Many clients, appreciating the transfer tax savings associated with making gifts during life, as opposed to utilizing their transfer tax exemption at death, have “maxed out” their available transfer tax exemption. For individuals who have made lifetime transfers in excess of current exemption amounts ($11,580,000 per person in 2020), all is not lost. There are a number of estate planning techniques still available as well as techniques that can be used to enhance gifts that have already been made and trusts that are already in place.

Zeroed-Out GRATs

GRAT stands for grantor retained annuity trust. To create a GRAT, someone (the grantor) makes a gift to a trust. The trust agreement says that the trust will last for a certain number of years – by way of example, let’s say two years. The trust also says that the trustee has to pay an annuity back to the grantor (this is the “grantor retained annuity” part of the trust) for as long as the trust lasts – in this case, for two years. After two years of annuity payments back to the grantor, anything remaining in the trust passes to the grantor’s descendants.

The grantor makes a gift to his descendants on the day he creates the GRAT, since the lucky descendants are entitled to get something after two years; however, that gift is not equal to the amount the grantor put in the trust initially, since for two years, some of that money is flowing back to the grantor through the annuity. In order to determine the gift’s total, the Internal Revenue Service (IRS) releases a monthly hurdle rate and uses it to calculate how much the grantor gave away when he funded the trust.

The reason to discuss GRATs again today, when many high-net-worth individuals may have little or no gift tax exemption amount remaining, is because it is possible to create a zeroed-out GRAT: a GRAT designed to result in a taxable gift that is valued at or close to zero. This result is possible because the value of the gift is measured on the day the GRAT is funded, and the amount of the gift depends on the hurdle rate. In a zeroed-out GRAT, the annuity payments are calculated so that if the assets in the GRAT appreciate in an amount exactly equal to the hurdle rate, after two years the trust will be empty, and there will be nothing transferred to the next generation. The gift is valued at zero (and reported as such on a gift tax return). Then again, if the assets happen to beat the hurdle rate, the gift was already valued and reported in the year the trust was created; any assets above the hurdle rate pass to the grantor’s descendants gift tax free. If the assets in the GRAT do not beat the hurdle rate, there are no negative tax consequences; the GRAT will just be fully depleted by making payments back to the grantor, and there will be nothing left to pass to the next generation at the end of the GRAT term.

Gifts and Loans

Other strategies take advantage of current relatively low interest rates and lock in lower interest rates in what appears to be a rising rate environment. To put these “low” rates in context, nearby is a chart showing some historical rates for loans between family members and how they stack up against current rates. We have included the hurdle rates for the same time periods, given the earlier GRAT discussion. Loan rates assume annual compounding.

Giving Your All, Then Giving Some More: Creative Ways to Enhance Your Wealth Plan

These rates can be used to transfer money tax free. Following is an example of a client who took advantage of the low rates in 2013. A father loans his daughter $2 million for eight years. The IRS determines this is a “mid-term” loan, so the child has to pay her parent 0.87% interest annually (see the highlighted portion of the previous chart). This is a loan, not a gift, so the daughter also must pay back the full $2 million after eight years. If the child invests the $2 million at Brown Brothers Harriman (BBH), or buys an apartment with it, and it grows at a rate greater than 0.87% before she has to pay it back, she is able to keep that appreciation gift tax free. If, for example, the $2 million enjoys a 7% rate of return, parent/client has passed over $1 million to the child transfer tax free (see the chart below).

Giving Your All, Then Giving Some More: Creative Ways to Enhance Your Wealth Plan

If the parent was feeling especially generous, he might decide to forgive some of the interest each year using his annual exclusion (currently $15,000 per year, described further in this article).

Similarly, if you or members of your family have loans currently outstanding, and the borrower is in a lower generation, refinancing the note in a low interest rate environment would be a relatively painless way of reducing your estate and passing some money to the borrower. The lower rate would mean less interest would be required to be paid back before the end of the note’s term. As long as there is some consideration for refinancing (i.e., it is not just a gift from the lender to the borrower, but there is some reason to refinance – a longer loan term, or perhaps a partial prepayment), this strategy should not result in gift tax or use of exemption.

Finally, the simplest estate planning strategy around is still available and very effective. The annual gift tax exclusion has increased over the years in $1,000 increments from $10,000 to $15,000. This means that you can give away $15,000 each, to as many individuals (outright, or in a properly structured trust) as you choose, without incurring gift tax. If you plan to transfer wealth to grandchildren or more remote descendants, contact your estate planning attorney about GST tax implications.

