77 THE AMERICAN LAW INSTITUTE Continuing Legal Education Planning Techniques for Large Estates April 8-10, 2015 Scottsdale, Arizona Putting It All Together: Some of the Best Estate Planning Strategies We See In the New Frontier that Reduce Both Income and Estate Taxes By S. Stacy Eastland The Goldman Sachs Group Inc. Houston, Texas Goldman Sachs does not provide legal, tax or accounting advice. Clients of Goldman Sachs should obtain their own independent tax and legal advice based on their particular circumstances. The information herein is provided solely to educate on a variety of topics, including wealth planning, tax considerations, estate, gift and philanthropic planning.
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79 Table of Contents I. THE PRIMARY IMPORTANCE OF GOALS-BASED PLANNING FOR THE SUCCESSFUL SUCCESSION OF THE FAMILY WEALTH IRRESPECTIVE OF THE STATUS OF THE TAX LAW....1 A. The Importance of First Determining a Client s Goals That Determine the Estate Plan s Essential Strategies...1 1. The Prevalence of Tax Driven Wealth Preservation Focus and Four Suggested Rules to Change the Priority of That Focus....1 2. Estate Plans Developed Around the Stewardship Purpose of the Family Wealth....1 3. Organizational Pattern of a Purpose-Based Estate Plan:...3 4. Compatibility of Strategies and Legal Structures with the Stated Purpose of the Family Wealth....3 B. Once the Purpose and Use of the Family s Capital Has Been Determined, Strategies Should Be Developed to Maximize the Investment Risk-Adjusted, After-Tax Wealth That May be Applied to Those Purposes and Uses....3 II. DEVELOPING WEALTH MANAGEMENT STRATEGIES TO ACCOMPLISH A CLIENT S GOALS IN THE NEW TAX ENVIRONMENT....4 A. Income Tax Versus Estate Tax: A New Paradigm? (It May Not Have to Be)....4 1. Some of the Key Income Tax and Basis Rules....4 a. Certain key basis rules....4 b. Certain key partnership income tax and basis accounting rules....6 2. If Lifetime Basis Enhancing Strategies Are Not Used, From a Tax Perspective, at What Assumed Growth Rate is it Better to Use a Lifetime Transfer Strategy With a Low Basis Asset in Comparison to Retaining the Asset Until Death?...9 3. There May Be Non-tax Factors, Such as Risk-adjusted Investment Considerations, Which Make Holding a Low Basis Asset Until Death for the Basis Step-up Disadvantageous...11 4. The Capital Gains Tax Advantage of a Step-up at Death May Be Unimportant, if the Asset is a Legacy Asset That Will Not Be Sold By the Taxpayer s Heirs....12 5. Taking All of the Above Factors Into Account, When Should a Gifting Strategy for a Low Basis Asset Be Considered?...12 i
80 B. Why Wealth Management Strategies, Including Investment Management Strategies, Are Entirely Different for the Private Wealth Investor in Comparison to the Institutional Investor and Why Tax Management Strategies Are an Important Consideration for the Private Wealth Investor....13 1. Congress Gives the Private Investor Significant After Tax Subsidies for his Equity Investments in Comparison to His Fixed Income Investments....13 2. What is the Efficient Investment Frontier for the Private Investor? (Hint: It is Probably Not What You Learned in Finance Class.)...13 3. What are the Key Components of Structuring a Wealth Management Strategy for a Private Investor?...14 C. The Purposes of This Paper: Explore Wealth Management Strategies That Utilize a Combination of Effective Estate Planning Strategies, Optimized Location of Asset Classes in Family Entities and Basis Enhancing Strategies to Decrease Both Income Taxes and Transfer Taxes on a Net Basis....15 III. WEALTH MANAGEMENT STRATEGIES THAT USE GRANTOR TRUSTS TO LOWER A TAXPAYER S TOTAL NET INCOME AND TRANSFER TAXES....15 A. Contributing and/or Selling Assets to a Grantor Trust....15 1. The Technique....15 2. Advantages of the Technique....17 a. Tax advantage....17 b. The appreciation of the assets of the trust above the interest of the note used in any sale to a grantor trust for the grantor s spouse will not be taxable in the grantor/seller s estate....19 c. The advantage of locating income tax inefficient asset classes inside a grantor trust that is not subject to estate taxes....19 d. Location of tax inefficient classes in a grantor trust, and managing the grantor trust through substitution strategies, further enhances the after tax advantage of a low turnover index fund....22 e. Flexibility advantages of gifting and selling non-managing interests in family entities to a grantor trust in which the grantor s spouse is a beneficiary....22 f. The taxpayer may retain investment control of the family s assets and may also retain limited control of any distributions from the transferred entity interests to family members....23 ii
