by: Jeff M. Brandon, Senior Wealth Planner
Many wealthy individuals own assets they expect to appreciate significantly in years to come. Whether that’s an equity position in a business, a real estate asset, or some other investment, it can often be beneficial to move this asset outside of your estate.
Doing so allows the expected appreciation to occur outside of your estate, resulting in significant estate tax savings and maximizing the financial legacy individuals are able to build for their heirs.
This strategy, broadly referred to as a freeze technique, can be executed in a variety of ways. The optimal strategy is driven by the nature of the assets you wish to freeze and your financial goals – both in the short and the long term.
In this overview, we explore the different types of estate freeze techniques, outlining the benefits, drawbacks, and key considerations of each. These strategies can be complex, should be done with the advice of qualified estate and tax professionals, and should always be tailored to each person’s circumstances.
There are a variety of estate freeze strategies that individuals can adopt to transfer ownership of fast-growing assets outside of their estate. Below is an overview of several of the most widely used.
Installment sales occur when the owner of an asset (typically a business) agrees to sell the asset at a fixed price and receive payment in a fixed series of installments. It’s a straightforward strategy that allows the seller to spread the capital gains from the sale of their business out over several years.
Installment sales can include a self-canceling provision, which specifies that installment payments end early if the seller passes before the buyer has completed the agreed payments. The buyer of the asset must pay a premium if a self-canceling provision is included. A tax professional can assist in determining this premium, which is set by the IRS. Installment sales can be used both for sales to family members and to unrelated parties, although non-family transactions typically do not include a self-canceling provision.
While installment sales offer a relatively simple way to dispose of an asset, there are a couple of complications to be aware of. If the seller passes before the installment payments are completed, these unpaid installments are considered part of their estate.
Grantor Retained Annuity Trusts, often referred to as GRATs, are suitable for a wide variety of assets. The grantor transfers their asset(s) into the GRAT. In exchange, the trust pays an annuity payment to the grantor over a fixed term. Any appreciation in the asset occurs outside of the grantor’s estate.
The rate the annuity is paid at is set by the IRS under Section 7520 and is updated monthly. In a low interest rate environment, this strategy is popular, as the appreciation of the asset in the trust has a low hurdle rate to exceed. In a higher interest rate environment, GRATs are less attractive, but if grantors believe their assets are going to grow at a rate that outstrips interest rates, GRATs can still be an effective strategy.
As the gift to the GRAT is a future interest, grantors may take a discount on their gift to the trust. The level of the discount is calculated according to the age of the grantor and IRS rates. It’s important to note that for a GRAT to be effective, the grantor must outlive the term of the annuity. If the grantor passes during the annuity’s term, the asset will be included in their estate. Grantors can specify the length of this trust to be any term they wish.
Intentionally Defective Grantor Trusts, otherwise known as IDGTs, are a unique freeze technique in that they allow the grantor to retain control of their asset while moving it outside of their estate. IDGTs are a strong match for business owners.
The grantor sets up a trust and sells preferred stock in their business to the trust. The trust pays for these shares through an installment note, with payments funded by the dividends the business distributes to its shareholders. The minimum interest rate of the installment note is set by the IRS and these non-voting shares can be sold at a discount due to their non-marketability.
Meanwhile, the grantor retains voting shares, which, unlike non-voting shares, has full voting rights. This ensures that the grantor retains full control over the business, but the vast majority of the business’s value is assigned to the trust.
The grantor can also pay the income taxes on behalf of the trust. This essentially allows grantors to pass more money to future generations, simultaneously reducing the level of taxes the beneficiaries of the trust are required to pay and lessening the wealth in the grantor’s personal estate.
Individuals looking to freeze the value of fast-appreciating assets in their estate have a variety of options. When determining the best fit, it’s important to evaluate a wide range of factors related to the makeup of your assets and your personal financial goals.
Many of these options are irrevocable, meaning they cannot be altered once they are set up. Individuals should make sure that the strategy they embrace provides them with sufficient liquidity to satisfy their cash needs on an ongoing basis.
Selecting the optimal strategy for your personal situation demands the knowledge of experienced estate planning professionals. At Smith + Howard Wealth Management, our team brings a values-driven approach to financial planning that helps our clients build their financial legacy.
To learn how estate freeze strategies might fit into your estate planning process, contact a Smith + Howard Wealth Management advisor.
Unless stated otherwise, any estimates or projections (including performance and risk) given in this presentation are intended to be forward-looking statements. Such estimates are subject to actual known and unknown risks, uncertainties, and other factors that could cause actual results to differ materially from those projected. The securities described within this presentation do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in such securities was or will be profitable. Past performance does not indicate future results.
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