Planning with Your Dynasty Trust

In 2012, facing the dreaded “fiscal cliff,” and in 2020, in anticipation of a change in the political landscape, many clients took advantage of their lifetime gift and GST tax exemptions by transferring assets to a dynasty trust designed to benefit multiple generations without payment of transfer tax at each level. Although the cliff was basically avoided with respect to transfer taxes in 2012, and we are still unclear as to the potential changes in 2021 and beyond, existing dynasty trusts that are “seasoned” with assets that have been in trust for some time, present excellent planning opportunities. Many of these dynasty trusts were structured as grantor trusts, meaning that the trust gets to pass along its income tax bill to the client who funded it. The grantor/client and the trust are treated as the same for income tax purposes. This is nice for the trust beneficiaries (frequently the client’s children and grandchildren), because money is not taken out of the trust account and mailed to the IRS each year – instead mom or dad writes a check to the IRS from a personal account, and the trust account continues to grow tax free. So, for each year that the trust has taxable income and mom or dad pays its income tax bill, children and grandchildren are enriched in a manner that is not currently subject to gift tax. In case mom and dad have second thoughts about this generous structure, some clients included a provision in the trust agreement allowing them to “turn off” the grantor trust status and decide when to shift the income tax burden to the next generation.

If you funded a dynasty trust in 2012, this is not a “set it and forget it” wealth transfer strategy. First, because the exemptions doubled in 2018 and are indexed annually for inflation, the amount you can transfer tax free has increased. Each year, to the extent aligned with your values and overall wealth plan, you should “max out” your trust – for example, in 2012, you could give $5.12 million transfer tax free. By 2020, the amount had increased to $11.58 million – transferring to the trust the spread between the original funding amount and the current year’s inflation adjustment, if higher, moves additional assets, as well as any appreciation between the date of transfer and your death, out of your estate, free of any transfer tax.

Second, many of these trusts included a provision allowing the donor to reacquire trust property and substitute property of equal value. Assuming the trust was funded with property that was expected to appreciate, you should keep an eye on the growth of the trust assets and consider swapping out the assets and substituting cash to lock in gains. If your trust account is at BBH, your relationship manager and, if BBH is named as a trustee, trust officer are keeping close watch on the trust account for such opportunities.

Finally, even if you have maxed out your trust, you can enhance it in other ways. One great strategy is to lend assets to the trust for a few years. Why would you loan assets to a trust if the trust is just going to have to pay the assets right back to you, plus interest? Because you can take advantage of the same low rates discussed earlier. Even better, there is no income tax on loans between the grantor and a grantor trust because, as noted, they are the same for income tax purposes. On the other hand, if the loan is not between a grantor and a grantor trust (for example, the eight-year loan between parent and child discussed earlier), the lender (parent) would pay income tax on the interest payments (even if interest is forgiven and not paid).

If you did not fund a grantor dynasty trust in 2012 and still have exemption remaining, it is not too late; however, we encourage you to consider acting soon. Even if 2020 presidential and congressional elections do not change the political landscape meaningfully, under the tax code as it exists today, the transfer tax exemptions will continue to increase with inflation until January 1, 2026, when they are scheduled to revert to 2017 levels ($5.49 million, adjusted for inflation, vs. the current $11.58 million).

Shifting Gears: From Lifetime to Testamentary Planning

In the course of structuring new wealth transfer plans and enhancing existing plans, we heard many clients note that their wills and other testamentary documents had not been revised in years, and in some cases did not reflect their current wishes. However, in the rush to create and fund new trust agreements, clients put wills and other testamentary documents aside to be focused on at a later date, given the time-sensitive nature of using up the increased exemption amount. So, just as you are breathing a sigh of relief and feeling as though you have finally accomplished your wealth planning goals, remember to also look back at your existing testamentary documents and, if necessary, update them to reflect any recent gifts.

If, for example, you used some of your exemption to purchase a home for one child in 2012, but your will currently provides that your assets pass equally to all of your children at your death, you may want to insert an “equalization clause” providing that your other children be made whole in light of the gift made to the first child during life. Planning during life is so connected with testamentary planning that anyone who engaged in significant gifting in the past several years should take a look at her will and the interplay between that document and the planning accomplished so far.

If you are not sure whether your estate plan should be revised this year, your BBH wealth planner and relationship manager would be happy to take an initial look and provide some suggestions. Above all, it is important to assess your estate planning objectives and work closely with your BBH team, accountant and estate planning attorney before moving forward with any of these strategies.

Brown Brothers Harriman & Co. and its affiliates do not provide tax, legal or investment advice, and this communication cannot be used to avoid tax penalties. This material is intended for general information purposes only and does not take into account the particular investment objectives, financial situation or needs of individual clients. Clients should consult with their legal or tax advisor before taking any action relating to the subject matter of this material.

Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2020. All rights reserved. PB-03967-2020-10-05