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Ten Estate Planning Strategies While Waiting for Tax Reform

How to proceed until Congress takes action.

The election of Donald J. Trump to the presidency and Republican control of both houses of Congress make estate tax reform extremely probable in the next two years. However, given the new administration’s other proclaimed priorities, including the repeal of Obamacare, minimization of illegal immigration, increases in defense spending and infrastructure improvements, there are likely several months before Congress turns its attention to a tax system overhaul.

There’s much uncertainty about particular aspects of the Republican tax proposal — including a replacement tax on the wealthy — and there’s already concern about the likely impermanence of any new legislation.  These factors highlight the importance of flexibility in preparing an estate plan and proceeding with wealth transfers suited to the current political and economic circumstances.

Here are 10 strategies to discuss with your clients while waiting for Congress to act.

1. Annual Exclusion Gifts

It’s still uncertain whether both the estate tax and the gift tax will be repealed. In the past, Congress has avoided taking action to repeal the gift tax because it prevents individuals from shifting assets to create a loophole to minimize income taxes.

Therefore, your client should make annual exclusion gifts to chosen loved ones of $14,000 per recipient, contribute to 529 Plans (which grow free of income tax) and contribute unlimited gifts for the benefit of family members directly to educational institutions and medical facilities for their benefit.

There’s been no discussion about raising the annual gift exclusion amount of $14,000, but taking advantage of the opportunity early in 2017 will maximize the potential appreciation on this year’s gift before 2018 gifts can be made beginning Jan. 1, 2018.

It’s also prudent for clients to consider completing these gifts in trusts, which protect the cash and investments gifted from attack by spouses, lawsuits and creditors and can allow the donor flexibility to control and access the funds held in trust. 

2. Lifetime Exemption Gifts

For the same reason, clients should also use the $5.49 million lifetime gift exemption. Larger gifts afford a far greater potential for shifting wealth because more assets are available for investment and, therefore, can compound in value to a greater extent.

Again, relying upon an irrevocable trust as the vehicle through which patterned and consistent lifetime gifts are made is one of the most reliable and powerful means of ensuring a legacy of substantial wealth for future generations of the family.

3. Short-Term and Mid-Term GRATs

Effectively, the purpose of the grantor retain annuity trust (GRAT) is for your client to make a loan of investment assets to his children or loved ones without using any of his lifetime gift exemption. Your client’s loved ones benefit from any growth above the initial contribution. To be valid, the original contribution must be paid back (with modest interest) in installments over a fixed period of years.

Because interest rates remain historically low, it’s still an ideal time to implement GRATs, especially because there are indications that interest rates will continue to rise in the foreseeable future.

When interest rates are lower, the GRAT pays less back to the grantor, meaning that more assets remain outside of the grantor’s estate after the completion of the GRAT term of years. 

4. Estate Freeze Installment Sales

An installment sale to a grantor trust is a strategy that’s comparable to the GRAT and works best with income-producing real estate, interests in a family business or more illiquid investments with potential for significant future growth. In this form of planning, the investments are sold to an irrevocable grantor trust in exchange for a promissory note.

Because the trust is a “grantor trust” for income tax purposes, no capital gains tax is realized at the time of the transfer. Additionally, because the trust buys the investments for fair market value, no lifetime gift tax exemption is used.

All growth on the investment takes place within the trust and therefore isn’t taxed as a part of the estate. Many also find this strategy appealing because the revenue or proceeds generated by the investment can be paid back to the original grantor as satisfaction of the debt on the promissory note that the trust is obligated to pay.

5. Family Limited Partnerships

The Internal Revenue Service issued proposed Internal Revenue Code regulations in 2016 that would limit discounting of transfers of family business interests. The adoption of these proposed regulations has been delayed, and Congress could defund their enforcement, but the Treasury is still likely to adopt them under a future administration.

Therefore, a family limited partnership (FLP) remains a viable tax minimization strategy. Partnerships are sophisticated vehicles for centralizing family investments, providing for the orderly transfer of assets, providing asset protection and expanding family investment opportunities. 

An ancillary benefit of establishing an FLP and funding it with assets is that the strategy has afforded the opportunity for discounts on wealth transfers to family members.

