Episode #16: The Effect of COVID-19 on Estate Planning (Jennifer Jordan McCall)

Joel Simon: Jenny, I know there are a number of legal specialty areas that are booming in light of the pandemic. Insurance, government investigations, and cybersecurity are a few that jump to mind. But what has COVID-19 done to the world of trusts and estates planning?

Jennifer Jordan McCall: It’s been a very busy year, Joel. It’s been overwhelmingly busy because all of our clients are aware more than ever of their mortality and their wish to take care of their loved ones and get their estate planning up to date. All of us are aware that if we should get sick, we might not have time or the ability to prepare our estate plans. In addition to that, there are opportunities right now with the exemptions that will not be here in the near future. So, the opportunities with high exemptions, lower rates and long-term exemptions combined with the mortality risk of COVID-19, has brought kind of a perfect storm where folks are calling us right and left.

Simon: It sounds like there’s more urgency than we might usually see as tax preparation time approaches. In light of that, maybe you can elaborate on some of those changes and why they’re so important right now?

McCall: Yes, it’s because the transfer tax, which is the tax that’s imposed when a person makes a gift during life. That’s the gift tax. And when you die, it’s the estate tax imposed on all of your assets that you own at death. That tax is referred to generally as the transfer tax and is fairly significant. It’s 40 percent currently at federal level. Some states also have a state transfer tax—that tax is generally not apparent to people because it doesn’t apply unless you make a big taxable gift or after you’re deceased. When people find out about that, and they understand that occurs at every generation, they see that all the wealth they have amassed over their life can be eliminated in about two generations if they don’t do proper planning. This year we have extremely high exemptions. Much higher than ever before in history for each person to take advantage of to avoid that 40 percent federal tax. The exemption right now is $11.58 million for each individual, and that means that a person could transfer $11.58 million in a trust for their children and grandchildren and not have to pay gift or estate tax. However, there is urgency as you said, because that amount is scheduled to be reduced at the end of 2025 to about $5.5 million per person. On top of that, we have the uncertainty of the election. If Biden [is elected], the exemption is likely to go down, especially if the senate becomes democratic. So, we are preparing for the possibility that the exemptions will be gone and many of our clients are rushing to provide the right kind of planning to take advantage of the exemption this year before the amounts go down. In addition, the rate of tax may go up from 40 percent to a higher amount.

Simon: Can you illustrate that further?

McCall: A husband and wife are seen as one unit by the U.S. government. When they are both gone, the tax is applied before it can go down to the next generation. So, we have to view it as about 40 or 50 percent of the assets going in tax at each generation when mom and dad are both gone and it goes to the children. Then, when the children die and it goes to the grandchildren, another 40-50% goes out in tax. So, if we can take our exemption amounts—$11.58 million per person this year, $23 million for husband and wife—and fill up that tax-free bucket with assets now. Then that amount will be escaping that tax and if the exemptions go down next year, the fact that you took care of it this year and created a trust this year will mean that you will be safe and won’t be subject to those lower exemptions next year. The other urgent item is the generation-skipping transfer tax exemptions. That’s applying when you skip over your children and go to your grandchildren and the government wants to take 40 percent at every generation. In that example, they would apply a gift tax if this happened during life and the generation-skipping, or GST tax, when it goes to the next generation. Two taxes because two generations. Right now, the generation-skipping exemption is also that very high amount. The same number. $11.58 million, but also a different exemption—just the same number. That GST exemption under current law can last for an unlimited number of generations. So, if we put property in a trust in a state where we can hold property in trust for a long time, we can skip over an unlimited number of generations. Going back to the policy, we can see that that’s a wonderful, wonderful opportunity. Here, we can put our property in a long-term trust, put our long-term GST exemption on it, use a very high GST exemption to make the transfer, and then all the assets in that trust will be exempt, potentially forever, because of the long-term trust, and we’ll escape that tax every generation. That’s a huge tax savings. In addition, the appreciation on that property will also be exempt from the GST tax forever. So, it’s the unlimited duration in the GST, the very high amount of the GST exemption, and the fact that all the appreciation on those assets … all of that is exempt forever. It’s a real home run for the taxpayer.

The longevity of the GST exemption may also be diminished depending on the election and the control of the senate, so we want to take advantage of that right now. As you say, between now and the end of 2020 is the optimum time to take advantage of these opportunities.

Simon: That’s a fascinating explanation. I wanted to ask you about something else that I’ve heard about, which is that there is some financial engineering that can also be applied to what you just described to leverage the exemption even more. Can you describe how that works?

