By Moses & Singer – Trust & Estate Group
The new tax law, which took effect on Jan. 1, 2018, doubled the exemptions from federal estate, gift and generation-skipping transfer tax to $11.18 million per individual, with inflation adjustments going forward and a reversion to the base $5 million exemption (with inflation adjustment) on Jan. 1, 2026. This temporary increased exemption presents a number of planning opportunities, one of which is to forgive outstanding intrafamily debt.
One by-product of the historically low interest rate environment of the past several years is the increased use of intrafamily transactions involving promissory notes. These notes play a key role in many estate planning transactions, and their prevalence has made them a worthy target for the Internal Revenue Service. For certain clients, using the temporarily increased exemption amount to forgive these notes now could both eliminate a number of potential headaches down the line and open up some interesting new planning avenues.
One of the more popular current estate planning strategies consists of a sale to a grantor trust, whereby the value of the property sold is frozen in the hands of the seller in the form of a promissory note. This transaction can produce substantial estate tax savings to the extent that the property sold to the trust outperforms the interest rate on the promissory note. Since the sale is made to a grantor trust, the transaction is disregarded for income tax purposes. No capital gain is recognized on the sale and the interest paid pursuant to the promissory note isn’t subject to income tax.
If the seller dies while the promissory note remains outstanding, the note’s then value is included in the seller’s estate for estate tax purposes. The IRS has yet to adopt a definitive position as to how this scenario is treated for income tax purposes. Some commentators opine that no capital gain is realized and the note’s income tax basis is stepped up to equal its value in the seller’s estate. Other commentators maintain that there’s no basis step-up and capital gain is recognized to the extent the amount due on the note exceeds the seller’s original cost of the assets sold. By choosing to forgive the note now, the potential income tax exposure that may result on death can be eliminated.
Forgiving a note may also unlock other tax planning opportunities.
After the debt is eliminated, it may be possible to convert the trust into a non-grantor trust. This switch could potentially eliminate state income taxation on the trust’s income, an especially welcome result given that the new tax law limits state tax deductions to $10,000 per year.
Furthermore, using the additional, but temporary, gift tax exemption to forgive and thereby eliminate intrafamily debt can help safeguard existing estate planning transactions from IRS scrutiny.