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How to Freeze Your Assets

How to Freeze Your Assets


SML Perspectives
(March 9, 2011)

A Sophisticated Way to Escape Gift Taxes

There are some sophisticated estate planning options available that allow you to “freeze” the value of an asset and transfer the asset at a discounted value.  One option is commonly referred to as a sale to an intentionally defective grantor trust (“IDGT”) in return for a note.

With the gift tax exemption amount and generation skipping transfer (“GST”) tax exemption amount increasing to $5,000,000 in 2011 and 2012 under the new tax law, the sale to the IDGT in return for a note has become an even more viable estate planning option.

The transaction looks something like this. Prior to the sale, you would establish a trust and fund it with a “seed” gift equal to at least 10% of the value of the asset sold to the trust. The initial “seed” gift will be subject to the gift tax, but the gift tax can be offset by your $5,000,000 gift tax exemption amount. After the trust has been funded for a while, you would sell the discounted asset to the trust in return for a note that is usually less than nine years and is interest only with a balloon payment at the end. The “seed” gift and the sale are then reported on your gift tax return the following year, although there should be no gift tax due.

This strategy works best if the asset sold to the trust is an interest in a corporation, limited liability company, or limited partnership. If you own marketable securities or real estate, you could contribute these assets to a limited partnership or limited liability company (assuming there are valid business purposes to establish the entity), wait a while, and then sell an interest in the entity to the IDGT.

Advantages

Some of the advantages of this estate planning option include the following:

    1. If the asset is a non-controlling interest in a corporation, limited liability company, or limited partnership, the value of such asset may be discounted between 20% to 40%. The discounted amount of the asset and the appreciation on the asset should escape gift and estate taxation. This allows more of your gift tax exemption and estate tax exemption, currently $5,000,000 per person, to be used for other gifts during lifetime or to shelter assets from the estate tax at death. 

    2. You have not departed with the entire asset because you receive a note from the trust equal to the value of the asset sold to the trust.

    3. The interest rate on the note is at the favorable applicable federal rate (“AFR”). Currently, we are in an environment where these rates are at historic lows. For example, the interest rate for a nine year note for the month of March is 2.44%. If the assets in the trust appreciate at a greater rate than the interest rate on the note, you “win.”

    4. The trust is structured in a manner so that you are responsible for payment of the income taxes associated with the trust. This allows the assets in the trust to grow without being depleted by income taxes. Your payment of the income taxes with respect to the trust is treated as a tax-free gift to the beneficiaries of the trust but it does not count against your $13,000 annual exclusion or the $5,000,000 gift tax exemption. If you decide to discontinue paying the income taxes on the trust, the income tax burden can shift to the trust.

    5. Since you are responsible for the payment of the income taxes associated with the trust, the sale to the trust is not subject to the income tax.

    6. The trust can be structured so that it is a generation skipping trust. This should allow the assets in the trust to escape the transfer tax system so that there is no estate or GST tax when a beneficiary dies. You can use your GST tax exemption amount, currently $5,000,000, in a way that should shelter the trust from the GST tax. The GST tax applies when an asset is transferred two or more generations below you so that the transferred property is subject to a 35% tax (this rate is scheduled to rise to 55% in 2013); however, if structured properly, the GST tax should not apply to the trust.

    7. If the trust is established in a state that has the “rule against perpetuities”, the trust will have to end at some point. For example, if the trust is established in South Carolina, generally, the longest the trust could last is around 90 years. Many times it is beneficial for you to establish a trust in a jurisdiction, such as Delaware or Alaska, that does not have the rule against perpetuities so that the trust, in theory, can last forever. This type of trust is commonly referred to as a “dynasty” trust. In order to establish a trust in a state such as Delaware or Alaska, the trust must have a connection to such state, and one way to establish this connection is to name a trustee who is located in such state.

    8. The assets in the trust should be protected from the claims of creditors and divorce, and the assets in the trust should be available to help provide for the beneficiary for the rest of his or her life.

Disadvantages

Some of the disadvantages of this estate planning option include the following:

    1. Although several parts of the Internal Revenue Code and Treasury Regulations must be pieced together to provide the support to substantiate this transaction, the IRS has not published specific guidance on how to structure each step of the sale to the IDGT, unlike other estate planning options such as a qualified personal residence trust or a grantor retained annuity trust.

    2. The IRS may disagree with the valuation of the asset sold to the trust. In the event that the asset is undervalued, the excess value would be treated as a gift which would have to be sheltered by your remaining gift tax exemption amount to avoid the gift tax. There are certain ways to minimize the risk of undervaluation. For example, you could structure the sale with a “formula clause” by stating that the excess value will be contributed to a charity or a trust for the benefit of the surviving spouse.

    3. If the return on the asset is not greater than the AFR rate, the transaction will be “underwater” and will accomplish no gift or estate tax savings.

    4. The asset in the trust will have to generate enough distributions or income to pay off the note. If the asset does not generate enough distributions or income to pay off the note, the trustee of the trust could pay off the note by using the asset itself, but this is not the preferred option as you will be receiving a discounted asset.

Although there are some disadvantages to the sale to an IDGT, they are outweighed by the many advantages, especially in 2011 and 2012 when the gift tax and GST tax exemptions have increased to $5,000,000 per person. In the appropriate situation, you should seriously consider moving forward with the sale to an IDGT in return for a note in order to take advantage of all the tax and nontax benefits.

Click here to view the full digital version of the The Boomers & Beyond edition of SML Perspectives. 

Authors
J. Tod Hyche
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