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Estate tax strategies to help avoid nasty surprises

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How can financial planners help wealthy clients lessen their tax risk when it comes to some complex estate planning strategies?

As of now, the estate tax exemption is $5.49 million, or $10.98 million for a married couple ($5.6 million or $11.2 million for a couple in 2018) but there is talk of the estate tax being repealed. Does this mean planners no longer need to study up on complex estate planning mechanisms for their wealthier clientele? But it may not be.

Clients looking to move assets out of their ownership to avoid future estate tax costs, achieve asset protection benefits or meet other objectives still need to use sophisticated planning techniques. There has also been little to no talk in Washington of a gift tax repeal, so that tax is likely to remain for the foreseeable future.

Until estate tax repeal becomes a reality, planners should grasp the basics of complex estate planning transactions, and coordinate with other experts to ensure tax risk is mitigated as much as possible.
Consider, as an example, a client who owns 100% of the stock in a family business worth $20 million. They wish to gift $5 million to a trust for their daughter, who is running the business. They could simply gift 25% of the stock to a trust for her. However, if the IRS determines on a tax audit that the stock was worth $40 million, not $20 million, the value of the gift would be doubled and the client might owe gift tax at a 40% rate on the excess value. That about $2 million unintended gift tax would not be a pleasant surprise for your client.

How can this potentially be avoided? Enter valuation adjustment techniques. These are strategies that attempt to assure that, when a taxpayer transfers an interest in an asset that is hard to value, an unintended tax cost is not incurred.

Adjustment mechanisms that minimize the potential for an adverse tax consequence can be used in several planning scenarios, including:

  • A client is making a large gift of an interest in real estate or an entity owning real estate.
  • A client wishes to shift the value of a large interest in a business that is not publicly traded to a trust by selling it to that trust for a note.
  • A non-marketable asset is held in a trust and a client wants to swap cash or marketable securities they have into the trust in exchange for that asset, e.g. stock in a closely held business. An advisor might help a client do this so the stock is included in the client’s estate when they die, thereby obtaining a step-up income tax basis on death (which can eliminate all capital gains), or perhaps because the client wishes to gift the stock to a different family member than the trust provided.
Advisors should be wary of one approach used to avoid an unintended tax cost: the property adjustment clause. It doesn’t work.

Advisors should be wary of one approach used to avoid an unintended tax cost: a reversion to the donor. It doesn’t work.

Using this mechanism, a client would gift or sell assets to a trust or their children. However, if the IRS determines the value is greater than originally intended, they would get that excess property back. The courts have viewed this as creating a “condition subsequent” and see it as a violation of public policy; if the IRS attempts to enforce the tax law, this mechanism renders the issue the IRS challenged irrelevant. This is because the audit itself would shift the excess value back to the transferor.
The price adjustment clause is another strategy that may be more successful. This method doesn’t bring the property back to the client as the transferor, but instead provides that, if the IRS determines the value is higher for gift tax purposes, the trust receiving the gift or buying the asset from the client would pay the difference back to them (or give a note) with interest from the effective date of transfer.

Another approach, called the Wandry method, has been recognized by one court and is relatively simple to understand and implement. It may be best used for smaller and simpler transactions, but not all advisers are comfortable with it. With this approach the client can make a gift, or sell an asset, based on a specified dollar amount. The dollar figure is fixed, but the number of shares actually sold may be adjusted if the IRS determines the value of those shares to be higher than the appraised value used in estimating the sale.

Using a defined value mechanism is perhaps the approach that most estate planners believe has the greatest likelihood of success because several court cases have approved variations of it. But it presents costs and complications.

In this approach, the client would part with all interests in the assets involved, regardless of value. Assume the client owns 100 shares of stock in XYZ, Inc., a family business worth $100 million. They want to transfer $20 million or 20% of the stock.

The client agrees, no matter what, to part with any right to 20% of the shares they believe should be valued (based on an independent appraisal) at $20 million. The client sells those interests to a trust they have created for a promissory note with $20 million.

If the IRS determines the value is not $20 million but $30 million, the client does not receive anything back; they have given up full control of the shares involved. How can the client avoid the gift tax if such an audit occurs? The excess value of $10 million in shares is transferred by contract to a different entity than the trust consummating the purchase from the client. That other entity is one that will negate the assessment of a gift tax. The most common entities used in this type of plan are:

  • A charity (no gift tax as the value qualifies for the unlimited gift tax charitable contribution deduction). This is the preferable approach but not all clients will accept it.
  • A marital trust (no gift tax as the value qualifies for the unlimited gift tax marital contribution deduction).
  • A grantor retained annuity trust which by its structure can reduce the gift tax to zero or near zero as a result of an annuity payment back to the client.

Large and complex estate planning transactions are vitally important to the security and goals of many wealthy clients. Advisors can demonstrate their value during uncertain times by using mechanisms to help these clients avoid nasty tax surprises when these planning strategies are used.

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