Current Market Conditions Create Opportunities for Estate Planning Strategies

Transcription

1 Current Market Conditions Create Opportunities for Strategies SUMMARY The recent decline in stock prices and today s low interest rates for intra-family loans present a unique opportunity to transfer wealth to younger generations in a tax-efficient manner. Strategies such as gifts to defective grantor trusts, grantor retained annuity trusts ( GRATs ) and below-market rate loans may allow a donor to make funds available to his or her descendants during his or her lifetime without imposition of substantial gift taxes and also reduce the donor s estate tax burden by decreasing the size of his or her estate for estate tax purposes. The current market environment may make such strategies particularly attractive. FEDERAL ESTATE AND GIFT TAXATION The federal estate and gift tax currently is imposed on taxable estates and gifts at the rate of 45% on amounts in excess of a taxpayer s exemption amount. State estate and gift tax also may be imposed. The federal lifetime gift tax exemption currently is $1 million. The federal estate tax exemption is $2 million (less the amount of any gift tax exemption used during life), and is scheduled to increase to $3.5 million in In 2010, the estate tax is scheduled to be repealed for one year and the gift tax rate to be reduced to 35%. In 2011, however, repeal of the estate tax is scheduled to expire, with the highest estate and gift tax rate increasing to 55%. Alternative rate and exemption structures continue to be debated in Congress and by the presidential candidates. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 Current market conditions present opportunities for donors to make gifts of stock at depressed prices. Donors may use their lifetime gift tax exemption amount to transfer potentially greater value without paying gift or estate taxes than would have been possible before the recent market declines, and may do so through estate planning strategies utilizing trust and loan structures. GIFTS TO TRUSTS It is often advantageous for a donor to make gifts to beneficiaries in trust. Trusts are simple and flexible structures for holding assets that allow a donor to determine the degree and timing of control the beneficiaries will have over gifted assets, while removing the assets from the donor s estate for estate tax purposes. For example, a donor can determine whether some or all of the gifted assets will be distributed to his or her child outright on reaching designated ages or educational goals and whether the trustee will have discretion to direct assets away from the child to other family members or to charity. The use of certain trusts can have additional tax planning benefits. A donor can create an intentionallydefective grantor trust, which is a trust over which the donor retains specific powers (for example, the power to substitute assets of equal value for the trust assets) that cause the donor to be treated as the owner of the trust assets for income tax purposes, but not for estate and gift tax purposes. Because the grantor of a grantor trust is legally responsible to pay the income taxes on the trust s income, the payment of such taxes is not deemed a further gift to the trust, thereby enabling the trust to grow for the beneficiaries on an income tax-free basis. Defective trusts also can be useful structures for engaging in more complex sale transactions, including family limited partnership transactions, and generation-skipping transfer tax planning. GRANTOR RETAINED ANNUITY TRUSTS A grantor retained annuity trust ( GRAT ) allows a donor to transfer any appreciation in the value of property over a fixed interest rate (set monthly by the Internal Revenue Service, 3.8% for October and 3.6% for November) at a nominal gift tax cost. A GRAT is an irrevocable trust to which the grantor contributes property for at least two years while retaining the right to receive an annuity back from the trust in cash or in kind at the end of each year. At the end of end of the GRAT term, any remaining assets of the trust after payment of the annuities pass to the trust s remainderman (typically one or more defective grantor trusts for the benefit of children). When the GRAT is created, the grantor is deemed to make a gift of the remainder interest to the beneficiary. The annuity payments can be fixed, however, such that the value of the GRAT remainder interest at the time of the initial transfer is very close to zero (i.e., a so-called zeroed-out GRAT). -2-

3 To illustrate how a successful zeroed out GRAT would work, assume a grantor transfers $100 in value of assets to a two-year GRAT and retains the right, under the trust terms, to receive an annuity each year. Using the IRS-mandated interest rate for October 2008, each of the two annuity payments would be % of the original $100. Assume further that the trust assets increase in value at a 10% annual rate of return. By the time the trust term ends, the trust will have paid out approximately $106 in annuity payments to the grantor, which is more than the initial value of the trust. However, the trust still will have $10 of value remaining at the end of its term to distribute to the remainder beneficiaries free of gift and estate tax. Had the initial $100 not been funded in the GRAT, the $10 growth on those assets would be subject to estate tax in the grantor s estate rather than having passed tax-free to the grantor s descendants through the GRAT. A GRAT works particularly well when the value of the asset at the funding of the GRAT is low, which may prove to be the case following the recent drop in stock prices. Also, the interest rate set by the IRS currently is low by historical standards, making it easier to produce a successful GRAT if the asset appreciates. The current market is thus particularly attractive for the creation of GRATs. A GRAT will not produce benefits if the investment return on the GRAT assets underperforms the fixed interest rate or if the grantor dies during the term of the GRAT. A GRAT is a grantor trust and therefore all income of the GRAT is taxable to the donor and none of the transfers between the GRAT and the donor would be taxable for income tax purposes. BELOW-MARKET RATE LOANS Loans may be made to family members or trusts for their benefit at the Applicable Federal Rate ( AFR ), which is the minimum rate that must be charged in order to avoid gift treatment. For loans made in October, 2008, the AFR is 2.19% for loans with a maturity up to three years and 3.16% for loans with a maturity up to nine years. The rates are 1.63% and 2.97%, respectively, in November. To the extent the return on investments made by the borrower with the loan proceeds exceeds the relevant interest rate, the lender will effect a gift tax-free transfer to the borrower equal to the difference between the investment return and the interest rate paid. A trust borrower should have characteristics indicating an ability to repay the loan, including other assets with aggregate value equal to at least ten percent of the amount of the loan. If the grantor of a defective grantor trust makes the loan to the trust, there will be no income tax on the interest payments to the grantor. COMPARISON OF LOANS AND GRATS An advantage of a loan over a GRAT is that the interest rate that must be exceeded on the investment assets in order to pass value to children is lower (3.16% (for a mid-term loan) versus 3.8% (for GRATs) in -3-

4 October). There also is no requirement that the grantor survive the loan term, whereas a GRAT is successful only if the grantor lives until the end of the GRAT term. An advantage of a zeroed-out GRAT over a loan is that there is no risk of a significant taxable gift if a GRAT investment is not successful. If GRAT assets do not perform well enough to fund in full the required annuity payments to the grantor, then at the expiration of the GRAT, the grantor receives back whatever GRAT assets remain. The remainder beneficiary has no obligation in respect of the shortfall and no gift tax is payable. In contrast, if loan proceeds are lost and the loan cannot be repaid, it would have to be forgiven and a taxable gift would be made. Another advantage of a GRAT over a loan is that because unsuccessful GRATs are essentially disregarded and do not dilute positive investment performance of winning GRATs, the potential to pass value to children using GRATs can be greater than with a loan. A significant position in a single publicly traded stock is a particularly appropriate investment for a GRAT. It also is helpful for a GRAT investment to have some volatility. More diversified holdings may be more appropriate for loan transactions. In any wealth transfer strategy, if the asset transferred is company stock and the donor is an affiliate of the company, securities law issues should be considered. * * * Copyright Sullivan & Cromwell LLP

5 ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance and corporate transactions, significant litigation and corporate investigations, and complex regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has approximately 700 lawyers on four continents, with four offices in the U.S., including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Jennifer Rish ( ; rishj@sullcrom.com) or Alison Alifano ( ; alifanoa@sullcrom.com) in our New York office. CONTACTS New York James I. Black III blackj@sullcrom.com Charles T. Dowling dowlingc@sullcrom.com Basil P. Zirinis, III zirinisb@sullcrom.com NY12525: