Mathematics of Gifting & Inter Vivos Sales

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1 Mathematics of Gifting & Inter Vivos Sales Presented By: Robert S. Keebler, CPA, MST, AEP (Distinguished) Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication, including attachments, was not written to be used and cannot be used for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein. If you would like a written opinion upon which you can rely for the purpose of avoiding penalties, please contact us Robert S. Keebler, CPA, MST, AEP (Distinguished) All rights reserved WEALTH TRANSFER PLANNING OBJECTIVES Minimize estate tax exposure Minimize income tax exposure Minimize creditor exposure Maximize benefits to children and family Take full advantage of the currently low interest rates Robert S. Keebler, CPA, MST, DEP Virchow, Krause & Company, LLP All rights reserved 2 CONFISCATORY NATURE OF ESTATE TAXES* *Assuming death occurs in 2011 with estate of $10 million (plus a $3,500,000 estate tax exemption and a 45% estate tax rate) 3 1

2 KEY STRATEGIES Inter Vivos Gifts Annual Exclusion Gifts Unified Credit Gifts Dynasty Trust Grantor Retained Annuity Trust (GRAT) Intentionally Defective Grantor Trust (IDGT) Self-Canceling Installment Note (SCIN) Private Annuity 4 GIFTING/TRANSFER TECHNIQUES 5 GENERAL RECOMMENDATIONS Make full use of the Unified Credit during lifetime Transfer highly-appreciating assets to a Grantor Retained Annuity Trust (GRAT) Sell highly-appreciating assets to an Intentionally Defective Grantor Trust (IDGT) Installment Note Self-Canceling Installment Note (SCIN) Sell highly-appreciating assets to future generations in exchange for a private annuity 6 2

3 CURRENT INTEREST RATES 7 TAX EXCLUSIVE NATURE OF GIFTS 8 TAX EXCLUSIVE NATURE OF GIFTS Gift tax to the donor is calculated by the gift passing to the donee after the imposition of gift tax Estate tax is calculated based on the total taxable estate, regardless of the net amount passing to the beneficiaries of the estate 9 3

4 TAX EXCLUSIVE NATURE OF GIFTS EXAMPLE 10 TAX EXCLUSIVE NATURE OF GIFTS ADVANTAGES Removes highly-appreciating assets from the donor s estate Favorable tax treatment on taxable gift versus taxable estate 11 TAX EXCLUSIVE NATURE OF GIFTS DISADVANTAGES Taxable gifts and gift taxes paid by the donor are included in his/her estate if the donor dies within three years after making the taxable gift Potential repeal of the estate tax 12 4

5 DYNASTY TRUST 13 DYNASTY TRUST DISTRIBUTION UPON GRANTOR S DEATH Grantor / Parent Gift* No transfer tax paid. Dynasty Trust Advantages Creditor protection Divorce protection Estate tax protection Direct decedent protection Spendthrift protection Consolidation of capital * Gift should take advantage of any remaining Unified Credit / GST exclusion remaining. No transfer tax paid. No transfer tax paid. No transfer tax paid. Discretionary Distributions to Children for Life Discretionary Distributions to Grandchildren for Life Discretionary Distributions to Great-Grandchildren for Life Future Generations 14 DYNASTY TRUST ADVANTAGES OF AVOIDING GST TAX* * For sake of simplicity, it is assumed that the marginal estate tax rate at each generation s death is 45%. 15 5

6 DYNASTY TRUST ADVANTAGES Takes maximum advantage of the lifetime gift exclusion amount of $1,000,000 Takes maximum advantage of the one-time application of the $3,500,000 GSTT exemption Appreciation of assets will be estate tax free Provides a layer of asset protection from the beneficiaries creditors No transfer tax will be paid at the death of the grantor s descendants Provides flexibility Future trustees can be given the discretion to make distributions as appropriate, given the circumstances that exist at the time the distributions are made Grantor can use the trust to positively affect future behavior 16 GRANTOR RETAINED ANNUITY TRUST (GRAT) 17 STEP ONE: GIFT OF ASSETS Grantor / Parent Gift of assets GRAT For gift tax purposes, the initial gift is based upon a calculation of the present value of the annuity stream. All growth in excess of the IRC 7520 rate inures to the beneficiaries, effectively freezing growth of assets to the IRC 7520 rate. The IRC 7520 rate for September 2010 is 2.4%. 18 6

