How to Slash Gift, Estate, and Generation-Skipping Transfer Taxes: Part III
Good to Know
This blog is the third of a three-part series that includes:
- Part I: Reducing the IRS valuation (but not the real value) of Client Assets,
- Part II: Creative Use of Installment Sales and Specialized Trusts, and
- Part III: Using Annuities, Charitable Trusts, and Other Techniques.
Private Annuity Sale (PAS)
A private annuity sale may appeal to a client who places a high value on:
- Providing an income stream to themselves and
- Reducing or eliminating transfer taxes.
A private annuity sale (PAS) strategy may be part of a wealth transfer plan in which a high net worth client buys an annuity from their child or children. The beauty of the PAS is that it is not considered a gift by the IRS if properly structured. Translation-No gift tax! The cherry on top of the sundae is that the value of a straight-life annuity is zero at the annuitant’s death. Translation-No estate tax!
This strategy is income-tax effective if the annuity is purchased with cash rather than with appreciated securities. Changes to the tax code require the annuity buyer (your client) to recognize all deferred gains immediately at the purchase of the annuity. Although buyer and seller are not legally required to be related, the intra-family PAS is more commonly used than the unrelated-party PAS.
Key benefits can include:
- Lifetime income stream to the buyer (your client),
- Reduction of the buyer’s gross estate, and
- Transfer of property to the annuity seller (child) without paying gift, estate, or generation-skipping transfer taxes.
The annuity payout term can be straight-life (lifetime) or a period of years. The annuity can payout to just one annuitant or on a joint and survivor basis.
CAVEAT: Both parties have economic risks. The buyer (your client) cannot maintain a security interest in the assets used to purchase the annuity. Hence, your client has the risk that the sellers (generally the client’s children) will default. The annuity seller (your client’s children) has the risk that their parent (your client) will outlive their life expectancy if the annuity is structured as a lifetime payout.
Charitable Trusts
How would your charitably inclined high net worth client respond to these benefits?
- Potential for a significant income tax deduction
- Lifetime income for your client and their loved ones
- Transfer significant wealth to loved ones without transfer taxes
If you have clients that fit this profile, Charitable Trusts should be considered. We’ll review how two types of Charitable Trusts, Charitable Remainder Trusts, and Charitable Lead Trusts, can fit a client’s needs.
Charitable Remainder Trust (CRT)
A CRT may appeal to a client who places a high value on:
- Giving to charity,
- Providing an income stream to themselves or their loved ones, and
- Deducting charitable contributions for income tax purposes.
CRTs are perfectly named. A charity of your client’s choosing receives the ending balance of the trust (“the remainder”) after making a series of payments to the current beneficiary (your client or your client and their loved ones). Charitable remainder trusts can be created during a client’s lifetime or upon their death. We will focus on those created during life. Here are key aspects of a CRT:
- Income—The trust can provide payouts for one or more beneficiaries. Generally, only the client (grantor of the trust) or the client and their spouse are named as the current beneficiaries in order to avoid transfer tax issues associated with naming anyone else; however, naming other beneficiaries is possible.
- Income tax—A significant income tax deduction may be available to your client when the trust is funded.
- Termination—The trust can be written to terminate upon:
- The death of the current beneficiary if only one beneficiary is named,
- The death of the last living current beneficiary if more than one beneficiary is named,
- A specific number of years, or
- A combination such as “lifetime with 20 years certain.”
- Irrevocable—While the trust is irrevocable, the charitable beneficiary designation can be changed without losing the tax advantages of the trust.
- Annual payout—The annual payout to the current beneficiary or beneficiaries cannot be less than 5% or more than 50% of the value of the trust. This amount must be paid at least annually to the current beneficiary out of the income and/or principal of the trust.
It is simply not possible to explain the full potential of CRTs in just one blog. However, be aware that the current beneficiary can receive either a fixed payment amount or a fixed percentage of trust assets. Clients concerned about maintaining the purchasing power of the payout will tend to select a fixed percentage approach. In the approach, the payout increases as the value of the trust increases.
Charitable Lead Trust (CLT)
A CLT may appeal to a client who places a high value on:
- Transfering appreciating assets to loved ones,
- Reducing potential gift and estate taxes, and
- Providing an income stream to a charity.
A CLT is an irrevocable charitable trust in which the charity is the current beneficiary and receives an annual payout until the trust terminates, at which time the remaining property in the trust is distributed to the remainder beneficiaries. Remainder beneficiaries are frequently loved ones of your client (the “donor” of the trust). Typically, CLTs are utilized by very high net worth clients who have charitable intent and are looking for ways to minimize the transfer tax impact of transferring assets to their heirs. The following features are commonly found in the trust document of CLTs.
- Similar to a charitable remainder trust, a charitable lead trust may be structured to make annual payouts as fixed amounts or a fixed percentage of trust assets.
- The trust may last for the lifetime of the donor (your client), another individual named by the donor, or for a specific number of years. Unlike a Charitable Remainder Trust (CRT), the time span is not limited to 20 years if a specific number of years is chosen.
- Unlike a Charitable Remainder Trust, no minimum payout is required.
Expert income tax counsel is highly recommended for all strategies discussed in this series, especially the CLT strategy. The wrong choice in trust structure could mean your client has to include trust income in their total annual income or include the fair market value of trust assets in their gross estate at death.
Other Techniques (Honorable Mentions)
Private Foundation—The purpose for developing a private foundation can be varied, but the common denominator is the desire of an individual or family to utilize a portion of their wealth to fulfill their intent to better the world. Most foundations function as general-purpose endowment funds that the families use to make their charitable contributions. There is no payout to loved ones and no wealth transfer to loved ones in this strategy.
Sale-Leaseback‑This occurs when one party sells an asset (property) to another party and then leases that property back from them. The party selling the asset receives the cash inflow, is able to retain use of the asset, and can deduct the lease payments if the property is used for business purposes. The party buying the property receives ownership of the property as well as an income stream. Sale-leasebacks are often used within families. For example, a family member in a higher income tax bracket may sell an asset to another in a lower bracket and make monthly deductible lease payments to that family member. Oftentimes, the sale of the property is to a trust.
A gift leaseback is essentially the same as a sale-leaseback, except that the property is gifted instead of sold.
Disclaimer
The information presented herein is provided purely for educational purposes and to raise awareness of these issues; it is not meant to provide and should not be used to provide gift, estate, generation-skipping, or financial planning advice of any kind. An experienced estate planning attorney should advise clients in these transfer tax issues. There are variations, alternatives, and exceptions to this material that could not be covered within the scope of this blog.
