By Mark A. Schaum, Esq., CPA
This article has nothing to do with the Rolling Stones song by the same name, but for a tax lawyer to get the attention of some that are less tax oriented, one has to be a little creative. Indeed, the technique that is discussed in this article can be equally used with an elderly father or with both parents.
Estate planning attorneys generally focus on passing wealth down to children, grandchildren and even perhaps more remote generations. The primary point of this article is that, under the current tax laws, in certain instances there can be significant tax benefits to passing wealth up.
To set the framework requires a basic understanding of a few tax principles. References to IRS code sections are made only for those interested enough to check these out for themselves.
Principle #1- Unified Credit Against Estate and Gift Tax
Every US citizen (or US resident) has an estate/gift tax exemption (a “unified credit”) that can be used or applied, in whole or in part, during their lifetime or at their death. The unified credit has grown substantially in recent years and doubled in 2018. In 2019, the unified credit is a whopping $11,400,000 per person (IRS Section 2010 Unified Credit Against Estate Tax) and is indexed to inflation. This means that a person can own this amount of assets at death or give away this much during their lifetime before a tax is imposed upon them. In the event it is not obvious, a married couple then has combined estate/gift tax exemptions totaling double this amount or $22,800,000 this year. Consequently, most people will die not using all of their unified credit because the value of their estate is less than the unified credit amount.
A warning- the unified credit is not cast in stone. Congress could not get the votes to approve the increase in the unified credit permanently, so the republican majority passed the increase through the process known as “reconciliation”. The consequence is that the amount of the unified credit will “sunset” back to the previous level after December 31, 2025. For example, if the sunset occurred this year, the amount of the exemption would revert to $5,700,000 ($11,400,000/2).
Principle #2- Adjustment of Basis in Assets Upon Death
Generally, at death, for most assets owned by an individual, the tax basis in those assets will be adjusted to equal to the value on the date of death. While it is possible that an asset might be worth less at death than what the decedent ‘s tax basis was at the time of death, the tax planning opportunity we are discussing arises when the asset value has increased substantially and the value is greater than the decedent’s tax basis at the time of death. The result of this revaluation process at death is commonly referred to as getting a “stepped-up basis”. This step up in basis is only available for assets included in the taxable estate of the decedent for estate tax purposes and does not apply to assets that have never been subjected to ordinary income taxation (referred to in the IRS tax code as assets which have built-in “income in respect of a decedent” such as IRAs, pension accounts and annuities), (see Section 1014 of the IRS code Basis of Property Acquired From A Decedent).
As an example, assume mother owns $10,000,000 worth of stock at her death for which she paid $100,000. I did not make this one up as this is the case for the mother of one of my clients. If mother sells this stock during her lifetime, she would have to pay federal capital gains tax (largely at 23.8% in 2019) plus additional state income tax if mother lives in a state that imposes a state income tax.
If instead mother holds the stock until death, it will receive a new stepped-up tax basis equal to the value on the date of death and on a future sale, gain or loss will be calculated with a tax basis stepped up to the date of death value. Under the current tax law, if mother’s net estate is less than the then current unified credit (reduced by any prior gifts which were applied to the credit) no estate tax will be due. As an example, if mother’s only other assets are a home and a bank account collectively valued at $500,000, and she made no lifetime taxable gifts, there should be no estate tax due on mother’s estate if mother dies before December 31, 2025 because her taxable estate will be below the aforementioned exemption.
Principle #3- Downstream Defective Grantor Trusts
For many years, estate planners have been utilizing a certain type of trust to make downstream gifts that are treated as complete for gift purposes so that the assets are not included in the grantor’s estate at death for estate tax purposes. At the same time, because the trust maker (“the Grantor”) retains certain specified “grantor trust powers”, the grantor will continue to be considered the owner of the assets in the trust for income tax purposes. This technique is commonly referred to as an “intentionally defective grantor trust”. With a defective grantor trust, the grantor pays the tax on the income generated by the trust (as long as the grantor remains alive or until these powers are otherwise removed) and this essentially allows the grantor to make additional tax-free gifts in the amount of income tax paid. This benefits the downstream beneficiaries by
allowing the trust to essentially grow tax-free. In other words, the continuing payments of the trust’s income tax are not counted against the grantor’s unified credit.
Principle #4-Downstream Sale to a Defective Grantor Trust
Often, to reduce the amount of unified gift tax credit used, a gift to a defective grantor trust is combined with a sale to the trust from the grantor. Now I warn you, this next concept will sound absolutely crazy if you are not well versed in this area- since a defective grantor trust is considered to be the same taxpayer as the grantor for income tax purposes, a sale from the grantor to the defective grantor trust is not considered a taxable transaction for federal income tax purposes because it is essentially treated as a sale to yourself. Thus, no capital gain is realized at the time of the sale.
