Advanced Wealth Transfer Strategies

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1 Family Limited Partnerships (FLPS) Advanced Wealth Transfer Strategies The American Taxpayer Relief Act of 2012 established a permanent gift and estate tax exemption of $5 million, which is adjusted annually for inflation. For many individuals, the inflation adjusted gift and estate tax exemption amount of $5.43 million for 2015 is likely to eliminate most, if not all of their potential estate tax liability. But individuals with larger estates, or those who would like to continue receiving income from the assets they ultimately wish to transfer, may need something more. A number of more sophisticated wealth transfer strategies enable you to transfer assets at reduced values for gift and estate tax purposes often enabling you to remove assets worth well in excess of $5.43 million from your estate without triggering gift or estate taxes. Many of these strategies also provide a predictable income stream. Their interest rate sensitivity makes it advantageous to consider these strategies now, while interest rates are low. Grantor retained annuity trusts Grantor retained annuity trusts (GRATs) are an estate freeze technique that enable you to remove future appreciation from your taxable estate. They are particularly useful to individuals who have assets that: can benefit from a valuation discount, such as a minority stake in a private company or LLC, may appreciate substantially in value, such as ownership in a company that may be sold or taken public, or generate strong cash flow, such as commercial real estate. With a GRAT, you gift property to a trust that makes periodic payments to you. The present value of the payments you receive is taken into consideration in valuing your gift for gift tax purposes. The payments may be in-kind (such as a portion of any securities you have gifted) or in cash and, if set at a level that is high enough, they can possibly reduce the value of the gift for gift tax purposes to zero. As long as you outlive the GRAT, when it terminates, any property remaining in the trust passes to the remainder beneficiaries without any additional gift or estate tax consequences. Kathryn, age 50, is a senior executive at a company that is contemplating going public through an initial public offering (IPO). Several years ago, she used her full gift exemption to establish a trust for her son, but she would like to transfer some of the company stock she owns out of her estate before the IPO. She sets up a 3-year GRAT that names her son as remainder beneficiary, and contributes shares valued at $10 million. The valuation on the shares includes a 35% discount for lack of marketability and control placing the value before the discount at $15,384,615. By having the GRAT pay her $3,508,156 each year, she is able to reduce the value of the $10 million gift to zero for gift tax purposes eliminating the need to pay any federal gift tax. If the GRAT makes the payments in-kind and the value of the shares increases 10% each year, the GRAT will hold shares with an aggregate market value of $2,612,313 after making the final payment. If the stock goes public at the end of the GRAT s term at a price that is 10% higher, the GRAT will hold shares valued at $2,873,544. Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S), a registered broker-dealer, Member SIPC, and other subsidiaries of Bank of America Corporation (BofA Corp.). Investment and insurance products: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value Are Not Deposits Are Not Insured by Any Federal Government Agency Are Not a Condition to Any Banking Service or Activity

2 Kathryn Chris Kathryn GRAT: IPO at 10% Premium Pre-IPO shares valued at $10,000,000 Shares valued at $3,508,156 each year for three years Gift Tax Free GRAT: IPO at 20% Premium Pre-IPO shares valued at $10,000,000 Shares valued at $3,508,156 each year for three years GRAT $10,000,000 10% growth/year after IPO GRAT Remainder $2,873,544 (after payments to Kathryn) GRAT $10,000,000 10% growth/year after IPO Sales to intentionally defective grantor trusts Selling assets to an intentionally defective grantor trust (IDGT) can be a particularly attractive strategy for leveraging your federal gift and GST exemptions. Similar to a GRAT, an IDGT is useful for transferring assets that can benefit from a valuation discount, may appreciate substantially in value, or generate strong cash flow. With this strategy, you make an initial taxable seed gift to the trust. The trust then purchases additional assets from you that can be valued at up to nine times the value of seed gift by issuing an installment note. If you have not already used your $5.43 million 2015 federal gift tax exemption, the combined gift and sale would enable the trust to acquire assets valued at up to $54.3 