“Yes, your finances are likely taking a beating this year. Which means it’s the perfect moment to transfer as many assets as you can.”

Stock values are depressed. Interest rates continue at historic low rates. Transfers are generally valued based on their market values – values that are very low today. For many types of transfers, especially those that delay the recipients’ use of the gift use prescribed IRS rates to determine the value and taxation. These IRS rates are adjusted monthly to reflect the current economic conditions – conditions today that produce very low rates.

Ms. Tergesen suggested a number of effective strategies to transfer wealth to your heirs that are advantageous when the transferred values are depressed. One such idea included establishing an intentionally defective grantor trust (IDGT). Even though IDGTs are complex and often expensive to establish, the rewards can be worth the extra efforts and expense. These trusts can provide a tax-advantaged way to pass assets to heirs, limit future taxation of the assets, and remove these assets from your estate. To better illustrate these benefits, a case study using PlanLab and its suite of financial tools is presented.

Case Study

Kevin and Rebecca Strangelove have been very successful in recent years. They have a daughter, a son-in-law, and a new grandson (named for his grandfather) with whom they want to share their fortunes. Their hopes are that it could benefit future generations as well. About two-thirds of their assets are in stocks. Stocks that were worth $15 million a few months ago, but due to the “melt-down” are worth only $10 million now. Kevin figures that the market will eventually recover, although it may take up to twenty years to do so.

The Strangeloves establish the trust. It will need some cash which should be at least 10% of its initial holdings. Since they plan to put $10 million of stock into the trust, they make a gift of $1 million cash. One million dollars is also the limit an individual may give away gift tax free during his lifetime. Since they want the trust to last for possibly generations, they must either pay generation-skipping transfer tax on the $1 million gift or use some of the $2 million credit for that tax. They will do the latter. (Gifts of more than $2 million may have generation-skipping transfer tax up to 45% of the additional amount.)

They then lend the trust $10 million using an installment note. In this case, a fifteen year interest only note is used. Interest is set at the Applicable Federal Rate for loans of more than 9 years which for October 2008 was 4.32%. The length of the note is usually long enough for the trust to accumulate enough funds to repay the note, but hopefully less than life expectancy of the grantor. Any unpaid balance of the note is included in the estate of the grantor. The trust then uses the loan to buy the $10 million of stock from the Strangeloves.

Being a grantor trust, income taxation to the trust is passed through to the grantors. Therefore, for income tax purposes, the Strangeloves “bought the stock from themselves” for tax purposes; thus, no capital gains tax due. Also, the interest paid by the trust for the installment note is not considered income to the grantors.

The Strangeloves wanted to use conservative assumptions throughout their plans. Previously for their long-term planning, they assumed the stocks would appreciate in value by 3.6%, doubling in value in 20 years. They assumed that the stocks would produce an average of 2.4% earnings or dividends each year. (Basically, they wanted to assume a total return of 6 %.) That assumption was decided prior to the recent market collapse. Since they felt the market would recover over the next 20 years, they increased their appreciation assumption to 5.7%. (The original value of $15 million growing at 3.6% for 20 years equals the depressed value of $10 million growing at 5.7% for 20 years.)

Advantages of the IDGT

• As a grantor trust, no capital gains tax was due when the stock was sold to the trust.
• No income tax is due on the interest payments from the trust for the loan.
• All appreciation in the trust is outside of their estate. (Only the balance of the unpaid installment note is included in their taxable estate.)
• The Strangeloves pay income tax on all income received by the trust. These tax payments further reduce their estate, but more importantly, allow the trust to appreciate faster since it does not have to pay the taxes.
• Life insurance on the grantor’s life owned by the trust, assures the grantor that the installment note could be repaid at the grantor’s death.

How will all of this work for the Strangeloves?

• The IDGT is established and the $1 million cash gift is made to it.
• A $10 million loan is made to the trust — a 15 year interest only installment note at a rate of 4.32%.
• The IDGT buys the $10 million stock from the Strangeloves.
• The IDGT purchases $10 million of life insurance on Kevin with a monthly premium of $4,000. The trust is the owner and beneficiary of the policy.

In addition to the IDGT strategy, several other techniques were recommended. Their wills needed to be revised to take advantage of the large available estate tax exemptions. Annual exclusion gifts could be used to provide additional cash for estate settlement. There are many additional techniques and strategies that could be applied, but the Strangeloves preferred just the basic ones.

Results

PlanLab’s suite of tools allows us to see the results in various situations. For these results, (See Executive Summary from Estate Tax Analysis) it was assumed:

• No additional changes were made
• The markets recover over the next 20 years
• Change their wills to leave an amount equal to any applicable exclusion amount to a Family Trust
• Kevin dies in year 2028
• Rebecca survives him for 5 years

The net value to the heirs at Rebecca’s death in 2033 would be $40 million.

Adding the IDGT as described above, the net to the heirs in 2033 would be $57.1 million.

• Establish an irrevocable life insurance trust (ILIT) to acquire a survivorship policy and make annual exclusion gifts to the trust for the premiums
• ILIT purchases $20 million of survivor life on Kevin and Rebecca for $8,000 monthly premium.

The net value to the heirs in 2033 would be $85.8 million.

When this strategy was analyzed with Wealth Distribution Analysis, (See Planning Impact) the Strangeloves would have their new worth reduced by 38% but would have doubled the net to heirs or an increase of 102%. This was possible while meeting all lifestyle expenses.

Risks associated with this strategy

Neither the tax code nor case law specifically addresses IDGTs. The IRS has been known to challenge them on occasion. Establishing the trust with a cash gift some time before selling the assets is thought to reduce the chance of a challenge.

The biggest risk is for the trust to run out of income. Income is needed to make the interest payments on the loan and to pay the premiums on any life insurance it acquires. Gift taxes and possibly generation-skipping transfer taxes may be due, if the trust cannot meet its interest payment. Testing the cash flow arrangements of the trust is essential to avoid this costly problem. (See Trust Ledger from PlanLab)

In addition to the illustrations shown above, PlanLab effectively can illustrate all aspects of this case study. PlanLab’s Estate Tax Analysis shows how the proposed strategy would work. (See Estate Flow Chart) Since there is uncertainty as to what estate taxes might be in the future, “Needs over Time” graphs can be printed that show the current law and a hypothetical illustration assuming the 2009 limits and rates are extended (which is similar to the proposals of both Presidential candidates). (See Needs Over Time Compared)

PlanLab’s Wealth Strategies or Retirement Test Drive can consider the Strangelove’s strategy from different vantage points. Both of these tools can perform extensive Monte Carlo Simulations to determine the likely results when all variables fluctuate in accordance with their historical results. The year-by-year results and likely range of results can give the clients confidence that their strategy will work. (See Likely Net Worth)

PlanLab’s suite of financial tools help the advisor make “lemonade” out of the “lemons” of our present economy.

Photo credit: Adrian MB