Lock-In Estate Tax Discounts BEFORE the IRS Changes the Rules!
By: Attorneys Kenneth Ziskin & Michael J. Wittick
For decades, families facing exposure to Estate Taxes have used Family Limited Partnerships and LLCs to discount these taxes.
However, the time to use discounting strategies looks like it is about to expire.
In mid-May, 2015, a senior Obama Treasury Department official announced that it is nearly ready to adopt regulations that will limit, or even eliminate, the ability to use these discounts for your family. She projected that the IRS would adopt (or propose) these new regulations before the middle of September, 2015. Many experts believe the effective date will probably be the date the rules are announced, or shortly thereafter.
So, for those of you who have worked hard for decades building wealth above your estate tax exclusion, the time for some serious planning has come.
Discounting strategies are not the only way to reduce Estate and Gift Taxes, but they can be very important in transferring wealth to family members. If you do not act soon, you may forever lose the opportunity to choose a discounting strategy to save $$millions in Estate Taxes for your heirs.
In the April, 2015 issue, I summarized some of the basic principles behind Estate Tax Protection Strategies. These included Estate Freezes (largely through gifting), Discounting, “Squeezing” and the Time Value of Money.
This article will describe the basic elements and effects of a strategy I call a “Family Security Trust Superfreeze” (“FST”) that integrates these principles. While this strategy can remain valuable for many taxpayers even without discounting, it will normally create far more savings for taxpayers who use discounting properly before the IRS changes the rules on us.
Should You Worry About Estate Taxes?
The lifetime exclusion amount (the amount you can pass free of Estate and Gift Taxes) has grown to $5.43 million in 2015 ($10.86 million for a married couple). However, good investments and inflation have helped many apartment owners see values rise so fast that the exclusion does not fully protect them. And, most owners I talk to expect their wealth to grow faster than the Estate Tax Exclusion.
For example, a hypothetical married couple, both age 65, have an estimated life expectancy of 23 years. If they expect their assets to grow at 5% per annum (appreciation plus cash flow, minus expenses and taxes), a net worth of $8 million today is likely to more than triple during their joint life expectancy, to approximately $24.4 million. While Estate Tax Exclusions are scheduled to grow with inflation, most investors should not expect the exclusion to grow as fast as their assets will grow. Thus, the heirs of our hypothetical married couple may face very substantial exposure to estate taxes.
Bottom Line: If your net worth exceeds the Estate and Gift Tax Exclusion, or you think it will grow to exceed the Exclusion, you should consider advanced planning (and maybe an FST Strategy) to minimize or eliminate Estate Tax exposure BEFORE the IRS discounting rules change.
Key Elements of the Family Security Trust (“FST”) Strategy
A Family Security Trust (“FST”) is a special kind of irrevocable trust where the tax law treats you as the owner of trust assets for income tax purposes, but the property of the trust remains outside your estate for estate
tax purposes. This kind of trust is usually referred to as a “Grantor Trust” (one where the “grantor” is taxed on income in the trust) or sometimes as an “Intentionally Defective Grantor Trust” (“IDGT”).
In the Family Security Trust SuperFreeze, a grantor normally transfers the ownership of property to an entity structured in such a way that current tax principles allow it to be valued at a discount. Normally, the grantor retains operating control of the entity and most or all of the management rights.
Then, the grantor sells some, but usually not all, of the interests in such entity to the FST in exchange for an installment promissory note. This note will have a principal amount equal to the fair market value of the interests. As a result of discounts, that fair market value will normally equal substantially less than a pro rata portion of the net assets of the entity.
Before the sale is made, the grantor usually makes a gift to the FST sufficient to prevent the sale from being treated as a gift. Such a gift may consist of property or money, normally with a value not less than 11% of the maximum anticipated promissory note amount. The promissory note may contain clauses to adjust the amount of the note depending on final determinations of value of the interests sold to the FST.
Since the IRS treats the “grantor” (you) as the owner of the property in the FST for income tax purposes, you recognize no taxable income as a result of the sale to the FST, and no taxable income on interest paid on an installment note given back to you by the FST.
On the other hand, you normally continue to pay any taxes on income generated by the assets in the FST. As a result, your beneficiaries get the equivalent of an income tax-free yield on otherwise taxable investments. Your payment of these income taxes “squeezes” the value of what remains in your taxable estate. [You can also sometimes structure the strategy so that the FST pays the income taxes.]
While that may sound bad for you individually, it provides an enormous benefit for your heirs, since their inheritance in the FST grows free of income taxes. The IRS has confirmed in a formal revenue ruling that payment of such income taxes by you, even though an economic benefit for the beneficiaries of the FST, does not constitute a gift by you for transfer tax (estate and gift tax) purposes!
The Internal Revenue Code allows a relatively low interest rate (the “Applicable Federal Rate” or “AFR”) to be charged on an installment loan from a FST, without adverse gift or income tax results. For May, 2015, that rate was as low as 1.52% per annum for notes maturing in less than 9 years, and 2.28% on longer terms loans.
This low rate of interest enables a FST earning market returns to use the cash flow or appreciation in excess of debt service to fund growth in the values transferred free of Estate Taxes to the beneficiaries you choose for your FST. In addition, since you pay taxes on the income of the FST instead of your trust or its beneficiaries, it enhances the return for the beneficiaries of your trust.