million without triggering any federal gift taxes. And, if you are transferring ownership in a private company or LLC, selling a minority stake or nonvoting shares may enable you to take maximum advantage of any available valuation discount and ultimately transfer even greater value free of federal gift taxes. Chris Gift Tax Free GRAT Remainder $3,134,755 (after payments to Kathryn) These figures and illustrations are based on a discount rate of 2.6%. This rate, set by the IRS, varies monthly and must be used in determining the gift value of a GRAT. A higher or lower price for the IPO or price appreciation thereafter would change the final value of the trust property but would not affect the gift-tax consequences. If the IPO price is 20% higher, the value of the shares held by the GRAT will be $3,134,755. The GRAT enables Kathryn to transfer stock valued at over $2.8 million to a trust for her son without paying any federal gift tax. By establishing a new GRAT each year using the shares that are returned to her, Kathryn may be able to transfer additional shares free of gift and estate tax. GRATs are particularly useful for individuals who want to transfer appreciation on an asset, but may want to continue receiving some benefit from it. They are often structured with a relatively short term because the tax benefits are lost unless you outlive the GRAT. The interest rate used to value the annuity payments is determined by the IRS at the time the GRAT is established. Lower interest rates increase the present value of the annuity payments and therefore reduce the gift tax value, making the GRAT more attractive. The current low interest rates make it advantageous for anyone with appreciating assets to consider a GRAT now. In order to avoid federal gift tax consequences, however, the interest rate on the note must be at least as high as the rate set by the IRS, but the note can be structured with a balloon payment to minimize the annual payments. The note can also be refinanced to defer repayment of principal even further, if needed. It is important to note that the sale of the assets to the trust is not a taxable event. Because the trust is structured to be intentionally defective for income, but not gift tax purposes, the sale of the assets to the trust is treated as though it were a sale to yourself. No gain or loss is triggered until the assets are sold to a third party. Roger, age 60, owns a closely-held business that he believes he can eventually sell for $120 million to a company that could distribute his product more broadly. He recognizes that the $5.43 million federal gift tax exemption provides him with an opportunity to transfer an ownership stake, and the potential price appreciation on it, out of his taxable estate. A valuation firm has told him that the company is worth $90 million based on its current cash flow, and indicates that a 35% discount for lack of control would apply to the value of any non-voting shares. 2 ADVANCED WEALTH TRANSFER STRATEGIES

3 Incorporating Life Insurance into Your Wealth Transfer Plan Life insurance can be an attractive addition to most wealth transfer plans because of the beneficial tax treatment it receives when properly incorporated into a trust, the proceeds of life insurance are free of both income and estate taxes. This can make insurance an attractive component for providing liquidity to offset estate taxes or for heirs. Individuals using GRATs may find insurance particularly useful. A GRAT removes assets from the Grantor s taxable estate only if the Grantor outlives the term of the GRAT. As a result, individuals using GRATs often pair the GRAT with a life insurance policy that will provide funds to offset any estate taxes that might be triggered if the assets are brought back into the Grantor s taxable estate as a result of an untimely death. Roger establishes an IDGT, gifts $5 million to the trust and then sells non-voting shares valued at $50 million to the trust. The trust issues a 15-year installment note with an interest rate equal to the IRS mandated rate of 4.5% to finance the purchase of $45 million of the stock. Because the note is structured with a balloon payment, annual payments by the trust are limited to $2,025,000 for the first 14 years, with cash flow from the company being more than adequate to cover the payments. Although Roger will be taxed on any income earned by the trust assets, he won t be taxed on the interest payments he receives from the trust and won t recognize a capital gain on the sale of the shares to the trust. He won t recognize any capital gain on the transferred shares until they are sold by the trust. Three years later, when the company is sold for $120 million, the trust repays the $45 million outstanding on the note and is left with $57,564,103 in cash. 1 Roger receives a combined $62,435,897 