of this article addressed non-tax estate planning issues confronted by unmarried couples; and part two
dealt with basic gifting strategies for unmarried couples. This article will focus on several advanced gifting strategies that high net worth unmarried couples can use to reduce or eliminate death taxes.
For unmarried couples with very large estates, fully utilizing the $13,000 annual gift tax exclusion and $1 million gift tax exemption may not be enough to significantly reduce the overall estate tax. Gifts in excess of the $1 million gift tax exemption are taxed at the same rates as estate transfers. In light of possible estate tax repeal or reform, many people are reluctant to make taxable gifts to reduce estate taxes. Therefore, effective estate planning for persons with large estates must involve strategies that help freeze or reduce the value of assets at minimal gift tax cost. Following are some strategies that the wealthier partner can use to shift future appreciation to the less wealthy partner while minimizing taxable gifts to the maximum extent possible:
Low interest rate loans.
One simple way to shift potential appreciation from the wealthier partner to the less wealthy partner without incurring a gift tax is to make an interest-only loan. The loan must bear interest at the Applicable Federal Rate (AFR), published monthly by the IRS. The less wealthy partner reinvests the loan proceeds, and the appreciation in excess of the AFR will pass to the borrower free of gift tax and will also be excluded from the lender's estate. For the last several years, the AFR has been at all-time lows, making this strategy particularly beneficial. The loan should be documented with a promissory note.
FLPs or FLLCs.
A Family Limited Partnership (FLP) or Family Limited Liability Company (FLLC) allows the wealthier partner to make gifts to the less wealthy partner on a "discounted" basis, while retaining some measure of control over the gifted partnership/membership interest. For example, the wealthier partner could transfer property to an FLLC in exchange for a 1 percent voting interest and a 99 percent non-voting interest. The nonvoting interests are then gifted to the less wealthy partner (either outright or in trust). The wealthier partner maintains control over the FLLCs assets through the voting interests by naming him or herself as the manager of the FLLC. Moreover, the gift tax value of the non-voting interests may be discounted because they lack control and marketability.
Besides the tax reasons for creating an FLP or FLLC (i.e., discounting the value of the property for gift tax purposes and removing the income and appreciation on the gifted property from the donor's estate), there is also a variety of non-tax reasons for using an FLP or FLLC. As mentioned above, the donor can retain control over the management of the entity's property and the distribution of its profits. Assets in an FLP or FLLC are protected (to a degree) from creditors, and FLPs and FLLCs facilitate the making of gifts in much more efficient ways than direct gifts of property, particularly when real estate is involved.
The substantial benefits of using FLPS and FLLCs have subjected their use to increased scrutiny and challenge by the IRS. A recent line of case law has complicated the task of estate planners in advising clients on the use of FLPs and FLLCs. Thus, the proper structuring, administering and defending of the FLP or FLLC must be placed in the hands of a knowledgeable attorney.
Grantor retained income trusts.
A Grantor Retained Income Trust (GRIT) is an estate planning tool that has been around for many years. However, the Revenue Reconciliation Act of 1990 effectively eliminated the GRIT as a wealth transfer technique among "family" members. But GRITs are still a viable tool for unmarried couples -- one of the few areas of the tax laws where an unmarried couple has an advantage over a married couple.
A GRIT is an irrevocable trust whereby the grantor (the wealthier partner) transfers assets to a trust while retaining the right to receive all of the net income from the trust assets for a fixed term of years. The net income must be paid at least annually. At the expiration of the fixed term of years, the remaining trust principal is either distributed to the remainder beneficiary (the less wealthy partner) or held in further trust for the benefit of such beneficiary. However, if the grantor does not survive the fixed term, the assets in the GRIT are included in his or her estate, but any gift tax exemption used in establishing the GRIT is restored. Thus, the grantor is no worse off than if no GRIT had been created. In many cases, it might be advisable for the grantor to create an Irrevocable Life Insurance Trust to own a policy on his or her life to provide the liquidity -- both income and estate tax free --to pay the increased estate tax that will be owed if the grantor fails to survive the GRIT's term.
The gift tax value with a GRIT will be only the value of the remainder interest (i.e., the difference between the full value of the property transferred to the GRIT and the present value of the grantor's income interest). The idea is to select a term that will give the present value of the grantor's income interest a substantial value (using the IRS's monthly published discount rate), but that the grantor is likely to outlive.
A big advantage of a GRIT is that if the assets transferred to the GRIT generate income at a rate lower than the IRS's discount rate for the month of the transaction, the net effect is to undervalue the gift to the remainder beneficiary. In contrast, where the remainder beneficiary is a family member, the Internal Revenue Code requires the payout to be a fixed annuity, a so-called Grantor Retained Annuity Trust, or GRAT.
The gift tax value can be further reduced if the assets transferred to the GRIT qualify for valuation discounts (such as an interest in a family limited partnership). It is possible, with a long enough term and a large enough valuation discount, that the gift tax value will be nominal. Appreciation of the asset's value during the fixed term thus escapes estate taxation. The GRIT should be drafted so that, if the grantor and the beneficiary are no longer in a relationship, then another person already named in the GRIT automatically becomes the new beneficiary.
The laws affecting unmarried couples are changing rapidly. Certainly more changes are likely, even challenges in the federal courts to the Defense of Marriage Act. The different rules concerning property rights from state to state add complexity to the situation, particularly for same-sex couples who move from a state recognizing civil unions or same-sex marriages to a state that does not. For unmarried couples it is important to have some form of estate planning to prevent state default laws from disinheriting their partners. Finally, because unmarried couples with large estates do not have the benefit of the unlimited marital deduction and other advantages that married persons enjoy, they need to aggressively seek out alternative solutions to maximize assets, reduce estate taxes and make use of powerful techniques not available to married couples.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.
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