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This page contains a single entry by Associate Editor - 2 published on September 25, 2012 10:13 PM.

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COME FOR THE EXCLUSION, STAY FOR THE INTEREST RATE

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COME FOR THE EXCLUSION,
STAY FOR THE INTEREST RATE

By Bruce Givner, Esq. and Owen Kaye, Esq.
Givner & Kaye, A Professional Corporation,
Los Angeles, California
Bruce@GivnerKaye.com; Owen@GivnerKaye.com


Much is being written about the opportunity to use the $5,120,000 per person gift tax
exclusion before it is reduced to $1,000,000 on January 1, 2013.  The other time pressure to 
plan is the increase on that same date in the estate and gift tax rate from 35% to 55%.  Of 
course, it is wonderful to have so many families come to our offices now wanting to engage in 
planning.  However, the reality is that for most families with modest size estates - and for 
this purpose we mean estates of $30,000,000 and less - the current estate tax exclusion is 
not the most significant factor in achieving their planning goals.

There are other factors that help make this a wonderful time to engage in estate tax planning.  See Givner & Kaye, "Once-in-a-Generation Opportunity to Engage In Estate Tax Planning," Journal of Financial Service Professionals (May, 2009) at 38.  First are the historic low rates of interest we must use: (i) the short-term, mid-term and long-term applicable federal rates ("AFRs") for sales (which influence self-canceling installment notes ("SCINs")); and (ii) the IRC §7520 rate for annuities such as qualified personal residence trusts ("QPRTs"), grantor retained annuity trusts ("GRATs") and private annuities.  These rates have been coming down in almost a straight line since the peak in 1990, as we can tell by focusing on October (AFR rates are for annual payments):

Year Short-Term      Mid-Term      Long-Term          IRC 
AFR         AFR         AFR        §7520

1990 8.16% 8.82% 9.12%        10.6%
1991 6.14% 7.54% 8.09% 9.0%
1992 3.85% 5.78% 7.03% 7.0%
1993 3.69% 5.00% 5.84% 6.0%
1994 6.00% 7.10% 7.69% 8.6%
1995 5.90% 6.31% 6.77% 7.6%
1996 6.07% 6.72% 7.13% 8.0%
1997 5.84% 6.34% 6.68% 7.6%
1998 5.06% 5.12% 5.46% 6.2%
1999 5.54% 6.02% 6.31% 7.2%
2000 6.30% 6.09% 5.96% 7.4%
2001 3.58% 4.59% 5.39% 5.6%
2002 2.03% 3.46% 4.90% 4.2%
2003 1.68% 3.65% 5.23% 4.4%
2004 2.26% 3.62% 4.84% 4.4%
2005 3.89% 4.08% 4.40% 5.0%
2006 5.00% 4.82% 5.02% 5.8%
2007 4.19% 4.35% 4.88% 5.2%
2008 2.19% 3.16% 4.32% 3.8%
2009 0.75% 2.66% 4.10% 3.2%
2010 0.41% 1.73% 3.32% 2.0%
2011 0.16% 1.19% 2.95% 1.4%
2012 0.23% 0.93% 2.36% 1.2%

The second factor is the valuation adjustment for lack of marketability and lack of control.  These come into play when valuing interests in closely held businesses that are given or sold to trusts for the children.  (Trusts for the children, in these situations, are almost always "grantor trusts," meaning they are ignored for income tax purposes.  Some people refer to these as "defective" trusts.  However, few lawyers would acknowledge drafting "defective" trusts, so we shun that label.)  We often set up family holding entities - family limited partnerships and family limited liability companies - for investment real estate and even liquid assets, and the value of the interests in these entities, when given or sold to children's trusts, can also be adjusted by these discounts.

The third factor is that underlying asset values are still not what they were in the boom, pre-2008 (pre-Lehman Brothers-collapse) days.  There are many more buyers now for attractive real estate and closely held businesses, and the stock market has recovered from its bottom.  However, the values are still not what they were.  
Let us consider a not unusual fact situation.  Mom and Dad, ages 70 and 75.  Their $28,000,000 estate consists of the following:

$ 15,000,000 100% of the stock of a closely held "S" corporation

$  4,000,000 building (free and clear) occupied by the business

$  3,000,000 apartment building (free and clear)

$  2,000,000         liquid assets

$  2,000,000 retirement plans

$  1,500,000 principal residence (free and clear)

$    500,000 vacation residence (free and clear)

Mom and Dad's income consists of: 

$1,300,000 business (compensation and dividends)