from the sale of his remaining 14.5% stake in the company and the repayment of the $45 million note. 2 He uses a portion of those funds to pay the tax on the capital gain triggered by the sale of the company. The strategy enables him to transfer over $55 million in value to his children over a three year period by using just $5 million of his $5.43 million gift tax exemption. Given the amount of assets that can be transferred to an IDGT without triggering federal gift taxes, it is often advantageous to allocate your GST exemption to the gift to the extent practical. This enables the trust to make tax-free distributions to grandchildren and future generations. Roger Roger Sale to an IDGT Transfer of Shares Gift $5,000,000 Sale of shares valued at $50,000,000 $45,000,000 Installment Note with annual interest payments of $2,025,000 and principal payment of $45,000,000 at end of year 15 (Grantor is taxed on trust income) Sale of Company Three Years Later Repayment of Installment Note for $45,000,000 Intentionally Defective Grantor Trust Purchaser of Company $102,564,103 Shares Intentionally Defective Grantor Trust $57,564,103 (after sale and repayment of Installment Note) Illustration assumes an interest rate on the installment note of 4.5%. This rate, set by the IRS, varies monthly. A higher or lower sale price for the company ($120 million) would change the final value of the trust property but would not affect the gift tax consequences. Establishing the IDGT in a state such as Delaware, that does not limit the duration of a trust, can help you extend the term of the trust and its ability to provide tax-free payments to future generations. Sale to an IDGT is often an advantageous way to leverage your gift tax exemption and remove appreciation from your taxable estate, while continuing to receive income from the transferred assets. IDGTs also offer greater flexibility than GRATs the term can be much longer because there is no requirement that you outlive the IDGT, the repayment schedule can use a balloon structure, and the note can be repaid at any time. The minimum ADVANCED WEALTH TRANSFER STRATEGIES 3

4 interest rate on the note is mandated by the IRS and varies with the note s term but is generally lower than the GRAT hurdle rate. Current low interest rates make a sale to an IDGT an attractive alternative for anyone who is interested in removing future appreciation from their taxable estate. Qualified personal residence trusts For individuals with a primary residence or vacation home that they would like to leave to family members, a qualified personal residence trust (QPRT) can be a useful strategy for transferring ownership in a tax-advantaged manner. With a QPRT, you transfer a personal residence to a trust, but retain the right to occupy it for a fixed period. At the end of the period, ownership passes to your designated beneficiaries. Although the transfer to the trust is a taxable gift, the value for federal gift tax purposes is reduced by your retained interest the value assigned to your ability to use the residence during the stated term. As a result, the amount of the taxable gift is generally well below the fair market value of the home. And, you can use any remaining lifetime gift tax exemption amount to offset some, or all, of the federal gift tax. Linda, age 60, transfers her vacation home, valued at $2 million, to a qualified personal residence trust set up to last 10 years. Over that period, the home appreciates 2% a year. When the trust ends, it s worth $2,437,989, and the ownership of the home is transferred to Linda s daughter. Assuming an IRS mandated interest rate of 3%, Linda can potentially realize estate tax savings of nearly $466,916. What about gift tax? Linda s top gift tax rate would be 40%. If Linda gave her home to her daughter outright, the value of the transfer for gift tax purposes would be $2,000,000. If she had already used her $5.43 million lifetime gift tax exemption, she would have to pay $800,000 in gift tax. In contrast, gifting the home in trust with the right to live in the residence for ten years reduces the taxable value of her gift to $1,270,700. As a result, the maximum amount of federal gift tax that Linda would have to pay would be $508,280 a savings of over $291,720. It s important to remember that from a legal perspective, you are giving away your home. The trust can provide a degree of flexibility, but your overall control over the residence is effectively terminated when the trust term ends. You do have the ability to include a provision in the trust agreement that allows you to continue living in the residence after the term QPRT Grantor irrevocably transfers residence to a trust. The transfer is subject to gift tax, but all of the tax will be offset by partial use of the grantor s gift tax exemptions. Linda Linda uses rent