81 3. Considerations of the Technique....34 a. There may need to be substantive equity in the trust from prior gifts (is 10% equity enough?) before the sale is made....34 b. State income tax considerations....35 c. The IRS could be successful in the argument, that because of the step transaction doctrine, a valuation discount is not appropriate in valuing the transferred entity interest....35 d. If the assets decrease in value, the gift tax exemption equivalent may not be recoverable....38 e. There may be capital gains consequences with respect to the note receivables and/or note payables that may exist at death....38 f. The IRS May Contest the Valuation of Any Assets That Are Hard to Value That Are Donated to a Grantor Trust or Are Sold to Such a Trust....40 B. The Advantages and Considerations for a Taxpayer to Contribute and Sell the Taxpayer s Investments to a Single Member FLLC and Then Contributing Non-Managing Member Interests in That FLLC to a Grantor Retained Annuity Trust ( GRAT )....44 1. What is the Technique?...44 2. Advantages of the Technique....48 a. If leverage is used in creating the FLLC that is contributed to the GRAT, much more wealth will be transferred to the remainderman of the GRAT than through the use of a conventional GRAT....48 b. The technique has many of the same advantages as the sale to the grantor trust....49 c. Valuation advantage of a GRAT....50 d. Ability of grantor to pay for income taxes associated with Holdco, the GRAT and remainder grantor trust gift tax-free and substitute assets of Holdco, the GRAT and remainder grantor trust income tax-free....50 e. Synergy with other techniques....50 f. Comparatively low hurdle rate....51 g. High leverage....51 h. Non-recourse risk to remaindermen...51 i. The Atkinson worry about paying a GRAT annuity with a hard-to-value asset may be eliminated....51 iii
82 j. The taxpayer s unified credit does not have to be used with this technique as it would with most other freeze techniques, which could save capital gains taxes on the death of the taxpayer....52 k. There may be less danger that the retained note will be recharacterized as a deemed retained interest in a trust with this technique than with a sale to a grantor trust....53 3. Considerations of the Technique....53 a. Part (but not all) of the FLLC interests could be taxable in the grantor s estate if the grantor does not survive the term of the GRAT....53 b. It is more complex than the other GRAT techniques....53 c. Care must be taken if the underlying asset that is sold or contributed to the single member LLC is stock in a Subchapter S corporation....54 C. Swapping Assets Inside a Grantor Trust, or a Disregarded Single Member LLC, Before the Death of the Grantor...54 1. Advantages of the Technique....54 a. The low basis assets, if retained by the grantor, will receive a basis step-up on the grantor s death....54 b. If the low basis assets are sold by the grantor before his or her death the cost of the capital gains taxes will be borne by the grantor (just as they would have been if the assets had been sold by the grantor trust or a disregarded single member LLC.)...54 2. Considerations of the Technique....54 a. The grantor may not have any high basis assets, or cash, to swap....54 b. To the extent, after the swap of assets, swapped low basis assets grow more than the swapped high basis assets in the grantor trust, the grantor s estate taxes will increase....54 D. Gifting and Selling Low Basis Assets to a Grantor Trust That is Subject to an Older Generation s General Power of Appointment and Estate Taxes....55 1. The Technique....55 2. Advantages of the Technique....56 a. This technique has the same advantages as a sale to a grantor trust....56 b. The assets of the trust will receive a step-up in basis on the older generation beneficiary s death equal to the fair market value of the assets, if net value rule of Treas. Reg. 2053-7 does not iv