$  200,000         building leased by business

$  150,000         apartment building

$  150,000         liquid assets

$  100,000         retirement plans

$1,900,000 Annual Income
A thorough discussion of their goals reveals that they wish to (i) use their gift tax exclusions before the reduction to $1,000,000; (ii) ease the estate tax burden on their three children; (iii) keep dictatorial control of all of their assets from now until the day that the survivor of the two of them dies; and (iv) keep all of their income.  Although they love their children and want to take advantage of the perceived opportunity presented by the change of the estate and gift tax laws, their most important goals are (iii) and (iv): to maintain dictatorial control of their assets and income.  Who can blame them?  They are like virtually every other owner of a closely held business.  We must be able to suggest planning that meets both their (understandably) selfish goals and their estate planning goals.
The closely held business, which Mom, Dad and their CPA value at $15,000,000, will not be appraised at that number.  Assume the EBITDA is $1,300,000.  Unless it is (i) an internet business; (ii) acquired by a strategic buyer; or (iii) growing by 20% per year, the appraiser will value it at six times EBITDA, in this case $7,800,000.  We will recapitalize it into 1 share of voting common and 99 shares of non-voting common.  IRC §1361(c)(4), entitled "Differences in common stock voting rights disregarded."  Mom and Dad will sell or give a non-controlling interest in non-voting stock.  As a result, the aggregate gift value of the corporation will be approximately: 

$7,800,000

X 80%      20% lack of marketability discount

$6,240,000

X 85%      15% lack of control discount

$5,304,000

What structure will accomplish both of the following: (i) allow Mom and Dad to keep all the income (and control); and (ii) make the estate tax on this valuable asset go to zero?  A sale of the non-voting common to irrevocable trusts for each child for a private annuity.  For two people ages 75 and 70 the annuity rate is 6.62546%.  Mom and Dad can reduce their compensation so that the corporation can pay a dividend large enough so that the children's trusts will have the funds to pay the annuity.  On the surviving parent's death, nothing will be included in the parent's estate.  The only usage of the lifetime exclusion for this transaction would be a gift by Mom and Dad of liquid assets to each child's trust to allow it to make a downpayment to Mom and Dad.  So the transaction would look like this:

$5,304,000 transaction value

X 10%         needed for a down payment

$  530,400         total downpayment

$5,304,000 transaction value

  -  530,400 downpayment

$4,773,600 due as a private annuity

$4,773,600 ÷ 3 children's trusts = $1,591,200 annuity per child's trust

$1,591,200

X  6.62546% private annuity rate

        $  105,424.32    per year per child's trust

A similar analysis applies to the $7,000,000 of investment real estate: contribute it to a family limited liability company.  As a result, the transaction would look like this: 

$7,000,000
X 80%         20% lack of marketability discount 

$5,600,000
X       80%         20% lack of control discount, higher than the discount for the  
stock in the "S" corporation
$4,480,000 transaction value
X       10%         downpayment
$  448,000

$4,480,000 transaction value
 -  448,000         downpayment
$4,032,000 balance due as private annuity

$4,032,000 ÷ 3 children's trusts = $1,344,000 per child's trust

If, for some reason, the two buildings do not generate enough to allow the children's trusts to pay the annuity, Mom and Dad can gift a portion of the limited partnership units so that the children's trust has enough income to buy the non-gifted portion.  For example, assume that the apartment building generates $150,000 and the building rented to the business generates zero.  On the $4,480,000 valuation, the parents would make a gift of $2,220,000 of the interests.  Then the children's trust would have enough to pay the annuity required for the remaining $2,260,000: $149,736.  
We complete the planning with the $2,000,000 of residential property.  Set aside the fact that what Mom and Dad think is worth $2,000,000 may not be appraised at $2,000,000.  Also set aside that a business appraiser would determine a tenancy in common discount for each spouse's 50% interest.  Instead, assume a 10 year term for the 75 year old parent in a QPRT: $1,000,000 generates a $483,360 gift; and a 15 year term for the 70 year old parent, which generates a $396,980 gift.  (Of course, there would be one QPRT per parent for the principal residence and one QPRT per parent for the vacation residence.)  As long as the parents survive their respective terms, another $2,000,000 has been eliminated from the estate.
With these planning alternatives, the total gift exclusion used is as follows:

$   530,400 downpayment for the transaction involving the corporation

$   448,000 downpayment for the investment real estate transaction

$   483,360 Dad's QPRTs

$   396,980 Mom's QPRTs

$ 1,858,740 Total
Of course there are other planning alternatives.  Instead of private annuities, we would test a sale for a long-term, interest only installment note and a sale for a SCIN.  Also note that the least "efficient," in terms of transferring value for each unit of gift exclusion, are the QPRTs.  However, if the parents survive the QPRT terms, the structures described above will remove $24,000,0000 of value from a $28,000,000 estate using up less than the exclusion the parents will have available in 2013.  Yet the parents have retained all of their income and control of all of their income producing assets for as long as they live.  
As tax planners we welcome the stream of families coming to our offices motivated by the desire to engage in planning before the change in the law that is scheduled to occur on January 1, 2013.  However, we know that the tools in our toolbox do not depend exclusively, and sometimes not even heavily, on that exclusion.