free for term of trust Grantor pays fair market value rent once trust term ends. Potential estate tax savings = $466,916 Family / Other Beneficiary Value at transfer to QPRT $2,000,000 These figures and illustration are based on an IRS mandated rate of 3.0% and a federal estate tax rate of 40%, and assume the grantor is age 60 when the trust is created. The discount rate, set by the IRS, varies monthly and must be used in determining the gift value of a qualified personal residence trust. A higher or lower actual appreciation (than the 2% illustrated) would change the final value of the trust property and potential estate tax savings but would not affect the gift-tax consequences. Outright Gift Taxable Gift $2,000,000 Gift Tax Cost Use $2,000,000 of exemption or pay $800,000 2% appreciation for 10 years Value at end of trust term $2,437,989 Ownership of residence is transferred to family member or other beneficiary when trust term ends Outright Gift vs. Gift in Trust Gift in Trust Taxable Gift $1,270,700 Gift Tax Cost Use $1,270,700 of exemption or pay $508,280 ends, but you must pay fair market rent to the new owner in order to avoid adverse tax consequences. Should you fail to survive the trust term, the value of the residence would be included in your estate. You should avoid using a QPRT on any property that has an outstanding mortgage as mortgage payments would be considered additional gifts to the trust. With real estate prices reduced in many regions across the country, now may be an opportune time to consider establishing a QPRT. It should be noted, however, that with a QPRT, lower interest rates actually increase the size of the taxable gift. 4 ADVANCED WEALTH TRANSFER STRATEGIES

5 Charitable lead annuity trusts Individuals who are interested in philanthropy and who would like to transfer assets to beneficiaries at a reduced valuation for gift tax purposes may find a charitable lead annuity trust (CLAT) useful. With a CLAT, you gift assets to a trust that makes annual payments to charities of your choice for a designated period. The present value of the charitable payments is taken into consideration when calculating the gift tax value of the assets you transfer to the CLAT. At the end of the trust s term, any assets remaining in the trust pass to your designated remainder beneficiaries without triggering any additional federal gift or estate taxes. A low discount rate coupled with a high payout rate can substantially reduce the gift tax value of the remainder interest. Carlos would like to leave a portion of his securities portfolio to his son, but has already used his lifetime gift exemption. He creates a CLAT with $5 million worth of appreciating securities and names his son as the remainder beneficiary. The CLAT will pay his favorite charity $200,000 a year for 15 years for a total contribution of $3,000,000. If the IRS mandated discount rate is 3%, the charitable payments will reduce the taxable value of his gift to the trust to just $2,612,420. Assuming the trust earns an annual return of 7.5%, at the end of the 15-year term, the assets remaining in the CLAT that will pass to his son will be worth $9,570,714. If Carlos still has $1,500,000 of his lifetime gift tax exemption remaining how much could he transfer to the trust without triggering gift taxes? If he increases the annual charitable payments to $293,500, the taxable value of the portfolio will be reduced to just under $1,500,000 for federal gift tax purposes and his son will receive the $7,128,647 remaining when the trust terminates without triggering additional federal gift or estate taxes. CLAT: $200,000 Annual Charitable Gift Carlos Charitable Lead Trust $5,000,000 CLAT: $293,500 Annual Charitable Gift Carlos 7.5% growth for 15 years Value at end of trust term $9,570,714 (after payments to charity) 7.5% growth for 15 years Value at end of trust term $7,128,647 (after payments to charity) Grantor taxed on trust income $200,000 a year for 15 years = $3,000,000 Charity Children or Other Heirs Taxable gift of $2,612,420 results in transfer of $9,570,714 to heirs Charitable Lead Trust $5,000,000 Grantor taxed on trust income $293,500 a year for 15 years = $4,402,500 Tax free with use of approximately $1,500,000 of gift tax exemption amount Charity Children or Other Heirs These figures and illustrations are based on discount rate of 3.0%. The discount rate, set by the IRS, varies monthly. A higher or lower actual return (than the 7.5% illustrated) would change the final value of the trust property but would not affect the gift-tax consequences. By carefully planning and managing your giving through a CLAT, you can effectively reduce or even eliminate the federal gift tax liability on assets transferred to beneficiaries. This makes it an effective strategy for transferring appreciating assets if you have already utilized all or a portion of your lifetime gift tax exemption and are making, or plan on making gifts to charity. ADVANCED WEALTH TRANSFER STRATEGIES 5

