A MESSAGE FROM DELEGATE REGARDING COVID-19

Estate and Tax Opportunities That Are Emerging in the Current Economic Environment

Question: Why should an investor consider transferring assets at a time like this?

There are three primary “drivers” or actions that can increase estate tax efficiency.

The first action is to transfer assets when their value is low, and their potential future return is higher. The current market pullback is providing an opportunity to transfer assets at lower market values. If transferred, the rebound in value when markets recover would then occur outside of the transferor’s estate. Transferring future growth into trusts for the benefit of your children and grandchildren will ensure that the subsequent growth will not be taxed when you die, whereas if you wait for the rebound to occur, the growth will be costlier to transfer and may require payment of a transfer tax. So, you should consider taking action now, before a recovery occurs.

The second action is to “freeze” the value of your estate by selling or transferring high growth assets for a low, fixed return. The Federal Reserve has lowered short-term interest rates to near zero, and we are seeing yields on 10 year Treasury notes at all-time lows. As expected, the applicable federal rates (“AFR”) for April 2020 are extremely low. The AFR is the lowest rate at which one can lend money to a related party without the risk of a deemed gift. There are a number of planning strategies that work exceptionally well when interest rates are low. The concept is simple. You sell a high growth asset to a trust for the benefit of your children (and perhaps even for future generations) in return for a note bearing a low, fixed rate. The trust pays interest and eventually pays back the principal over time. As the recovery occurs, or as the value of the asset grows in the trust, the excess value above the interest and principal payments remains in the trust for the benefit of the trust beneficiaries. By taking advantage of today’s extremely low interest rates, and by selling assets at depressed values, you can combine two of the key drivers for estate tax efficiency. Lastly, the compound benefit of taking advantage of low interest rates is materials. Saving even 1% can have a significant compound benefit over many years.

The third key action for estate tax efficiency is for the grantor (parents most commonly) to pay the tax that’s due on trusts benefitting their children. These trusts are referred to as “Intentionally Defective Grantor Trusts” or “IDGTs”. In simple terms, the parents (grantors) retain certain rights over the trust assets and because they’ve retained these rights, the IRS considers the IDGTs as taxable to the parents (grantors). The result is that the parents end up reducing their estate by paying the tax for their children’s trust and the trust gets to compound its portfolio growth at a pre-tax return. For every $1 that the parents pay in tax for their children’s trust, they are saving ~$0.40 in transfer tax that would otherwise be required to be paid if the taxes were paid out of the trust’s corpus. (This assumes that the parents have fully utilized their available lifetime exemptions.)

Question: Are there changes to estate tax law that could make giving more difficult once the markets normalize?

The short answer is yes. The key factor to watch is the result of the 2020 election. If the Democrats win control of both Congress and the White House most of the tax attorneys with whom we work agree that a change in both income tax and estate tax law is a distinct possibility. So, we have been counseling all of our clients to consider their estate plans and their giving objectives. The two primary Democratic Presidential candidates have both noted that they would change the most recent tax law that passed in 2017 to reduce the lifetime estate tax exemption from ~$11.58 million per person. Biden has stated that he would support a $5 million dollar personal exemption. That’s the figure that will become the law when the 2017 tax law “sunsets” in 2026. Given the relative uncertainty, we believe it is prudent to take advantage of this pullback in the markets and to make use of today’s low interest rates to utilize some or all of the current $11.58 million lifetime exemption.

Question: Who should pursue these kinds of opportunities?

In very simple terms, individuals who have more than “enough” to take care of all of their objectives for the rest of their lives should consider how they would like the excess value in their estate to be held, and for whose benefit. An optimal financial plan provides individuals with financial security for the rest of their life. After they have attained financial security, even anticipating major pullbacks such as the one we’re currently experiencing, they can begin to transfer the excess value that they will not need into trusts for the benefit of others. The remainder above what they need and the amounts they wish to leave to others may be given to charity, either over the remaining years of their life, or when they die.