7 STEP TWO: PAYMENT OF GIFT TAX Grantor / Parent Gift tax payment Most likely will equal zero IRS The amount of the taxable gift is the value of the property transferred to the trust minus the present value of the annuity interest that the grantor retains. In valuing the lead interest, the IRS assumes that the trust assets produce a return equal to the IRC 7520 rate, effectively freezing growth of assets to the IRC 7520 rate. 19 STEP THREE: ANNUITY PAYMENTS Grantor / Parent Annuity payments GRAT The GRAT must provide for payment of an annuity to the grantor not less frequently than annually. As cash flow may be insufficient to satisfy the GRAT annuity payments, in-kind distributions may have to be made to the grantor to satisfy the annuity payments. However, these in-kind distributions could be contributed to new GRATs to avoid estate inclusion of the in-kind distributions. 20 STEP FOUR: PAYMENT TO BENEFICIARIES GRAT Children At conclusion of GRAT term, remaining assets are transferred to children. At this point, no further tax is imposed. 21 7

8 EXAMPLE* TEN-YEAR TERM 10% GROWTH Benefit: $13,256,331 Transferred to Beneficiaries Tax-Free * Assuming a $7,000,000 (after valuation adjustments) initial contribution 22 WHY GRAT WORKS Difference Between Rates of Return Benefit: $7,821,516 Additional Wealth Transferred to Beneficiaries Tax-Free (of which $1,640,473 is due to taxes paid to grantor) 23 WHY GRAT WORKS Valuation Adjustments Benefit: $5,434,754 Additional Wealth Transferred to Beneficiaries Tax-Free 24 8

9 WHY GRAT WORKS Payment of Taxes by Grantor Benefit: $1,640,473 Additional Wealth Transferred to Beneficiaries Tax-Free 25 WHY GRAT WORKS Summary 26 WHY GRAT WORKS Payment of trust income taxes by the grantor Valuation adjustments on assets transferred Difference between actual rate of return and IRC 7520 rate 27 9

10 ADDITIONAL GRAT FEATURE 20% Increasing Payment Under Treas. Reg (b)(1)(ii)(B), the annual GRAT payment may increase by up to 20% over the annuity payment from the previous year. Accordingly, by back-end loading the GRAT payments, more wealth is left to future generations. Benefit: $1,269,563 Additional Wealth Transferred to Beneficiaries Tax-Free 28 ADVANTAGES Annuity payments provide income stream to the grantor Ability to make gifts of substantial amounts of property tax-free Grantor pays income tax on trust income, leaving more assets in the GRAT for remainder beneficiaries Reduces the taxable estate of the grantor Valuation adjustments increase effectiveness of sale for estate tax purposes 29 DISAVANTAGES If the grantor dies before the end of the GRAT term, the assets in the GRAT are included in the grantor s estate The remainder beneficiaries will have the same basis in the property transferred to the GRAT as the grantor had at the time the property was transferred (no step-up in basis) Risk that rate of return will not exceed interest rate resulting in no assets being transferred to remainder beneficiaries 30 10

11 SALE TO AN INTENTIONALLY DEFECTIVE GRANTOR TRUST (IDGT) 31 STEP ONE: GIFT OF ASSETS Grantor / Parent Gift IDGT Gift approximately 10% of total value that needs to be transferred to trust. This transfer will be a taxable gift that may require gift tax to be paid. The assets transferred, and the earnings on the assets transferred, will pay for future installment payments. 32 STEP TWO: SALE OF ASSETS Grantor / Parent Sale Note payable IDGT The remaining assets are transferred to the IDGT in exchange for an installment note payable

