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COVID-19 has created uncertainty in many aspects of our daily lives and caused an unprecedented disruption to the economy. Financial markets have been turned upside down, asset values have dropped, and interest rates have been decreased to record-low levels. Combined with the current era of historically high estate tax exemptions, depressed asset values and low interest rates have created an opportune time to review and revise one’s estate plan.
With some businesses struggling in the era of social distancing, current asset values may be artificially low. In such an environment, it is an ideal time to gift assets with depressed values in order to maximize the use of an individual’s gift tax annual exclusion and lifetime gift tax credit. An individual may gift up to $15,000 per person per year without using his or her lifetime gift tax credit. A married couple may elect to “split” their gift and double the annual exclusion to $30,000 per person per year. In addition, each individual has a lifetime credit against the gift and estate tax that currently allows an individual to gift during life or bequeath at death up to $11,580,000 before incurring gift or estate tax. The gift and estate tax exemption is due to revert back to $5 million (adjusted for inflation) on January 1, 2026, so depressed asset values and the temporary high estate and gift tax exemptions make the current environment ideal for optimizing the use of your lifetime gift tax credit.
The current low interest rate environment makes loans to family members an ideal planning tool. Unlike gifts, which use some or part of your lifetime gift tax credit, intra-family loans freeze the value of an asset in your estate without using any of your lifetime gift tax credit. By loaning assets to a family member, an individual may take back a note in an amount equal to the value of the assets loaned. The value of the note will be frozen in the donor’s estate and will be reduced as the donee family member pays down the loan. The lender may also decide to forgive all or portions of the loan over time, using his or her gift tax exclusions to avoid gift tax.
The assets loaned to the donee family member may then grow and appreciate outside of the donor’s estate. The interest charged on the note to the donee family member is based on the current applicable federal rate (AFR) established by the IRS each month. In June, the annual short-term AFR (for notes of three years or less) will be 0.18 percent, the mid-term AFR (for notes of more than three years and up to nine years) will be 0.43 percent, and the long-term AFR (for notes of more than nine years) will be 1.01 percent. Thus, depending on the length of the loan, the interest paid by the donee family member on the intra-family loan could be very little.
Instead of loaning assets to a family member, the donor could instead sell or loan assets to a trust established by the donor for the benefit of a family member. Such a strategy would move the appreciation of the assets out of the donor’s estate and freeze the current value of the assets in the donor’s estate just as with the intra-family loan strategy. However, the trust provides the added benefits of creating an estate planning structure for the beneficiaries of the trust, providing asset protection for the beneficiaries of the trust, and allowing the donor to establish a structure that could be exempt from generation-skipping transfer tax for future generations. In addition, if a grantor trust is used, the loan can be structured so that the interest payments do not trigger an income tax.
An individual may also use a grantor retained annuity trust (GRAT), which is most effective in a low interest rate environment when asset values are low. A GRAT is a type of grantor trust that permits an individual to transfer assets to a trust and retain an annuity interest for a defined term. At the conclusion of the trust term, the asset appreciation in excess of the annuity payments made to the grantor passes to the designated beneficiaries. The required annuity payments are based on several factors, including the applicable interest rate in the month of the creation of the GRAT. As the interest rate decreases, the required annuity payment is lower, providing a greater chance that the assets appreciate in excess of the retained annuity payments.
In addition, GRATs can be structured to use little or no lifetime gift credit. With a June AFR for GRATs of only 0.6 percent, the assets inside of the GRAT must only appreciate at a rate in excess of 0.6 percent to be successful.
Earlier this year, the Setting Every Community Up for Retirement Enhancement Act (SECURE Act) significantly changed the planning strategies associated with individual retirement accounts. For inherited IRAs, the SECURE Act now requires that most inherited IRAs must be liquidated within 10 years following the death of the IRA owner.
Roth IRAs are not immune to the forced liquidation of the 10-year rule. However, Roth IRAs are not subject to income tax upon liquidation. The beneficiary of a Roth IRA will never have to pay income tax on the growth inside of the IRA during the 10-year period and will never have to pay income tax on the liquidation of the IRA during or at the conclusion of the 10-year period.
If an individual owns a traditional IRA, the individual may convert his or her traditional IRA into a Roth IRA during his or her lifetime. The conversion is treated as an income taxable event to the individual. Ideally, the individual would pay the income tax incurred on the conversion out of non-IRA assets so that the full converted IRA could grow income tax free.
The SECURE Act has highlighted a planning dilemma whereby an individual may either convert his or her IRA to a Roth IRA and pay the income tax on the value of the IRA on the date of the conversion, or keep his or her “traditional” IRA and the owner’s beneficiaries will pay the income tax during the 10-year period after the IRA owner’s death. In an environment where IRA values may be expected to appreciate, a Roth conversion would enable an individual to pay the income tax now on the low value so that if the value of the IRA appreciates and returns to its pre-coronavirus level, the appreciation will be tax-free, and the beneficiaries will not pay any income tax when they are ultimately forced to liquidate the inherited IRA at the conclusion of the 10- year period after the owner’s death. Of course, there is no way of predicting future values or how much of the IRA might be depleted over the owner’s lifetime.
In this period fraught with so many uncertainties, the high estate tax exemption, low asset values, and low interest rates have combined to create the perfect opportunity to review and revise one’s estate plan and take advantage of one or more of the above planning strategies. If you would like to discuss potential planning opportunities, please contact any of the attorneys in our Private Client group.
We wish you continued good health and safety in these uncertain times, and we hope to see you back in our offices in the not too distant future. In the meantime, we remain available to talk with you about these opportunities or any other concerns you may have regarding your estate plans.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.