83 IV. apply (see the discussion below in Section III E 3 e of this paper)....56 c. The assets of the trust may be generation skipping tax protected...56 d. The older generation beneficiary may not have to pay estate taxes because of her general power of appointment, if her then available unified credit exceeds the net value of the trust....56 3. Considerations of the Technique....56 a. The grantor of the trust will still have a low basis in his or her note upon the death of the older generation beneficiary....56 b. The older generation beneficiary could exercise his or her general power of appointment in an unanticipated way....57 c. Many of the same considerations for the use of a grantor trust and a sale to a grantor trust would also be present for this technique. See Section III A 3 of this paper....57 d. The effect of IRC Sec. 1014(e) must be considered, if cash is not given and low basis assets are used to capitalize the trust....57 e. The effect of Treas. Reg. 20.2053-7 needs to be considered....57 f. Is grantor trust status lost for the original grantor when the older generation beneficiary dies and the trust assets are included in the beneficiary s estate?...58 THE ADVANTAGES AND CONSIDERATIONS OF A TRANSFEROR SELLING ASSETS TO A TRUST CREATED BY THE TRANSFEROR S SPOUSE THAT NAMES THE TRANSFEROR AS A BENEFICIARY, GIVES THE TRANSFEROR A SPECIAL POWER OF APPOINTMENT, AND UNDER WHICH THE TRANSFEROR S SPOUSE IS CONSIDERED THE INCOME TAX OWNER ( SPOUSAL GRANTOR TRUST )...59 A. What is the Technique?...59 B. Advantages of the Technique....60 1. There Will Be No Capital Gains Consequence on the Original Sale of the Assets to the Trust....60 2. The Technique, With Respect to a Sale to the Trust in Which the Seller has a Power of Appointment, Has the Potential of Mitigating Gift Tax Surprises....61 3. It Has the Advantage of Allowing the Transferor to Be a Beneficiary of the Trust and Have a Power of Appointment Over the Trust....61 4. The Technique Has Many of the Other Advantages of the Sale to a Grantor Trust Technique....61 v
84 C. Considerations of the Technique....62 1. This Technique Has Many of the Considerations of the Sale to a Grantor Trust Technique....62 2. Additional Federal Income Tax Considerations....62 3. Estate Tax Considerations Because of Potential Application of IRC Secs. 2036 and/or 2038....62 4. Estate Tax Considerations if Under Applicable State Law or Federal Bankruptcy Law the Seller/Beneficiary s Creditors Can Reach the Spousal Grantor Trust assets....63 5. If it is Possible For a Current or Future Creditor of an Assigning Seller/Beneficiary to Reach That Part of the Trust Assets That Are Sold, Then That Part of the Trust May Not Constitute a Complete Gift For Gift Tax Purposes....65 V. BORROWING STRATEGIES THAT LOWER THE NET TOTAL INCOME TAX AND TRANSFER TAX....66 A. Managing a Grantor Trust, or a Spousal Grantor Trust, By Making it a Reverse Grantor Trust. The Grantor Could Purchase Low Basis Assets From a Grantor Trust By Using Either a Financed Note or a Loan From a Third Party Bank....66 1. The Technique....66 2. Advantages of the Technique....66 a. The low basis asset will receive a step-up in basis on the grantor s death....66 b. Estate taxes will be saved if the interest carry on the note owed to the grantor trust exceeds the growth of the purchased low basis note....66 c. As long as the trust is a grantor trust, the interest payments on the note could be made in-kind without any income tax consequences...66 3. Considerations of the Technique....67 a. An independent appraisal will be necessary to determine that the interest rate on the recourse, unsecured note is a fair market value interest rate. If the interest rate is too high, there may be gift tax consequences....67 b. If the note is paid back after the grantor s death, there may be capital gains consequences to the trust. See the discussion in Section III A E of this paper. Stated differently, the trust s basis in the note may be equal to the basis of the low basis asset that is exchanged for the note. That result may not change on the death of the grantor, when the trust becomes a complex trust....67 vi