12 STEP THREE: INSTALLMENT PAYMENTS Grantor / Parent Installment payments IDGT Annual installment payments are made from the IDGT to the seller/grantor. These may include interest and principal or just interest with a balloon payment due at the end of the term. 34 EXAMPLE* TEN-YEAR TERM 10% GROWTH Benefit: $14,854,256 Transferred to Beneficiaries Tax-Free * Assuming a $7,000,000 (after valuation adjustments) interest only, balloon payment feature installment note with a 3.66% annual interest rate (long-term AFR) 35 WHY WORKS Difference Between Rates of Return Benefit: $10,104,327 Additional Wealth Transferred to Beneficiaries Tax-Free (of which $5,971,931 is due to taxes paid to grantor) 36 12

13 WHY WORKS Valuation Adjustments Benefit: $4,749,929 Additional Wealth Transferred to Beneficiaries Tax-Free 37 WHY WORKS Payment of Taxes by Grantor Benefit: $5,971,931 Additional Wealth Transferred to Beneficiaries Tax-Free 38 WHY WORKS Summary 39 13

14 WHY A WORKS Back end-loading of installment payments Payment of trust income taxes by the grantor Valuation adjustments on assets sold Difference between actual rate of return and AFR 40 INTENTIONALLY DEFECTIVE GRANTOR TRUST Trust income is taxed to the seller/grantor Trust assets sold are not in seller/grantor s estate for estate tax purposes Payments of income tax on behalf of the trust should not be an additional gift to the trust 41 ADVANTAGES Freezes value of appreciation on assets sold in the seller/grantor s taxable estate at the low interest rate on the installment note payable No capital gains tax due on installment sale Interest income on installment note is not taxable to the seller/grantor Grantor pays income tax on trust income, leaving more assets in the IDGT for remainder beneficiaries Valuation adjustments increase effectiveness of sale for estate tax purposes 42 14

15 DISADVANTAGES Estate inclusion of note if seller/grantor dies during term of installment note No step-up in basis at seller/grantor s death Trust income taxable to seller/grantor during his/her life could cause a cash flow problem if there is not sufficient income earned by the seller/grantor Possible gift and estate tax exposure if insufficient assets are used to fund the trust Possible taxable gift for amount of loan Possible taxable estate inclusion under Karmazin (retained life estate) 43 USING A SELF-CANCELING INSTALLMENT NOTE (SCIN) 44 USING A SCIN Transaction similar to an ordinary installment sale to an IDGT Cancellation at death feature added to note Premium must be paid, either in the form of additional principal or increased interest rate to compensate for the cancellation-at-death feature OBJECTIVE: Reduction of estate tax if premature death occurs 45 15

16 USING A SCIN THREE TYPES OF SCINs Hedge SCIN A SCIN designed to hedge against the possibility of death during a betto-live strategy (taxable gifts, GRAT, etc ) Bridge SCIN SM A SCIN designed to take advantage of the increases in the Unified Credit Mortality SCIN A SCIN designed for those who have a high likelihood of dying within a short period of time 46 USING A SCIN SAMPLE OF SCIN RISK PREMIUMS* 47 USING A SCIN EXAMPLE* TEN-YEAR TERM 10% GROWTH / 78 YEAR-OLD SELLER Benefit: $5,673,822 Transferred to Beneficiaries Tax-Free * Assuming a $7,000,000 (after valuation adjustments) interest only, balloon payment feature installment note with a % annual interest rate (3.66% long-term AFR % risk premium ) 48 16

17 USING A SCIN ADVANTAGES Future appreciation above the note interest rate, including the risk premium, is removed from the seller/grantor s estate Asset not included in seller/grantor s estate in case of premature death during SCIN term Value of assets transferred out greatly exceeds value of payments coming back into the estate of the seller/grantor if he/she passes away prematurely No gain or loss on sale Trust income taxable to seller/grantor allows for greater appreciation to inure to future generations, thereby creating an additional tax-free gift Valuation adjustments increase effectiveness of sale for estate tax purposes 49 USING A SCIN DISADVANTAGES Complex calculation of risk premium Possible gift tax exposure if SCIN risk premium is inadequate Possible gift tax exposure if insufficient assets are used to fund the trust Possible taxable estate inclusion under Karmazin (retained life estate) No step-up in basis at seller/grantor s death Possible acceleration of capital gain at seller/grantor s death Trust income taxable to seller/grantor during his/her life could cause a cash flow problem if there is there is not sufficient income earned by the seller/grantor Possible upstream transfer to seller/grantor if he/she survives term of note (or lives a significant portion of the term and/or is relatively old) 50 USING A SCIN WHY A USING A SCIN WORKS Back end-loading of installment payments Payment of trust income taxes by the grantor Valuation adjustments on assets sold Cancellation-at-death feature Difference between actual rate of return and risk-adjusted AFR 51 17

