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Time May Be Running Out on Certain Estate Planning Opportunities

December 29, 2011
by: Scott Borsack

The start of the new year is upon us, and 2012 promises to be an interesting year. With the Presidential election season getting into full swing, congressional contests and the wrangling that will go on with tax provisions, which are due to expire when we next gather to sing “Auld Lang Syne”, there are many balls to keep an eye upon. As you are no doubt aware, if Congress fails to act in the next 11 or so months, the federal estate and gift tax exemption will drop from $5 million ($10 million for a married couple) to $1 million ($2 million for a married couple). Additionally, the rate of tax will increase from 35% to 55%. There is plenty of incentive, therefore, to plan before the end of the year if you are considering a wealth transfer. Late in December, the Internal Revenue Service announced that the rate which is used to establish, among other things, the minimum interest rates used in many sophisticated estate planning techniques will match the 22-year lows we saw in October 2011. There are several planning possibilities that look particularly attractive given these low rates.

The first technique which comes to mind is the Grantor Retained Annuity Trust, or GRAT, which allows one to establish a trust for a term of years in exchange for an annuity payment for the term of the trust. If the creator outlives the term of the trust, the assets which remain pass to the named beneficiaries without incidence of the federal gift tax; likewise the assets are not included in the estate of the creator. GRATs work particularly well for assets that either produce steady income or have the potential to appreciate significantly in value. The benefit comes from comparing the rate at which the GRAT makes distributions to the creator and the test rate set by the Internal Revenue Service. The age of the creator is factored into the analysis as well. For January 2012, an individual age 60 could create a GRAT into which he transfers $5 million of value and reserves the right to receive distributions of $300,000 per year for 15 years.  Such a trust would be treated as if the creator made a gift with a value of only $1.45 million.  If the principal in the trust appreciated at the rate of 4% each year, and earned income at the rate of 1.5% each year, the GRAT would pass nearly $4.5 million to the named beneficiaries without incurring a federal gift or estate tax.

Another popular technique is the sale to a grantor trust, sometimes called a sale to an intentionally defective grantor trust. This technique allows for the “sale” of a valuable asset using the income which the asset produces to fund the promissory note that is issued in exchange for the asset transferred. Since the “purchaser” is a special kind of trust, known as a grantor trust or sometimes called an intentionally defective grantor trust, though the transfer looks like a sale, there is no income or capital gains taxes generated by the sale. For income tax purposes a grantor trust is treated as indistinguishable from the person who set up the trust, known as the grantor. So a grantor with a valuable asset to transfer can “sell” the asset to the grantor trust in exchange for a note that pays a minimal interest rate. The interest is not subject to income taxation because the trust, which is paying the interest, does not have a tax identity separate from the grantor or creator of the trust. The interest rates now are ridiculously low. A note for a term of 10 years or more requires an interest rate of 2.63%.  Payments could be calculated with principal and interest, or interest only with a balloon at the end of the term. So an asset worth $5 million can be sold for a note paying interest and principal over 15 years with monthly payments of $33,646 or $10,958 for payments of interest only.  Since this technique depends on income to be able to make payments due under the note, it works best for the sale of interests in a pass through entity, like a subchapter S corporation, limited liability company or partnership. These entities incur a single level of tax allowing for more cash to be available to pay down debt than a regular corporation which must also pay a corporate level income tax at 35%.

The grantor trust technique discussed above could also be used with a private annuity contract between the trust and the “seller.” Under this variant of the sale technique, instead of receiving a promissory note with a finite repayment period, a seller can take back an annuity which calls for the payment of a fixed amount for the remainder of the seller’s natural life. The annuity can call for joint and survivor payments, making distributions for the lifetime of the seller and his or her spouse, for example. Unlike the promissory note, the private annuity does introduce mortality risk into the equation because such relationships call for an end to payments on the death of the seller or annuitant. If an individual age 60 exchanged an asset worth $5 million for a lifetime annuity and closed the deal in January 2012, the monthly payment would be $23,673, or $284,076 each year.  Unlike the GRAT, the private annuity can be paid for the joint lives of two individuals. So our grantor could include his or her spouse, age 56 into the equation, and monthly payments are reduced to $17,955, or $215,460 each year. As the asset sold appreciates in value, the appreciation as well as the principal escapes estate and gift taxation.

Consider that the grantor trust technique works well for those assets which are not subject to income taxation, such as entities taxed as partnerships or S corporations. In those situations, the seller has historically received all of the income from the entity. If that income amount is at least as much as the amount which is needed to fund the promissory note or private annuity payment, these techniques allow the seller to transfer an asset to the next generation using income which he or she would have received if they held the property, to fund the transfer of the property estate and gift tax free. With federal interest rates at all time lows, these techniques are uniquely suited to present conditions allowing for painless wealth transfer.  We commend these techniques to your attention.

Again, unless Congress takes some action before the end of the 2012 calendar year, the exemption against the federal estate and gift taxes will be reduced from the current $5 million ($10 million for a married couple) amount to $1 million ($2 million for a married couple) and the tax rate will increase from 35% to 55%. Tax rates on ordinary income, capital gains and dividends will rise as well.

For more information regarding this alert, please contact Scott Borsack (215.864.7048 or The Tax and Estates Practice Group at White and Williams is committed to keeping our clients and friends up to date with important tax developments.  For current information, please refer to the Tax and Estates page on our website,

To ensure compliance with certain regulations promulgated by the U.S. Internal Revenue Service, we inform you that any federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding tax-related penalties under the U.S. Internal Revenue Code, or (2) promoting, marketing or recommending to another party any tax-related matters addressed herein, unless expressly stated otherwise.

This correspondence should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation and legal questions.
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