The Value of Discounting
The FST works even better if property is first contributed to a Family Limited Liability Company (“LLC”). [You could also use a Family Limited Partnership, or “FLP” instead of an LLC with substantially the same effect.] Then, instead of selling the property directly to the FST, you sell the non-managing LLC interests to the FST. This lets you keep greater control as Manager of the LLC (or by designating the manager), while it can enhance protections from creditors and should, under current rules, also reduce the value used to calculate the gift and sale portions.
Generally, the fair market value of LLC interests is adjusted (“discounted”) downward from the liquidation value of the assets in the LLC due to lack of control, minority interests and lack of marketability. Long-standing legal and valuation principles, as well as numerous court cases, support both the reality of these discounts and the ability to families to use them in their planning for Estate and Gift Tax valuations.
Typical discounts often range from 35-50%, although the IRS sometimes argues that discounts should be lower. These valuation discounts reduce the principal amount of the note, while increasing the effective yield to FST from the underlying assets. Valuation discounts need to be established by a “qualified appraisal” in order to be recognized for Estate and Gift Tax purposes.
If you get a 40% discount (I have seen higher and lower discounts accepted by the IRS in some cases), the effective rate on the note from the FST back to the grantor would be less than 1% of the underlying assets in the FST acquired in the “purchase” of the LLC. Thus, if the LLC achieves a total pre-tax return of 6% per annum, that would be about SIX TIMES the leakage (the amount that comes back to the grantor) from the interest. Over time, this transfers very substantial value to your heirs free of Estate, Gift and even Generation Skipping Taxes.
Imminent IRS Attack on Discounting
However, the IRS has long thought that the discounts, while real for persons outside the family, often do not reduce the real value for family members.
As discussed above, the Treasury Department made it clear recently that it intends to announce regulations soon that would limit the use of discounts in family estate planning transactions. Those who complete Family Security Trust Superfreezes or other transfer strategies before the effective date of the regulations (probably shortly after they are formally announced or proposed) can reap the advantages of discounting. But, if you procrastinate too long, you may never be able to lock-in the benefits of discounting for your heirs.
Can You Still Get a Step-Up In Basis?
Usually, gifting strategies that take property out of your estate will usually have one major cost: They preclude your family from getting a step-up in basis.
However, it is possible to structure and operate a Family Security Trust Superfreeze in a way that can produce both substantial Estate Tax savings, and allow your family to get a step-up in basis when you pass away. When you get both these effects, you have achieved estate planning nirvana. An experienced lawyer who works with these strategies can explain how this can be done and show you how these strategies can work for your specific estate.
I plan to discuss the principles behind this “two-for-one” benefit in upcoming free Estate Planning for Apartment Owners” Seminars in Los Angeles on June 30, Orange County on July 21, in Van Nuys on July 23, and in Torrance on September 1, 2015. If you are worried that you might not be able to implement a discount strategy if you wait for the seminar, you should consult with experienced counsel as soon as practical. Remember, this is a sophisticated strategy that cannot be implemented well in just a few days.
IF YOU HAVE A LARGE ESTATE AND WANT TO AVOID ESTATE TAXES, YOU NEED TO PLAN WELL NOW!
Until you meet with an experienced Estate Planning Attorney who can evaluate your situation and goals, you cannot predict whether you should implement a Family Security Trust Superfreeze, or any other strategy, to protect your heirs.
Of course, Estate Planning usually produces the best results when you do not delay doing it for too long.
Now, however, with imminent changes to the IRS rules that may reduce, or eliminate, discounts in estate planning, you need to learn right now whether or not discounts could work well for your family. Families that plan well before the IRS changes the rules should save millions of dollars more than families who delay their planning.
My Estate Planning Motto has always been: “IF YOU FAIL TO PLAN (WELL), PLAN TO FAIL.”
Given the risk that the IRS will act to limit discounts, perhaps it needs to change to: “IF YOU FAIL TO PLAN (WELL) VERY SOON, PLAN TO FAIL.”
If you have, or expect to have, a large enough estate that your heirs will face estate taxes, I urge you to consult with an attorney experienced in advanced estate planning strategies before the IRS limits the ability to use discount planning.
Kenneth Ziskin
Kenneth Ziskin, an estate planning attorney, focuses on integrated estate planning for apartment owners throughout California to save income, property, gift and estate Taxes. He holds the, which also gave him a Client Choice Award in 2014.
Ken works in Orange County with Attorney Michael J. Wittick, who is a Certified Specialist in Estate Planning, Trust and Probate Law. Ken and Michael both hold the coveted AV Preeminent peer reviewed rating for Ethical Standards and Legal Ability from Martindale-Hubbell, and a perfect 10 out of 10 rating on legal website AVVO. In San Diego, Ken works with Attorney John Demas, while in Northern California he works with San Jose Attorney Robert J. Bergman.
Ken is presenting upcoming seminars on Estate Planning for Apartment Owners in Los Angeles on June 30, in Orange County (with Michael J. Wittick) on July 21 and in Van Nuys on July 23, 2015. For reservations, call (818) 613-8442 or email [email protected]
This article is intended to assist readers to get a general understanding of some estate planning concepts relevant for income property owners. To keep it concise, it does not discuss all of the exceptions, qualifications and other concepts that might affect their utility in your situation. You can only rely on counsel you specifically retain, and not on these materials, in connection with your planning.
Accessibility