The first step is to evaluate the “costs” of everything one wants to do for the rest of one’s life relative to what one has today, and what one expects to earn or receive in the future. For example, if you have a hundred million dollar investment portfolio and you spend a million dollars a year, that’s basically equal to one percent of your total net worth. If you assume that you’re wealth will grow at a conservative rate of ~5%, and if you leave 2% to cover inflation (the anticipated decline in your future purchasing power), you have ~3% that you can use to support your lifestyle. If you look at your available $100M of investment assets, you could say that you only need ~$33M (one-third) of these assets to support your lifestyle if you assume a 3% after-tax, “real” (after-inflation) annual return. Under these assumptions, your expected buying power is preserved for the rest of your life. This is the classic “endowment model”. You live off the returns of your portfolio and you always ensure that your “real” buying power is preserved. Using these assumptions, you have ~$66M or two-thirds of your investment assets that you are not going to need unless you increase your consumption. So, you have plenty of assets, and you can step back and plan for how you would like your excess net worth to be held, and for whose benefit. This analysis is the same for individuals with $1M or $10M of investment assets. Once you know with a high degree of certainty that you have enough to support your future lifestyle, you should consider planning where you would like the excess to be held.

The sooner you make those plans, the better. Once you have determined that you have “enough”, you should begin the process of moving growth outside of your estate if your overall objective is to be estate tax efficient. There are planning tools that one can use to engineer estate tax efficiency while still preserving some level of access in case you find that your objectives change. We consider it important for individuals to have such flexibility in their plans, as you never know what the future will hold.

Question: If a client is concerned about the possible impact of future tax law changes, what would you say to them?

If your objective is to ensure that you have a tax efficient estate plan, then now is the best time to be planning. Tax law has never been more generous. Interest rates are low, so strategies that utilize low interest rates are efficient. And, markets have pulled back, providing an opportunity to sell or give assets at lower values to trusts benefitting your children and grandchildren. It’s a perfect time to be thinking about how to optimize your tax efficiency.

Question: What is the best way to begin this process?

We realize that it’s hard to look beyond the current volatility, but it’s important to take a moment and consider the future, when this crisis has passed. The first step is to thoroughly evaluate your financial objectives. We call this process “Horizon Planning.” Now that our clients are spending time with their families in ways that they may not have previously, we are asking them to consider their core values. What do they consider important (as a family and as individuals). Are their current plans aligned with their family’s long-term objectives? What do they want their legacy to be?

It’s important to consider the long-term. This too shall pass. This is not an ‘end of days’ type of plague; this is more of a ‘manageable situation’ that we’re trying to figure out how to work around. Eventually there will be a vaccine, and eventually we will get back to our normal lives, but right now, this coming week, if you step back and you say I want to revisit my thinking on what’s truly important to my family, and if securing the family’s financial future is a key priority, then now is a very good time to consider your estate plan and take advantage of some great planning opportunities. Especially through the month of April, interest rates are low, quite possibly as low we think they’re going to get, and if markets have not fully recovered, it’s a very good time to do so. This opportunity may persist through May, June, and July, depending on how long these shelter in place orders last and how deeply the economy is impacted.

We are encouraging all clients to begin the evaluation process now. We’ll take things one month at a time, but April looks to be a very good month for executing certain strategies.

Question: Are there any other thoughts on this topic that individuals should consider?

As I mentioned earlier, there are certain planning techniques that work well when interest rates are low. The benefit of a lower rate is material. When you consider the interest expense of a 1.5% rate versus a 3% rate over 30 years, you are saving 35%, or in other words, your estate tax efficiency is ~55% higher.

Also, if you use your current $11.58M lifetime exemption and the tax law changes, most legal practitioners who are experts in estate tax law expect that you will not be subject to a clawback of previous planning. This means that even if they reduce the lifetime exemption to $5M, gifts that have been given in excess of this figure will not be taxable. So, it appears that one must either “use it or lose it”, and if you use it, you likely won’t be subject to a future tax on previous gifts that exceed a lower exemption limit.

We look forward to discussing this topic with each of our clients. And, we hope to see all of you, in person, very soon.