McCall: The appreciation on the exempt property is also exempt. If we were to transfer, say, $10 million today, and the husband makes a gift into a long-term trust for the benefit of his children and grandchildren. (As an aside, the husband is allowed to include his wife as a potential beneficiary as long as the amount that can be distributed to her is limited by an ascertainable standard of house support and maintenance after considering her other resources, so there is a way to reclaim some of that property into the spouses hands if you decide later that you gave away too much and you want some back.) So, the money can be given to this long-term trust in a favorable jurisdiction such as Delaware, Wyoming, Alaska, Nevada, Florida and various states that allow long-term trusts. We put our GST exemption on that $10 million, which means that it will never be subject to this tax for all the generations that it’s in the trust. The family can use the property. In fact, the trust can [dictate] that the family will use such as a residence or an investment in a business. But the property itself won’t be decimated by this tax. Now that trust can actually leverage its assets to increase the exempt amount. One very popular way today is that the trust could borrow assets from the person who put the property in. We call that the grantor or the trustor. In fact, it could buy assets from that person for a note, because the trust will be what we call a “Grantor Trust.”

Simon: Tell our audience more about that.

McCall: A Grantor Trust means that for income tax purposes, the trust is the same as the grantor, whereas for estate tax purposes it’s out of his or her estate when he dies. It’s a grantor trust meaning that the income from that trust is taxed to the person who put the property in. So, that person writes a check for the income taxes, which obviously amplifies the assets in the trust—they’re not reduced by tax obligations every year. And that payment of income tax by the grantor is not itself a gift because, as I said, they are one and the same for income tax purposes. It’s the obligation of the grantor to pay that tax, which is a great way to transfer property tax free to the trust. Because it is a grantor trust and one in the same for income tax purposes, the grantor can sell assets to the trust in exchange for a note without that being a recognition event for capital gains purposes. So, the grantor could sell, say, non-voting stock or a minority interest in a partnership to the trust, take a discount, say, 30 percent for lack of marketability on those assets he sold, and the trust will give a note back to the grantor for that appraised value—discounted value of those assets. We can go up to nine times what’s in the trust, so if the trust has $10 million, we could go as high as $90 million, but we could go with any number that feels comfortable to the grantor—maybe $20 million. So, we’ll give a note back to the grantor for $20 million, and that $20 million will represent the discounted value of the assets we’re buying because of lack of control and lack of marketability. Say the assets are really worth $30 million, but with those discounts, the appraised value is say, $20 million. So now the note comes back for $20 million and the interest rates today as we know, are at an all-time low, and in the world of trusts and estates, we have to abide by the applicable federal rate, or AFR, which is the minimum required interest rate between related parties, which currently is 40 basis points. The lowest it’s ever been historically. The note can be a very low amount of interest. So, now we have the $10 million of original gift, the $20 million of discounted assets that we purchased for the note which really represents $30 million face value. So, we have $40 million in there, and the note is going to be $20 million interest only for nine years. The interest will be very small, can be paid in kind, doesn’t have to be paid with cash, and now when the nine-year period comes, the trust will pay the grantor back the $20 million face value, but in the interim of nine years, that $30 million has probably grown to say, $60 million. So, that is the non-discounted face value of those assets. So, we have $60 million plus the original $10 million, that’s $70 million, minus we paid back $20 million, so now we have $50 million in the trust which is exempt forever under our wonderful long-term GST exemption today. That’s a very good way to leverage and although someone might say, “gosh, that sounds very aggressive,” there’s actually a revenue procedure on point that says that that works and we are comfortable referring to that as authority for the fact that it’s all right to have it be linked for income tax purposes but out of your state for…

Simon: Right. And a revenue rolling means the IRS has effectively approved it.

McCall: Exactly. Treasury has indicated that that’s a valid transaction.

Simon: I know there are other types of trusts. We don’t have a lot of time to go into detail on them, but could you just mention a few of those because there are other ways that people can achieve their goals.

McCall: Exactly. Every client has different priorities and, as I mentioned before, some clients—for example, private equity venture folks, hedge funds—they may want to put in a great deal of wealth into these trusts. In fact, a percentage of the carry can go into the trust. I will also caution the listeners that this must be done according to very strict IRS rules in terms of how to transfer interest and entities. Essentially a prorated slice of every class of equity interest that the trustor owns. So, we can’t just transfer one class and not the other, we have to talk with our lawyers at Pillsbury about the right way to transfer and not run afoul of these rules. But provided that those transfers are done correctly, there should be no problem with the transfer going in to take advantage of the transaction I mentioned. In addition to that, there are other trusts that are very popular such as charitable trusts where the trustor can transfer assets to a trust—for example, a charitable remainder trust. The assets on hand at the end can go to the favorite charity which could be his foundation, or to the college of the grantor which could be her university for example. And then they get an income stream back from this charitable remainder trust. So, the charitable remainder trust means the charity gets the remainder. The individual gets income back, and there are income tax advantages to this, as well. And there are multiple other types of trusts—spousal trust for each other which can provide some creditor protection potentially, and charitable annuity trusts. There are many different types of trusts, so we need to find out what the client’s goals are and then recommend what is favorable to that person. I should mention state income tax as well because that’s also very important today. With the state income taxes not being deductible for federal, it’s increasingly popular to go to states such as Wyoming or Delaware or Florida where there is no state income tax, and have our trust operate there. We have to make sure we have the right components to our trust planning so that we don’t attract state income tax inadvertently from say, New York or California.

Simon: Jenny, in the short time we’ve had today, you’ve delivered some great insights. Thank you so much for joining me today.