Refinanced your estate plan lately?

The savings from almost any mortgage refinancing pales in comparison to that obtained from proper timing and implementation of estate-tax planning.

Authored by Paul Arslanian, Attorney, C.P.A., Managing Partner , and Eric J. Wells, Partner, Arslanian Wells PC

If large estates were as common as mortgages, perhaps advertising for opportunities to save on estate taxes would be as common as it is for mortgage refinancings during these times of low interest rates. The fact is that the savings from almost any mortgage refinancing pales in comparison to that obtained from proper timing and implementation of estate-tax planning techniques.

One estate-tax planning tactic that is well-suited for the current interest rate environment is the sale to an intentionally defective irrevocable trust (IDIT). Let’s apply this technique to the case of an owner of a closely held business—a corporation, partnership or limited liability company. This company can be an operating business or an entity that owns rental real estate. Simply put, if your client owns a business that, through a combination of appreciation and income, produces an average annual return in excess of the Applicable Federal Rate (AFR), which applies to the sale, savings will result. This applies even before taking into account the additional savings afforded by discounting techniques that may be used in conjunction with the sale.

Why should clients consider an IDIT now? The answer is that the AFR recently has been as low as 4.17 percent for a long-term obligation, making an IDIT even more attractive.

Assume, for example, a father (a business owner) establishes an IDIT, hoping to transfer a significant portion of the value of his business, an S corporation, to his children. He does not wish for his children, who are trustees of the IDIT, to have voting control over the stock in the business. Therefore, the father causes the business to "re capitalize," issuing himself 90 shares of non-voting stock and ten shares of voting stock for his 100 shares of voting stock that constituted all of the outstanding shares in the business before the re capitalization.

The father has the business appraised, and it is deemed worth $5,000,000. The non-voting shares constitute 90 percent of the total shares. According to the appraisal, however, a purchaser would not pay 90 percent of the value of the business for the non-voting stock. The appraisal suggests that marketability and minority discounts totaling 40 percent apply, meaning that the non-voting stock is worth only $2,700,000, rather than $4,500,000.

To better position the IDIT as a bona fide purchaser of stock, the father first transfers (by gift) 10 percent of the stock to the IDIT, all in non-voting shares. The value of this gift is not $500,000 (10 percent of the value of the business), but $300,000 because of the discounts. The father pays no tax on this gift because it applies against his unused gift and estate tax exemption (currently $1,000,000). This gift alone results in the "disappearance" of $200,000 for gift and estate tax purposes. The IDIT then purchases the remaining non-voting stock (80 percent of the business) from the father, not for 80 percent of the value of the business as a whole, but for $2,400,000, which is the value of these non-voting shares when the discount is applied. In exchange for the stock, the father receives a promissory note from the IDIT in the amount of $2,400,000, bearing an interest rate of 4.17 percent, and requiring equal annual payments for 20 years. The IDIT will pay to the father $179,265 in interest and principal each year, presumably by using distributions received from the business.

Assume that the business produces a return, including income and appreciation, of 15 percent annually. Due to the discounts applied, and the fact that the stock yields a return of 15 percent on the non-discounted value ($4,500,000) while the IDIT pays only 4.17 percent interest on the debt it incurred to purchase stock at the discounted value, the value which passes to the children in 20 years (on a non-discounted basis) is $55,284,869 (see chart). Offset by the proceeds of the promissory note, and accumulations there from, this is the amount of value that the father has removed from his estate, all stemming from a taxable gift in the amount of $300,000 and a sale of non-voting stock for $2,400,000.

Properly implemented, the IDIT provides for the distribution, or the administration in trust, of the IDIT assets for the children in a manner consistent with the father’s other estate-planning objectives. For example, it may, require that each child’s share be held in trust for his or her benefit to help protect the child in later life from creditors or a divorcing spouse.

Because it must be assumed in these circumstances that the father also will transfer the voting stock to his children during his lifetime or upon death, it is fair to value the property received by the children using non-discounted values, even though it was purchased for a discounted value. The example above makes no mention of income-tax liability or the capital-gains tax liability of the father upon sale of the stock to the IDIT. Although the IDIT property will not be included in the father’s estate for estate tax purposes upon his death, it is structured as a grantor trust for income tax purposes. The assets and income of the IDIT thus being treated as owned by the father for income tax purposes, the father’s sale of stock to the IDIT is not recognized, and the taxable income and gains of the trust after the sale are taxable to the father, rather than the IDIT.

This is a significant advantage, because the father’s payment of this tax liability on income that is earned for the benefit of the children does not constitute an additional gift for gift and estate tax purposes. The father’s income tax liability must be projected in advance to assume that this aspect of the IDIT does not become a disadvantage to the father in time. While it is beneficial to maximize the period of time during which the IDIT earns 15 percent income and appreciation on non-discounted value while it borrows at 4.17 percent against discounted value, there is a risk that the IRS will take the position that capital gain is triggered on the unpaid portion of the promissory note upon the father’s death because the IDIT is no longer a grantor trust. In cases with significant potential capital gain liability, this risk can be reduced or eliminated by pre-paying some or all of the note, even if this is accomplished with third party financing or return of a portion of the IDIT property to the father.

Although the IDIT offers many other advantages and disadvantages, the importance or relevance of each can only be determined based upon your client’s family, financial circumstances and estate-planning objectives. The IDIT is sometimes properly preceded in implementation by other techniques, such as a GRAT. The circumstances and client disposition will generally lend to determination of the appropriate technique, but integration with the other planning is still critical. Particularly with today’s exceptionally low interest rates, you should strongly consider the IDIT on behalf of your clients.

For more information on intentionally defective irrevocable trusts, please contact Paul Arslanian, managing partner of Arslanian Wells PC, at paul@estateplans.com, (248) 540-7500, or visit the Web site, www.estateplans.com.