6 Intra-family loans Intra-family loans offer an additional way to transfer future appreciation on assets without triggering gift taxes. With this strategy, you loan money to another family member, typically an adult child or grandchild, enabling him/her to purchase assets. The borrower agrees in writing to repay the principal plus interest at a rate equal to the IRS mandated rate in effect when the loan is made a rate that is typically lower than the rates on commercial loans. Because you are loaning and not gifting the money, a properly structured intra-family loan is not subject to gift tax, and any appreciation on assets purchased with the loan remains outside of your estate for estate tax purposes. You might also have the ability to reduce overall family income tax, since any income produced by the assets purchased with the loan proceeds will be taxable to the borrower typically a child or grandchild, who may be in a lower income tax bracket than you are. However, you must include the interest payments you receive in your taxable income, so this is a benefit only to the extent that the income produced by the assets is greater than the interest paid. Some families find intra-family loans an effective way to encourage younger family members to become actively engaged in and learn about investing. An intra-family loan allows the borrower to retain any income generated in excess of the loan rate, giving them incentive to become more knowledgeable about markets and skilled in their investment selections. Alex, age 72, is interested in encouraging his 21-year-old granddaughter to take a more active interest in investing. He loans Sarah $500,000 in exchange for a Note that requires her to pay interest at the 3.5% annual rate established by the IRS and repay the principal at the end of the 5-year term. If Sarah s investments appreciate 7.5% annually, she will have $116,168 left after making the interest and principal payments on the Note. Alex will have to recognize the annual interest payments as income and Sarah will have to recognize any annual income from the portfolio in excess of the annual interest payment. Alex Donor pays tax on interest income from Note. Donee pays tax on investment income in excess of Note payments. These figures and illustration are based on an IRS mandated interest rate of 3.5%. The rate varies monthly. A higher IRS mandated rate on the note or a lower return on investment portfolio would change the final value remaining in the investment portfolio after repayment of the note. Private annuities Private annuities offer another potential way to transfer assets without gift tax consequences. Assets are sold in exchange for a private annuity a promise to make periodic payments for the remainder of the seller s life. As long as the present value of the expected annuity payments under IRS valuation tables equals the fair market value of the assets, the transaction is free of federal gift tax consequences. This enables the seller to remove the assets, together with any subsequent appreciation on them, from his or her taxable estate. The amount actually paid depends on the length of time the seller lives. Intra-Family Loan $500,000 5-year Note with annual interest payments of $17,500 and principal payment of $500,000 at end of term $500,000 Sarah Annual withdrawals equal to payments on Note Investment Portfolio $116,168 after loan payments assuming a 7.5% annual growth Edna is a 65 year-old widow with an actuarial life expectancy of 19.5 years. Due to some recent significant health concerns, Edna does not expect to live to the age of 85. With that in mind, she decides to transfer $1,000,000 worth of securities to her daughter, Melissa. In exchange for the securities, Melissa agrees to pay Edna an annuity of $77,259 per year, representing the fair market value of the shares calculated using the IRS mandated interest rate of 3%. 6 ADVANCED WEALTH TRANSFER STRATEGIES

7 Eight years later, Edna dies. Assuming that the securities have an average annual return of 7.5%, and that Melissa paid the annuity (a total of $618,072) from other assets, at the end of the eight years, the shares owned by Melissa will be worth $1,783,478. As for the transfer tax consequences, the transfer is free of both federal gift and estate tax. Edna Private Annuity Annuity with annual payments of $77,259 Transfer Tax Consequences No gift tax No estate tax Securities valued at $1,000,000 Melissa 7.5% growth for eight years Value of Shares $1,783,478 (after payments to Edna) These figures and illustration are based on discount rate of 3.0%. This rate, set by the IRS, varies monthly. A higher or lower actual return (than the 7.5% illustrated) would