The prevailing wisdom in structuring a sale of an asset from a grantor to a defective grantor trust typically calls for a gift (often referred to as a “seed gift”) to be made by the grantor to the defective grantor trust of an amount in cash or property approximating 10%-20% of the sale price. Then, the balance is to structured to be paid by a note from the trust to the grantor. The note should be carefully structured as “bona fide transaction” with all the formalities of such transactions used in a commercial setting. In the traditional downstream sale to a defective grantor trust there is usually a desire to charge the lowest interest rate allowed to maximize the wealth that is passed down and many practitioners will use the low “Applicable Federal Rate”. Note- These sale transactions are typically picked up by the IRS on either an audit of the grantor’s gift tax return or on the estate tax return upon death.
The IRS has made it clear that they do not like these sale transactions to downstream defective grantor trusts. Practitioners had been hoping to get some guidance or comfort from the tax court in structuring these transactions (as the IRS broadly attacked this technique in the Woebling cases) but the IRS settled and we are left not knowing what was done right and what was done wrong. These IRS attacks, however, have scared a lot of practitioners and some are simply choosing not to do them.
The Opportunity for Upstream Gifts
The recent increases in the unified credit combined with the step up in basis for appreciated assets on death may provide what can be a very valuable income tax benefit, the opportunity to increase the taxable basis of assets which will then ultimately reduce taxable income.
Outright Gift– If we reverse the earlier hypothetical so that the son owns the stock (or any other highly appreciated asset such as depreciated real estate), then, look what happens if son gifts the stock to mother. If mother dies owning the stock there will be a
stepped up basis in the stock. There is one condition- mother must live at least 1 year after receiving the gift if the property returns to son. (see IRS code Section 1014(e) Appreciated Property Acquired By Decedent By Gift Within 1 year Of Death). This eliminates entitlement to the step-up in such case.
The risks and/or disadvantages to son in this simple structure are that mother may not return the stock to son, the asset may be subject to claims by any creditors of mother, and son’s unified credit is used to make the gift to mother. Referring back to the hypothetical, if son had no other assets and inherited the stock back from mother outright with no change in value, he would essentially have to make two uses of his unified credit- one to mother when he passes the property up and one to son’s beneficiaries when son dies and passes the property down. Thus, this could cause the son’s taxable estate to exceed the unified credit and result in an estate tax at the time of son’s death. Note- if the son is married, he and his spouse would have the benefit of two unified credits, but it is also possible that the unified credit amount, as previously mentioned, may go back down to previous levels.
An easy solution is to have mother leave the stock to son in a trust for son’s lifetime benefit with the remainder passing to son’s beneficiaries upon the son’s death. This is commonly referred to as a generation-skipping trust and can easily be accomplished by not giving son a general power of appointment in the trust assets. Structured this way, the stock will not be included in son’s estate at his death and/or when the trust assets pass to future generations. Florida has a “rule against perpetuities” allowing assets to remain in trust for up to 360 years. This technique eliminates the problem of double taxation on the stock and could also provide creditor protection from the son’s future creditors. A discussion of utilizing the generation-skipping exemption effectively is beyond the scope of this article but I mention it merely to emphasize how our focus in using this technique has been on passing assets down.
Gift To a Defective Grantor Trust -Next, bringing the complexity up a notch, suppose son owns the stock and creates a defective grantor trust for the benefit of mother and gifts the stock to it. If son grants to mother a limited general power of appointment in the trust (a narrow but permitted example of this would be the power to appoint to mother’s creditors) this should cause the assets in the defective grantor trust to be included in mother’s estate upon her death with a resulting step-up in basis equal to the value on date of death. Then, upon mother’s death the trust could provide a generation skipping trust for the lifetime benefit of the son.
In these hypothetical examples, we’ve used most of son’s available exemption. Can we do significantly better? Maybe.
Combining an Upstream Gift To a Defective Grantor Trust with a Sale
What if instead of son gifting all of the stock to the trust, son gifts 10-20% of the stock to the defective grantor trust and enters into a sale transaction with the trust taking back a note for the balance. As with the note on the downstream trust, interest will need to be paid on the note, but we might not be as focused on choosing the lowest rate (the AFR). Indeed, a higher interest rate, one closer to what a commercial lender would charge, may be a convenient way to get cash flow out of the trust to the grantor. Furthermore, the issues on which the IRS has exhibited their displeasure are not present in the upstream sale- primarily inclusion of full value in parent’s estate. These transactions are picked up by the IRS on either an audit of a gift tax return or an estate tax return of the grantor. In an upstream transaction, the plan is that the parent will die before the child having a gross estate, including the assets of the defective grantor trust, that will be less than the amount of the unified credit amount and therefore, not large enough to even require the filing of a federal estate tax return.
Now, when mother dies, the trust continues its defective grantor status as to son, but now, voila, holding the stock with a stepped up basis which can then be used to pay off the balance of the note to son. Likewise, the stock could be sold and the proceeds could be used to pay off the note. In other words, whenever the stock is sold, gain or loss will be determined based on the stepped up basis.
Mark A. Schaum of Mark A. Schaum, P.A. has his office in Boca Raton. He is Board Certified in Wills, Trusts, and Estates Law and is also a CPA