Tax-Efficient Timing for Wealth Transfer Strategies

Keven DuComb, JD
Keven DuComb, JD

07.22.20 in Wealth Planning & Investing

Estimated Reading Time: 6 Minutes (1011 words)


If you’re looking for tax-savvy wealth transfer strategies, the current economic environment could present some unique opportunities. You may already be familiar with the tax efficiency of the estate planning and gifting strategies I’ll discuss below, but they’re worth revisiting.

Why? One reason is the high gift and estate tax exemption, which is currently set at $11 million (adjusted for inflation), courtesy of the 2017 Tax Cuts and Jobs Act (TCJA). But what the TCJA gives, it may take away. Per a “sunset” clause in the law, the exemption is scheduled to revert to $5 million (adjusted for inflation) on January 1, 2026.

Given this limited window and overall market conditions, now might be an opportune time to pass on some family wealth to the next generation. Let’s consider four wealth transfer strategies that could benefit your clients, depending on their assets and liquidity.

1) Direct Wealth Transfers

Many people use either stock or cash to make a direct wealth transfer. Obviously, when significant assets are involved, the high gift and estate tax exemption offers a big tax advantage. And, fortunately, for exemptions used through the end of 2025, the IRS has ruled that a decedent’s estate won’t be penalized if the threshold is lower at the time of the owner’s death.

But other factors could come into play. Given this year’s market disruption due to the pandemic, certain client assets might be depreciated. In these cases, a timely transfer would be smart because:

  • Stock transfers are valued using the market price on the date of the transfer. A transfer of a devalued investment would use less of the client’s lifetime gift and estate tax exemption.

  • You could pair a direct cash transfer with a tax-loss harvesting strategy. The sale of a depreciated investment could raise cash for the transfer, while also providing a tax benefit.

2) Intrafamily Loans

With interest rates at historic lows, this may be the perfect time for clients to loan money to family members or to refinance an existing loan. Generally, provided an interest rate equal to the Applicable Federal Rate (AFR) is charged, no part of the loan is treated as a gift. The various AFRs are published monthly by the IRS. In July 2020, the AFRs are:

  • 18 percent for short-term loans (three years or less)

  • 45 percent for medium-term loans (up to nine years)

  • 17 percent for long-term loans (more than nine years)

The savings on interest could really add up. And, in these difficult times, the financial assistance might be especially meaningful for those dealing with unemployment or credit issues. An attorney can help clients understand the tax consequences of loan forgiveness down the road.

3) Grantor Retained Annuity Trust (GRAT)

A GRAT is an irrevocable trust that can pass a significant amount of wealth to the next generation with little or no gift or estate tax consequences. This strategy is useful for clients who have already exhausted their gift and estate tax exemption or plan to use it to shelter other assets.

With a GRAT, the trust owner or grantor receives an annual annuity payment from the trust for a set number of years. When that time is up, the remaining funds go to the trust beneficiaries. The annuity payment is calculated using the original value of the trust assets and a rate of return called the section 7520 rate, which is determined monthly by the IRS. The two most common ways to structure the annuity payments are:

  • Zeroed-out GRAT: The annuity payment is set to return the original principal and attributed 7520 interest to the grantor over the trust term. Any appreciation above the benchmark of the annuity payments goes to the beneficiaries without using any of the grantor’s gift and estate tax exemption.

  • Gift GRAT: The annuity payment is set lower than necessary to return the principal and attributed 7520 interest to the grantor. This lower annuity payment triggers a gift calculation that counts toward the gift and estate tax exemption. At the end of the trust, however, the remaining funds, including any appreciation, pass to the beneficiaries without further gift taxation.

Why might now be a useful time to fund a GRAT? In an economic downturn, the section 7520 interest rate is typically lower, which lowers the required payments to the grantor. (In July 2020, the 7520 rate is 0.6 percent.)

The downsides to a GRAT include:

  • Death of the grantor during the GRAT’s term, which transfers the remaining assets back into the taxable estate

  • Possibility that the GRAT will fail, which occurs when the trust doesn’t experience growth above applicable 7520 rate (In these cases, at the end of the term, the trust returns the remaining assets to the grantor and terminates.)

  • The potential liability for capital gains taxes on the part of the beneficiaries, based on the carryover cost basis

4) Family Limited Partnerships (FLPs)

FLPs operate with general partners who manage the business and limited partners who benefit from the proceeds. Typically, parents or grandparents contribute investment assets, real estate, or other business interests to an FLP. Serving as general partners, they slowly transfer partnership interests as gifts to their heirs. Often, the process is executed over many years to stay within the annual gift tax exclusion, currently $15,000 per year, per person.

In a market downturn, the valuation reduction of an FLP can be useful in two ways:

  • A larger percentage of interests can be passed on using the $15,000 annual gift tax exclusion. Once an asset is gifted, all growth, including any growth for market recovery, is outside of the client’s taxable estate.

  • An FLP may allow clients to transfer their interests while using little or none of their lifetime gift and estate tax exemption.

Working with an Attorney

Due to the complexities of these estate planning and gifting strategies, you and your clients should work with an attorney to discuss their potential rewards and risks and to set appropriate terms. An attorney’s assistance can also ensure that wealth transfer strategies are up to date with both federal and state tax codes and new laws such as the SECURE Act.

This material is for educational purposes only and is not intended to provide specific advice.

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