anti-abuse” Proposed Regulations on April 27, 2022 which limits available taxable gifting options discussed in paragraph G below. See our May 2022 Newsletter on this topic.

Earlier in 2020, we provided a three-part newsletter series on The Perfect Storm for Advanced Estate Planning. As we discussed, the convergence of three significant variables made this point in time an incredible opportunity for more advanced estate planning. These three variables included historically low-interest rates, relatively low and/or volatile asset values, and an expectation of higher taxation on the horizon.

What we have learned in the past few months is that one of these variables dwarfs the others in light of the upcoming Presidential and Congressional elections on November 3, 2020. While the 2017 Tax Act temporarily doubled the exemptions from the wealth transfer (gift, estate, and generation-skipping) taxes until the end of 2025, a significant risk exists that these exemptions may revert as early as 2021, depending on the outcome of the elections. As a result, our client conversations with those who are at risk of eventually paying significant wealth transfer taxes have concentrated on what can and should be considered now to take advantage of this potentially very short-lived doubling of the wealth transfer tax exemptions.

To take advantage of the temporary wealth transfer tax exemptions before they go away, an irrevocable gifting type transaction will need to be completed before the effective date of any such change in the law. The wealth transfer taxes have two exemptions, including the Basic Exclusion Amount (BEA) under the unified gift and estate taxes and the Generation-Skipping Transfer (GST) tax exemption under the GST tax. The primary goal of the gifting transactions discussed in this newsletter is to effectively use your BEA before it gets reduced. While not a topic of this newsletter, you should consider effectively using your GST tax exemption before it also gets reduced.

The BEA is $11.58 million for 2020, and without congressional action to do otherwise, it is scheduled to increase (per inflation indexing) to $11.7 million for 2021.

This newsletter will provide a discussion of our most important observations as to the ability to effectively utilize the existing BEA. You can think of this newsletter as an unofficial part four of our prior three-part newsletter series on The Perfect Storm for Advanced Estate Planning.

A. The gifting must be significant to use the temporary portion of the BEA.

It is important to understand that the BEA is used from the bottom up and not from the top down. For example, let’s assume that the BEA will be reduced to $5.85 million ($5 million indexed for inflation in 2021). As a result, you will need to use up all of the $5.85 remaining BEA amount before you ever get to use a dollar of the temporary portion of the BEA.

B. Determining the best way to gift is a personalized decision based on the individual’s or married couple’s particular situation.

C. Gifting can be done outright or in trust, but gifting in trust is often far better for you and your loved ones.

D. The terms of the trust are critically important, and built-in flexibility is key.

E. The trust should likely be structured as a grantor trust for income tax purposes.

Grantor trusts are normally the most flexible type of trust for gifting purposes and they permit post gifting transactions to take place on a non-taxable basis.

F. Creativity may be needed since a traditional gift may not be a viable option.

Because the amount of the taxable gift needs to be so significant, this will concern many about having direct or indirect access to the gifted assets in the future, if ever needed. Further, many who may want to maximize the use of the temporary BEA, may simply not have the right types of assets that can be easily gifted. As a result, some creativity may be needed to fully utilize the BEA in these cases.

G. The different types of gifting strategies can be categorized as follows:

Important Update: Gifting options listed under Items 4 – 7 below are no longer generally viable after IRS issued “anti-abuse” Proposed Regulations on April 27, 2022. See our May 2022 Newsletter on this topic.

