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Appreciation and Inflation
Appreciation and inflation will increase estate taxes upon death. As
mentioned earlier, any estate-reducing program is more effective if it
includes techniques to shift appreciation and income to a person's
intended beneficiaries.
Estate "Freezing"
For years, estate planning professionals have developed and implemented
estate "freezing" techniques so that the estate tax problem
would not get worse. Many of the freezing techniques involved creative
structuring of family-owned business entities so that the increasing
value of a growing business would shift to the next generation. Some of
those techniques were perceived as abusive by the IRS, which persuaded
Congress to adopt "anti-freeze" legislation that made the
freezing techniques ineffectual. In spite of that, there are still some
effective techniques that can be used to shift appreciation and to
"freeze" the value of an asset for estate-tax purposes.
Techniques Involving Asset Sales
Installment Sales
By selling an asset to family members on an installment basis, the
potential appreciation on the asset is shifted to the family members.
This works only if the purchase price is "full and adequate
consideration" and the arrangement is properly documented in order
to create a legally enforceable obligation. Upon the death of the payee,
the unpaid balance of the note is included in his or her taxable estate
for estate tax purposes, but the asset that was sold is out of the
estate, including its appreciated value. The installment note can be
secured by the property sold.
Death Terminating Notes*
Another version of the installment sale employs the use of promissory
notes that, by their express terms, expire upon the death of the payee.
This type of promissory note has the same advantages as any installment
note (including the ability to require security), but in addition to
shifting appreciation, the unpaid balance of the note is reduced to zero
at death, and there is nothing included in the payee's estate at death.
As with any installment note, the purchase price must reflect "full
and adequate consideration", but that also means the value of the
note must exceed the value of the property being sold. Because the note
may expire before the payee receives payments equal to the note's face
amount, an additional "premium" must be paid for that feature
so that the value of the note is considered adequate to pay for the
property. Determining the amount of the "premium" for the
death-termination aspect is the primary drawback to this technique. A
qualified expert is strongly recommended to make that determination.
*Note:
"Death terminating notes" are more often called "self-cancelling
installment notes" or "SCINs". The
"cancellation" of a debt can have adverse income-tax
consequences, so some commentators are advising against the use of that
term in the promissory note. This is another example of where form
becomes more important than substance, but that is frequently the case
when dealing with the federal tax laws.
Private Annuities
A private annuity is a contract that provides for specified payments to
the named annuitant during the annuitant's lifetime. This is similar to
the death-terminating promissory note, but under a private annuity, the
payments never cease so long as the annuitant is alive, even if the
annuitant outlives his or her life expectancy. The primary advantage of
the private annuity is the fact that the annuity amount can be
determined from the IRS valuation tables, eliminating the guess work as
to the amount of the periodic payments to be made. Unlike promissory
notes used with installment sales, private annuities cannot be secured,
putting the annuitant at risk that the payor may become bankrupt.
Retained-Interest
Gifts
Grantor Retained Interest Trusts
Most people would like to "have their cake and eat it, too."
If possible, people would retain all control and all benefits from an
asset up to their death and then have the value of the asset disappear
for estate-tax purposes. Unfortunately, federal gift and estate tax laws
do not permit this. The general rule is this: "If you give away the
tree, you cannot keep the fruit." If you give away only part of the
tree, you can keep the fruit only from the part you retain.
Over the years, various trusts (or trust-like arrangements) been devised
that allow the grantor of the trust to retain benefits for a specified
period of years so that the present value of the gift of the to children
is reduced according to the IRS' own valuation tables. The longer the
retained-interest period, the lower the value of the remainder interest
is. These trusts used to be called "grantor retained income
trusts" or "GRITs". Congress has now limited the use of
these techniques to a very few specific types of trusts, which I will
call "grantor retained interest trusts" (so that we can still
talk about them as "GRITs").
If the grantor of a retained-interest trust dies before his or her
benefits are terminated under the trust's terms, the asset is subject to
estate taxes in his or her estate (and any gift tax paid is credited
toward the estate tax). On the other hand, if the grantor outlives his
or benefits under the trust, the trust's assets are excluded, and the
only transfer-tax cost is the gift tax paid (or the applicable exclusion
applied) on the original value of the remainder interest.
While a GRIT can save transfer taxes, there is at least one
disadvantage: the lost of the stepped-up basis for income tax purposes.
Assets included in a decedent's estate for estate-tax purpose will
(under current law) receive a "stepped up" income tax basis
equal to the fair market value of the assets at the time of the
decedent's death. In other words, all potential capital gain is reduced
to zero. If a retained-interest trust is successful, the asset will not
be included in the grantor's estate at the time of the grantor's death,
so there will be no stepped-up income tax basis; the recipient will have
the grantor's original cost basis.
Qualified Personal Residence Trusts (QPRTs)
A "qualified personal residence trust" or QPRT is a type of
GRIT that is still permitted under federal law. A grantor can transfer
his or her primary residence or even a qualifying vacation home to the
trustee of a QPRT that allows the grantor to reside in the home for a
designated period of time. At the end of the designated period, the
property passes to designated remainder beneficiaries.
The gift to the trust's remainder beneficiaries is subject to the
federal gift tax, but the value of the gift is the present value of the
remainder interest, which is determined under the IRS tables after
taking into consideration the term of the grantor's retained interest,
the grantor's age, and the applicable interest rate published by the IRS
monthly.
If a home worth $500,000 is transferred into a 10-year QPRT, and the
remainder interest has a value equal to 60% of the value of the home,
40% of the value of the home escapes gift and estate taxes altogether if
the grantor outlives the term of his retained interest. If the grantor's
estate is in the 50% tax bracket, this transaction saved $100,000 in
estate taxes (not to mention the estate tax on any appreciation).
If the grantor dies before the retained-interest expires, the home is
subject to estate taxes, but since any gift taxes paid are credited
back, there is no true penalty. The cost of this gamble is the cost of
creating and administering the trust.
One psychological drawback to QPRTs is the fact that the grantor no
longer has the right to reside in the residence at the end of the term
of the grantor's retained interest. In order to remain in the home, the
grantor must make fair-market rental payment (according to an agreement
negotiated after the term has expired). Of course, the rent paid by the
grantor is another good way to make an estate-reducing transfer to the
trust's beneficiaries. [The IRS regulations currently prohibit the
grantor from purchasing the home before the expiration of the
retained-interest term.]
There are a number of technical rules for QPRTs. For example, there are
rules governing the possibility that a residence might be sold and a
substitute residence purchased. If a substitute residence is not
purchased within a specified time limit, the trust must become a grantor
retained annuity trust (which is discussed below).
Grantor Retained Annuity Trusts (GRATs)
Grantor retained annuity trusts (GRATs) are similar in structure to
charitable remainder annuity trusts. GRATs permit the gift of remainder
interests that are discounted for gift-tax purposes under the IRS
valuation tables. While longer terms produce lower remainder values,
even short-term GRATs can produce significant transfer-tax savings.
Grantor Retained Unitrusts (GRUTs)
Grantor retained unitrusts (GRUTs) are similar in structure to
charitable remainder unitrusts. GRUTs are similar to GRATs in their
general purpose, but GRUTs are not considered as effective as GRATs
where the trust's assets are expected to appreciate.
 
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