The structure of the FLP segregates ownership between general partners, which control all management of the partnership, and limited partners, which only have a right to receive its profit but little other rights in operating the partnership. As such, gifts made of the interest owned by a limited partner can receive a discount on its valuation (often between 30 percent and 40 percent) because of their lack of control and marketability. This allows the underlying assets to be shifted without depleting nearly as much of your client’s lifetime gift exemption, resulting in immediate estate tax savings on the completion of the gift and preserving the exemption for future wealth transfers. 

6. Upstream Gifting

Under the current tax laws, a step-up in the cost basis of an asset is granted when an individual passes away, meaning that the surviving family members can sell the asset without realizing any capital gains tax. This benefit is likely to be eliminated if the federal estate tax is repealed.

Furthermore, there are few options for an individual to minimize or eliminate capital gains tax before death. While the step-up in basis remains available, your client should consider giving appreciated assets to a trust specifically designed to cause the assets to be included in a less affluent parent’s estate. Inclusion in the parent’s estate would allow assets to be sold with minimal capital gains tax consequences within a reasonable period of time during the child’s lifetime.

The trust would then ensure that the proceeds would thereafter be held for the benefit of the child’s family after the parent’s death.

7. Community Property Trusts

It isn’t uncommon for a surviving spouse to desire to sell appreciated assets that were owned jointly while both spouses were living. Under such circumstances, the surviving spouse must still pay capital gains tax on 50 percent of the growth because only half of the property benefits from the step-up in basis on the first spouse’s death.

The only exception to this is joint assets that are characterized as “community property” and that enjoy a full step-up in basis when the first spouse passes.

Three states (Alaska, Tennessee and South Dakota) currently allow for out-of-state spouses to create and fund a trust, and to elect for the trust property to be treated as community property.

This presents an opportunity that would allow a surviving spouse in the future to sell assets without paying any capital gains tax 

8. Charitable Remainder Trusts

Those clients wishing to sell appreciated assets, liquidate inherited assets that have a carryover basis, and otherwise diversify in a tax-efficient manner, will continue to use charitable remainder trusts (CRTs).

In establishing a CRT, the creator of the trust retains the right to receive an annuity or fixed percentage of the trust assets each year. After the term of years of the CRT or the creator’s lifetime, the balance of the CRT assets pass to charitable organizations of your client’s choosing, including a private family foundation.

Because the beneficiaries after the CRT period are non-profit organizations, any sale of assets within the CRT doesn’t realize capital gains. The only tax that’s due is based on the amount of the annuity transferred back to the individual who funded the CRT.

Many families choose to couple the CRT with life insurance so that the proceeds of the insurance coverage replace the wealth passing to the charities (and which would have otherwise been distributed to the family members) after the CRT period.

9. Drafting Flexibility in Core Planning Documents

If Congress eliminates the step-up in basis, then the advantages of keeping certain assets inside the estate evaporate. Therefore, without the step-up in basis, it’s critical that your client has reverse swap powers in the trust provisions, which would allow the swap of low basis, appreciating assets (that are likely to see the greatest appreciation once the assets are inside the trust) in exchange for the trust’s high basis assets.

Given the uncertainty of future tax changes and family circumstances, it’s also critical for a trust to include limited powers of appointment for the beneficiaries (including a spouse) or the trustee (referred to as a “decanting”). This will allow the beneficiary or trustee to transfer the assets to a new trust that contains the provisions that best reflect the tax laws and your client’s wishes at that time.

Including these authorities in an irrevocable trust provides important options for family members to adapt to dramatically different circumstances that may arise in the future.

10. Philanthropic Planning

Rather than making gifts directly to charity and surrendering any say as to the application of the gifts thereafter, a private foundation (PF) allows your client to retain control over the administration and investment of the assets that he’s earmarked for future grant-making, while enjoying the full income tax benefit immediately. By making gifts to charities in increments over time, your client and his family can maximize their influence over their ongoing use to the selected charities.

The PF will be the recipient of any direct donations that your client makes and can be the recipient of any assets remaining in the CRT.

With respect to appreciated stock, your client wouldn’t have to liquidate any securities positions to make the donation (and therefore pay income tax on the capital gains tax due on the sale), which would reduce the net value of the gift to charity and deduction your client may enjoy. 

Rather, your client directly transfers the appreciated stock to the PF, getting a deduction for the full value of the positions transferred, and then the PF can sell those interests without any capital gains tax.

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