18 PRIVATE ANNUITY 52 PRIVATE ANNUITY Sale Parent Children Annuity payments for life The seller s age and the current IRC 7520 rate are used for purposes of determining the amount of the annuity. Provided that the annuity is calculated correctly, the future value of the assets sold less the future value of the payment stream retained by the seller inures to the buyer (beneficiaries) free of transfer taxes, thus effectively freezing the growth of assets at the IRC 7520 rate. The IRC 7520 rate for September 2010 is 2.4%. 53 PRIVATE ANNUITY SAMPLE OF PRIVATE ANNUITY AMOUNTS* 54 18

19 PRIVATE ANNUITY EXAMPLE* TEN-YEAR TERM 10% GROWTH / 78 YEAR-OLD SELLER Benefit: $12,048,772 Transferred to Beneficiaries Tax-Free * Assuming a $7,000,000 (after valuation adjustments) sale 55 PRIVATE ANNUITY ADVANTAGES Provides an income stream to the seller for life Asset not included in seller/grantor s estate in case of premature death during the annuity term Value of assets transferred out of the seller s estate greatly exceeds value of payments coming back if he/she passes away prematurely Valuation adjustments increase effectiveness of sale for estate tax purposes 56 PRIVATE ANNUITY DISADVANTAGES If not structured correctly, an immediate gain could be recognized by the seller The buyer s payments are not deductible as interest, thus causing more ordinary income to be recognized (double taxation) Potential upstream transfer if seller lives for a long period of time (especially if the seller lives longer than his/her life expectancy) If assets are sold to a trust, possible gift tax exposure could occur if the trust has inadequate assets to support the payments 57 19

20 PRIVATE ANNUITY WHY PRIVATE ANNUITY WORKS Valuation adjustments on assets transferred Cancellation-at-death feature Difference between actual rate of return and IRC 7520 rate 58 COMPARISON OF ESTATE PLANNING TECHNIQUES (Assuming Seller/Annuitant Lives Term) 59 COMPARISON OF ESTATE PLANNING TECHNIQUES (Assuming Seller/Annuitant Dies Midway Through Term) 60 20

21 TAX BURN SCIN SM 61 Tax Burn SCIN SM SCIN used in combination with IDGT Grantor / Parent Gift/Sale SCIN IDGT 62 Tax Burn SCIN SM Income tax liability of IDGT is paid by grantor due to the defective nature of the trust Taxable income Investment (i.e. closely-held stock, marketable securities, etc.) Cash flow Grantor / Parent IDGT IRS Payment of income tax on IDGT s taxable income 63 21

22 Tax Burn SCIN SM To the extent that the income tax liability on IDGT s income is greater than installment payments received back from the trust, the excess income tax liability will reduce the grantor s taxable estate (i.e. tax burn ). 64 Tax Burn SCIN SM If grantor dies during term of SCIN, the note and assets sold to the IDGT are out of the grantor s estate If the grantor survives the term of the SCIN, then the Tax Burn will have eroded the grantor s estate to the point where the repayment of the note will not increase the grantor s taxable estate 65 Tax Burn SCIN SM Initial Burn Point (a.k.a Tax Burn ) The point at which the income tax liability paid by the grantor becomes greater than the installment payments received from the trust. Full Burn Point The point at which any cumulative reinvested positive transfers (i.e. installment payment received > tax liability) by the grantor and the SCIN are eliminated by the cumulative effect of the tax burn

23 Tax Burn SCIN SM EXAMPLE 67 CONCLUSION 68 23

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