Advanced Estate Planning Considerations in the Time of COVID-19

At this unprecedented time, we are all grappling with the impacts of this COVID-19 pandemic on our families, health care system, educational system, and the economy at large. While many topics deserve our attention currently, one that should not be neglected is protecting the estate that you have worked hard to accrue. As with past economic downturns, when asset values are depressed and interest rates are low, there are a number of strategic estate planning opportunities that actually become more powerful in this difficult environment. Setting up these structures now could save your family significant estate tax dollars once global markets have stabilized and rebounded.

Before addressing a few of these strategic tools, a review of some important estate and gift concepts is appropriate. Under current law, each U.S. resident has a combined federal estate and gift tax exemption of $11,580,000 in 2020, which is indexed for inflation. Each resident also has a federal generation-skipping transfer tax exemption of $11,580,000 in 2020 (also indexed for inflation). These exemptions are scheduled to “sunset” at the end of 2025, which means that without further legislative action in 2026 the exemptions will revert back to a comparatively-small base level of $5,000,000, as adjusted for inflation.

With that background in mind, here are a few concepts to consider.

1. Utilizing an Intentionally Defective Grantor Trust ("IDGT").
   • Gifts to an IDGT. When an individual creates an irrevocable IDGT and transfers assets to it, that individual ceases to be the owner of those assets while continuing to be responsible for any income tax owed on those assets. In this manner, a transfer to an IDGT removes that property from the transferor’s estate for federal estate tax purposes, but is a non-taxable event for income tax purposes. The transfer is a gift for federal gift tax purposes, which would be reported on a gift tax return and would utilize a portion of the transferor’s lifetime estate and gift tax exemption. No gift tax would be owed if the exemption used is larger than the value of the transferred property. In addition, transferring assets at their currently depressed values allows for more asset growth to occur within the IDGT (i.e., outside of the transferor’s taxable estate) and potentially saving the transferor's estate approximately $0.40 of estate tax on every dollar of growth (under current federal estate tax laws). The income tax attributes of an IDGT are also advantageous because a transferor can further reduce the value of the transferor’s taxable estate by continuing to pay the income taxes attributable to the transferred property. The trust itself can benefit the transferor’s children, or others, pursuant to the transferor’s wishes.
   • Sale to an IDGT. Another option is for an individual to sell assets to an IDGT in order to take advantage of the current, historically low interest rates. A simplified explanation of a sale is as follows: (1) the transferor sells assets at their currently depressed fair market value to the IDGT in consideration for an interest-only promissory note with a balloon payment due after a set period of time; (2) the IDGT can utilize the income from the assets transferred to make payments on the note. A sale does not utilize a transferror’s lifetime estate and gift tax exemption because the transferor is swapping an asset for a promissory note of the same value. So the value of the transferor’s estate remains exactly the same immediately following the sale. The goal is that when the promissory note balloons the transferred assets will have grown in value exceeding the note's interest rate (around 0.18 - 1.01% in June 2020). Again, any asset growth exceeding the note's interests rate could save the transferor approximately $0.40 of tax on every dollar of growth (under current federal estate tax laws).
2. Utilizing a Spousal Lifetime Access Trust (“SLAT”). A SLAT can be established in much the same way as an IDGT with one primary difference—the transferor’s spouse is the initial beneficiary of the SLAT during his or her lifetime. This creates a safety net for the married couple, because the SLAT can distribute payments to the spouse for specific purposes if there is an economic need. After the spouse’s lifetime, the trustee would generally allocate the remaining SLAT assets to a separate trust or trusts for the benefit of children and more remote descendants of the transferor. Again, the transferor would utilize a portion of his or her lifetime estate and gift tax exemption to fund the SLAT. Like the IDGT, a SLAT may also be funded by a sale of assets in exchange for a promissory note, and the transferor could continue to pay all income taxes attributable to the SLAT property.
3. Intra-Family Loans. Some families may find younger generations in need of liquidity to make ends meet in these challenging times. Other families might want to loan funds to younger generations for potential arbitrage purposes. Generally, the long-term applicable federal rate ("AFR") is the minimum interest rate at which an intra-family loan of nine years or more can be made without the IRS categorizing the loan as a gift for federal gift tax purposes. The recently-published long-term AFR for June 2020 is 1.01%. Loans with terms of less than nine years have AFRs of 0.43% or less for June 2020. Such loans are likely to be more attractive than commercial loans. The borrowed funds could be used by the younger generation to invest in assets that outperform these low interest rates, thereby moving value into the estate of the younger generation. Of course, these loans should be documented with an appropriate promissory note, the terms of which should be closely adhered to by both parties.
4. Grantor Retained Annuity Trust (“GRAT”). For individuals who have utilized a majority of their estate and gift tax exemption with prior gifts or who are not financially ready to make outright gifts, an irrevocable GRAT can be used to potentially transfer future growth on currently depressed assets to children. Upon a transfer to a GRAT, two property interests are created: (i) a present annuity interest payable to the transferor for a minimum of two years; and (ii) a remainder interest that passes to the GRAT’s beneficiaries (typically the transferor’s children) following the annuity term. The trust can be established with a remainder interest value near zero for gift tax purposes, which means little federal gift tax exemption is needed to establish the GRAT. In general, if the GRAT's assets appreciate at a rate greater than the IRS’s defined rate of return (0.6% for a GRAT created in June 2020), then that appreciation above the IRS's rate of return would pass to the remainder beneficiaries free of estate tax.
5. Direct Gifts and Gifts to 529 Plan Accounts. Not all gifts require an irrevocable trust. For instance, a direct transfer of depressed stock or other depressed assets to children or grandchildren may be suitable in a given situation. If flexibility is important, a gift to a 529 plan account for the educational needs of a child or grandchild may be an option. A transferor can pre-fund up to five years of annual exclusion gifts (currently $15,000/year) in a single year per beneficiary (i.e, $75,000 in 2020). In addition, some state’s 529 plan accounts, including Indiana, allow the transferor to cancel the gift if the transferor wants the assets back (subject to a 10% penalty and income tax on the earnings).
6. Conversion of Traditional IRA to a Roth IRA. If you plan on transferring any traditional IRA balances to non-charitable beneficiaries upon your death, you might now consider converting your traditional IRAs to Roth IRAs. Converting all or a portion of a traditional IRA account to a Roth IRA at a time when your account balance is down has two advantages: (1) the timing of the conversion at lower valuations minimizes the ordinary income taxes due upon the conversion; and (2) the timing also allows for future growth of converted assets to occur tax-free within the Roth IRA account. In addition, unlike traditional IRAs, the Roth IRA is not subject to required minimum distributions beginning at age 72.

Like you, we are continuing to analyze the current circumstances through which we all find ourselves living. We will continue to look for opportunities for clients to potentially leverage and for best practices in shoring up estate plans in this challenging environment. We will have more thoughts to share with you in the coming weeks on these topics.

If you have questions or would like to discuss potential planning options and strategies, please contact Andrew Vento, Miranda Morgan, Steve Latterell, Gina Giacone, Bill Ellsworth, Kristine Bouaichi, or another attorney in the Trusts, Estates, & Private Wealth group at Ice Miller.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader’s specific circumstances.