change the final value of the transaction to the donee but would not affect the gift-tax consequences. With a private annuity, the seller recognizes a gain on the sale of the property. As a result, it may be advantageous to sell securities that have a cost basis close to the current market value. By selling the asset to a grantor trust, the seller may be able to avoid recognition of a gain on the sale. Each year for income tax purposes, the seller must also recognize the portion of the annual payment that is not allocated to the gain on the sale or to return of basis. However, the purchaser is not able to deduct the corresponding amount as implied interest. Because the present value of the annuity payments is higher when the IRS mandated rate is low, the economic benefits of a private annuity are typically more attractive when interest rates are low. Summary Although the $5.43 million federal gift and GST tax exemptions provide an opportunity for many individuals to eliminate most if not all of their potential estate tax liability, individuals with larger taxable estates may find some of these more advanced wealth transfer techniques useful in minimizing gift and estate taxes. The interest rate sensitivity of many of these strategies, combined with the current tax environment make it especially advantageous to consider these strategies now, while interest rates are low. Choosing an appropriate strategy, however, depends on your individual needs and goals as well as the nature of the assets you may wish to transfer. Your Financial Advisor, along with an experienced Trust Specialist, would be pleased to meet with you, your attorney and other advisors to help assess the various alternatives and discuss how they may benefit you, your family and future generations. If a trust is decided upon, your Financial Advisor and Trust Specialist will introduce experienced trust professionals from U.S. Trust. 4 As one of the nation s leading trust organizations, U.S. Trust brings deep fiduciary knowledge as well as experience managing a wide range of sophisticated trusts. Your team of Merrill Lynch and U.S. Trust professionals will work with you and your tax and legal advisors from concept through implementation. ADVANCED WEALTH TRANSFER STRATEGIES 7

8 ml.com/legacy All guarantees and benefits of an insurance policy are backed by the claims-paying ability of the issuing insurance company. They are not backed by Merrill Lynch or its affiliates, nor do Merrill Lynch or its affiliates make any representations or guarantees regarding the claims-paying ability of the issuing insurance company. Life insurance death benefit proceeds are generally excludable from the beneficiary s gross income for income tax purposes. There are a few exceptions, such as when a life insurance policy has been transferred for valuable consideration. Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions. The case studies are intended to illustrate trust products and services available through Merrill Lynch. They are not intended to serve as investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. They do not necessarily represent the experience of other clients, nor do they indicate future performance. Investment results may vary. The strategies presented are not necessarily appropriate for every investor. Individual clients should review with their Financial Advisors the terms and conditions and risks involved with specific trust products or services. 1 Assuming a $90 million valuation and a 35% discount for lack of control, the trust is able to acquire non-voting shares that represent an 85.5% ownership stake in the company. When the company is later sold for $120 million, the 85.5% interest held by the IDGT is sold for $102,564,103. After repaying the $45 million note, the trust is left with $57,564, Assumes that the remaining 14.5% stake is sold for $17,435,897. Roger receives a combined total of $62,435,897 from the sale of the stock and repayment of the $45 million note. 3 The estate tax savings are based on the difference between the gift tax value of $1,270,700 and the estimated value of the property at the end of the QPRT, $2,437, U.S. Trust is a division of Bank of America, N.A. Trust and fiduciary services are provided by U.S. Trust, a division of Bank of America, N.A., Member FDIC. Insurance products are offered through Merrill Lynch Life Agency Inc. (MLLA), a licensed insurance agency. Bank of America, N.A., MLPF&S and MLLA are wholly owned subsidiaries of BofA Corp. MLPF&S and U.S. Trust make available investment products sponsored, managed, distributed or provided by companies that are affiliates of BofA Corp. or in which BofA Corp. has a substantial economic interest Bank of America Corporation. All rights reserved. ARGWLRV3 Code PM-0315

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