On the Urgency of Transferring Wealth Before 2021

It is urgent for family business owners to consider transferring wealth to their children and other beneficiaries before the end of 2020.  There are substantial opportunities to manage the taxes on wealth transfers during the last two quarters of 2020 that may not continue into 2021.

Why is this urgent?

Currently, federal tax law affecting family wealth transfers, such as gifts, loans, and sales transactions, are more favorable than they have been in the last four decades.  This may change after the November elections, as the government seeks revenue to fund stimulus plans and other programs in response to Covid-19 and the related economic disruption.  Some politicians are already advocating for aggressive changes to tax law that presumably would have an effective date of January 1, 2021.

In particular, there have been calls to increase federal transfer taxes (i.e., gift taxes, estate taxes, and generation-skipping transfer ("GST") taxes) by substantially decreasing exemptions and raising marginal rates.

● Transfer Tax Exemptions.  Currently, transfer tax exemptions allow tax-free gifts or bequests to children, grandchildren, or more remote descendants totaling $11.5 million (or $23 million for a married couple).  Some legislative proposals would reduce these exemptions to $3.5 million (or $7 million for a married couple).

● Transfer Tax Rates. Currently, a taxable wealth transfer is taxed at a rate of 40% of the fair market value of the transferred asset.  Some legislative proposals would increase this rate.  In the not too distant past, the marginal rate was as high as 55%.

To use a very simple example, under current tax law, a married couple theoretically can transfer $23 million to a trust for their children without incurring transfer taxes.  If the trust continues for descendants indefinitely, the trust assets can continue to avoid transfer taxes at the passing of each generation of beneficiaries.

In contrast, if federal tax law is changed as described above, the same transfer could cause an immediate gift tax payable in the amount of approximately $8 million and could cause GST taxes to be assessed on trust distributions to grandchildren and members of future generations.

Further, past legislative proposals for more onerous transfer taxes often have targeted family businesses and family investment vehicles by proposing rules that would require gifts of family stock, LLC units, or limited partnership units to be taxed based on an artificially inflated value.

Why are other conditions favorable for wealth transfers in 2020?

In addition to the higher transfer tax exemptions and lower transfer tax rates in 2020 (discussed above), market conditions make many family wealth transfers particularly attractive now.  The present economic uncertainty should cause many family business interests to be valued with higher discounts for transfer tax purposes.  Also, safe harbor interest rates that must be charged on loans or installment notes between family members are at near historic lows.  For example, a nine-year note issued in August would require an interest rate of only 0.41%.  (See the discussion below about particular wealth transfer techniques that benefit from low interest rates.)

Of course, it is also likely that income tax rates will increase and capital gains tax law will become less favorable for taxpayers, but these may be additional reasons to engage in wealth transfers in 2020.

Income Tax Rates.  With some wealth transfers, the transferor has the ongoing obligation to pay the recipient's income taxes attributable to the transferred asset each year.  For example, if a business owner gifts $10 million of S corporation stock to a trust for his or her spouse and children, the transferor, not the trust or the beneficiaries, may be required to pay income taxes attributable to the transferred         stock every year until the transferor dies.  This substantial additional economic benefit that the transferor grants to the trust and its beneficiaries each year is not treated as a taxable gift.  If income tax rates are increased in 2021, therefore, this benefit could become an even more valuable wealth transfer technique.

Capital Gains Tax Rules.  Traditionally, the capital gains tax basis of any asset included in the owner's estate at death is adjusted (usually upward) to equal the asset's fair market value on the date of death. That "step up in basis" usually eliminates taxable gain for the deceased owner's estate beneficiaries. In contrast, if the owner gifts the asset to the beneficiaries during lifetime, there is no basis adjustment, so the recipients often receive the asset with a built-in capital gains tax liability.  Sometimes, that is a reason not to gift the asset to family members during the owner's lifetime.  Current legislative proposals, however, would eliminate the step up in basis at death, and therefore this would no longer be a reason to continue to hold low basis assets until death, rather than transfer them during lifetime.

What techniques should be considered before the end of 2020?

Different techniques will be more appropriate for different individuals, but here is a partial list of techniques to consider:

Lifetime Exclusion Gifts.  Make large gifts of non-voting stock, non-voting LLC units, or limited partnership units to maximize use of high gift tax exemptions. Minority or non-voting positions can be valued at a discount, which means that more can be gifted.

Dynasty Trusts.  Maximize use of high GST tax exemptions to shelter assets from transfer taxes in trusts that continue for multiple generations.

● Grantor Trusts.  Transfer assets to trusts that allow the transferor to confer an additional annual benefit by paying the trust's income tax liability.

Loans to family members or installment sales transactions.  Use low interest rates to shift wealth to the borrower.

Self-Cancelling Installment Notes ("SCINs") and Private Annuities.  Sell assets to a trust for family members in exchange for a SCIN, which is a note that cancels at the payee's death, or a private annuity, which is a promise to make annuity payments for the seller's life.  SCINs require the buyer to pay a premium for the self-canceling feature, but when interest rates are low, the premium is not expensive in most cases.  Private annuities also are more affordable to the payor when interest rates are low.

Grantor Retained Annuity Trust ("GRAT").  A GRAT is a trust that provides the transferor with an income for a term of years and then passes the benefit to family members or other beneficiaries.  This technique has a lower transfer tax impact when interest rates are low.

Charitable Lead Annuity Trust ("CLAT").  A CLAT is a trust that pays an annual benefit to a charity for a term of years and then passes the beneficial interest to family members or other non-charitable beneficiaries. This technique has a lower transfer tax impact when interest rates are low. It also can provide an annual income tax benefit, which may be enhanced by higher income tax rates.

What if the transferor gives away too much?

Ideally, the transferor will work with his or her financial advisors to make sure that he or she has retained sufficient resources apart from the transferred wealth to continue to enjoy a desired standard of living indefinitely, including after retirement.  Unfortunately, it may not be possible to complete that type of thoughtful and thorough planning in the five months of 2020 remaining.

Many of the wealth transfer techniques described above, however, can be structured with some measure of flexibility to address financial needs of the transferor if the transferor begins to fall short.  For example, the transferor can name his or her spouse as a beneficiary of the trust that receives the transferred wealth.  Also, in some cases, the trust can be modified to discontinue the transferor's liability for payment of the trust's income taxes.  Often, the transferor can receive a loan from the trust, or the transferor can swap assets with the trust, so that the transferor receives liquid assets or assets that produce a cash flow, in exchange for illiquid or unproductive assets.  If the transferor has transferred business interests to the trust, the transferor can continue to receive compensation, deferred compensation, or other employment benefits from the business.

What is the lesson?

Family business owners should act now.  They should speak with estate planning counsel about wealth transfer techniques that might be appropriate for them to execute before midnight, December 31, 2020.  Timely action could save millions of dollars for their children, grandchildren, and other beneficiaries.

Gregory Monday