1. 1. Traditional gift – Gift sufficient appropriate assets now. For those that would only like to make a large taxable gift if they become confident that the BEA will decrease fairly soon, they can sell assets to a grantor trust in return for a promissory note (Note). If and when a taxable gift is desired, they can forgive part or all of the Note. This strategy permits the taxable gift to be carried out quickly.
   2. Traditional gift to grantor trust where able to swap out gifted assets later- Gift cash (possibly from a loan?) or other assets of significant value now, but later switch them out for more appropriate assets of equivalent value, via a related party sale or the grantor trust’s swap powers. If a Note results from the related party sale, a concerted effort will need to be made to fully pay off the Note before the grantor’s death or the trust otherwise becomes a non-grantor trust.
   3. Gift under G.1. or G.2. above, but also utilizing a business entity, such as a family limited partnership (FLP) – This can be a traditional use of an FLP type entity where you transfer investment assets to the FLP and then gift an FLP interest to a grantor trust or otherwise. Alternatively, you can first gift assets to a grantor trust, and thereafter the grantor trust contributes assets to the FLP along with other family members. Adding a business entity into the mix can complicate the gift, but it can also provide significant additional tax and non-tax benefits.
   4. Gift “naked Note” to grantor trust –  You gift your IOU (naked Note) for “good” but not “valuable” consideration under applicable state laws that permit such transfers to be legally enforceable. This would normally be the best gifting strategy if it were not for its cons, which include: (i) opportunity cost (i.e., inability to use the BEA for other purposes if it turns out that the strategy did not work based on technical estate tax calculation issues or otherwise); and (ii) significant tax risks may exist if the naked Note remains outstanding upon the grantor’s death or upon the trust becoming a non-grantor trust during the grantor’s life. The pros of this strategy are incredible, including: (i) using the temporary BEA without giving up any significant assets; (ii) benefitting from step-up in income tax basis at death; and (iii) the potential to achieve significant asset protection benefits. Essentially, this strategy may work as intended, but it is likely only a temporary strategy since the naked Note should be fully paid off before the grantor’s death or the trust otherwise becomes a non-grantor trust.
   5. Utilize a defective IRC Section 2701 preferred partnership or defective IRC Section 2702 Grantor retained annuity or income trust – In both situations, you purposefully fail to satisfy the technical requirements under these code sections. By doing so, the retained preferred interest or the retained annuity or income interest is given a value of zero for gift tax (but not GST tax) purposes. As a result, you end up with an artificially high taxable gift to use the currently available BEA, the assets get included in your estate tax calculation (which also gives you the step-up in income tax basis), but you get an estate tax offset by getting credit for the prior taxable gift. In short, you get a large taxable gift now to use your BEA without giving up the benefits of anywhere close to the taxable gift amount. These transactions should work quite well, except for the risk that the IRS may later issue the “anti-abuse” regulations discussed below.
   6. Utilize an E-GRIT – The E-GRIT is a defective IRC Section 2702 transaction discussed above, but it is enhanced in order to provide the grantor with more control and access over the trust’s assets. In addition, an independent party may be given the power to carve off trust principal (appreciation) into another family gifting trust that will not be includible in the grantor’s estate for tax purposes. This enhancement adds the ability to manage the trust over time to maximize its tax benefits.
   7. Trigger IRC Section 2519 with an existing QTIP trust – This strategy may apply where an existing QTIP trust is in place that owns significant assets. In this situation, the spouse (sole current beneficiary of the QTIP trust) renounces (but not a technical disclaimer) a small portion of the spouse’s income interest, which in turn artificially kicks off a taxable gift of the entire principal of the trust (less the value of the retained income interest). However, it should be noted that a surviving spouse who previously received a ported BEA from their deceased spouse (DSUE) will likely need to cause a taxable gift using the DSUE (that is not otherwise at risk of being reduced) before the spouse can use their own BEA. This would further increase the necessary size of the taxable gift in order to utilize the spouse’s BEA that is at risk of being reduced.
   8. Utilize a Beneficiary Taxed Grantor Trust (BTGT) in conjunction with the primary gifting trust – Where a parent would like to gift significant assets to a child, the primary gift can be made to a normal gifting trust, and a small $5,000 gift (which is initially placed into a non-interest-bearing checking account) can be made to a BTGT. The child is given a withdrawal right as to the $5,000 for a short period (ex., 30 days). The withdrawal right lapses and the trust should then be considered as a grantor trust as to the child. The issue is how to grow the trust’s assets when it only owns $5,000. One option is to invest in ventures needing almost no upfront capital. Another option is to have the other gifting trust guarantee the debts of the BTGT, which is likely within the Trustee’s fiduciary duties since the two trusts are structured to have identical beneficiaries.

H. Important Considerations

1. 1. Need to Pay off resulting Notes
      1. What is the issue?
         One of the significant benefits of a grantor trust is the ability to transact with it in related party transactions without any income tax effect, such as sales, loans, and leases. Some of the strategies discussed above result in a Note, such as a sale to a grantor trust for a Note, purchases from a grantor trust for a Note, and the gift of a naked Note to a grantor trust. Little legal authority exists as to the income tax basis of the resulting Notes when the grantor trust changes to a non-grantor trust, either upon the death of the grantor or by an act to end grantor trust status during the grantor’s life. Legal arguments can be made for the income tax basis of such Notes to be (i) the fair market value (FMV) of the assets transferred for the Note or some other FMV determination, (ii) the basis of the assets transferred for the Note or some other carryover basis determination, or (iii) zero basis. While the first two options are excellent to acceptable, the third option could be a tax disaster.
      2. What is the practical effect of this issue?
         Bottom line is that a concerted effort needs to be made to fully pay off any such Notes before the grantor’s date of death or the trust is otherwise changed into a non-grantor trust. Various methods exist to do this, including among others: (i) using available assets to repay the Note; (ii) borrowing funds or creating a line of credit which can be readily available to pay off the Note; or (iii) for those that are likely to pay an estate tax, distributing funds from an Individual Retirement Account (IRA) or Qualified Retirement Plan (QP) and using the funds to pay the Note (with the income taxes on the distributions deductible from the taxable estate for estate tax purposes).
   2. Potential “anti-abuse” IRS Regulations
      1. What are they?
         IRS issued regulations stating that the use of the existing BEA would not be clawed back later if the taxpayer died when the BEA was lower. This was a taxpayer-friendly regulation. However, it also left open the possibility for future “anti-abuse” regulations. Specifically, the IRS may issue regulations later that prevent a prior taxable gift to use the temporary BEA from being treated as a prior taxable gift in determining the estate tax (i.e., which means it did not provide the intended benefit) if the gift was structured so that it would also be includible in the taxable estate for estate tax purposes. Presumably, the abuse is that the gift was more of a paper transaction rather than the normal type of gift where significant rights and benefits are given up in the process.
      2. What is the practical effect of this risk?
         If such “anti-abuse” regulations are later issued and finalized by the IRS, then some of the strategies discussed above may not end up working as intended. If the IRS ever issues such “anti-abuse” regulations, then the grantor will need to decide if the status quo should be maintained and still benefit from the step-up in income tax basis, or if some portion of the trust assets should be transferred to another family gifting trust (or otherwise to cut off the grantor’s retained interest) which will reduce potential estate taxation. The trust documents should be drafted in contemplation of this issue. Of course, no such ‘anti-abuse” regulations may ever be issued by the IRS in any form.

If you would like to learn more about this important and timely topic, please call our offices at (678) 720-0750 or e-mail us at info@morgandisalvo.com to schedule an estate planning consultation to discuss your particular situation.