MAXIMIZING AND MULTIPLYING THE “STEP-UP” IN BASIS – Part VI
“Reverse” Estate Planning: Turning your Poorer Parent into an Asset
Many clients who have taxable estates also have a surviving parent or parents who lack a taxable estate. A child of a parent whose taxable estate is less than the parent’s Applicable Exclusion Amount may make use of the excess to save income, estate, and generation skipping taxes if the child can transfer assets upstream, from child to parent, in such a way that the assets are included in the parent’s estate with little likelihood that the parent will divert the transferred assets away from the child or child’s descendants.
Although the benefits of such planning have always existed, the permanent increase in the Applicable Exclusion Amount recently has enhanced the benefits of such planning.
Estate and Generation Skipping Tax Benefits.
To the extent a child transfers assets to a parent, parent will include those assets in parent’s estate and may shelter those assets with the parent’s estate and GST tax exemptions. Transfers can be made without using the child’s Applicable Exclusion Amount:
(1) Annual exclusion gifts may be made to the parent. The gifts may be made outright or in trust depending on circumstances (e.g. parent may be given a Crummey withdrawal right). Discounted gifts may be made although doing so will add benefits to the transaction only if the discount is unlocked prior to parent’s death. The benefits of annual exclusion gifts may be significant. To illustrate, $13,000 per year for 10 years at 5% equals $163,000. If child is married and there are even two living parents, then $52,000 for 10 years at 5% exceeds $652,000.
(2) Child could make adjusted taxable gifts to the parent. Although it may appear that such would be a wasted use of the child’s gift tax exemption, if the parent is able to leave the $1,000,000 to child and child’s descendants without estate or generation-skipping tax then the only waste would be opportunity cost to the extent that other methods could be found to transfer assets to a parent without making a gift.
(3) May child loan securities to a parent under section 1058 and have the parent’s estate return those same securities, only now with a new basis? Treas. Reg. §1.1058-1(c)(1) states that “the lender’s basis in the identical securities returned by the borrower shall be the same as the lender’s basis in the securities lent to the borrower.” Arguably the “securities lent to the borrower” now have a new basis because the borrower died but there appears to be no authority directly on point. Certainly this is not the sort of transaction contemplated by section 1058.
(4) Child may create a GRAT that has a vested remainder in parent. That is, the GRAT assets, after the annuity term ends, will be paid to parent or to parent’s estate. The value of the remainder will be included in parent’s estate and will pass in accordance with parent’s estate plan.
Parent’s executor may allocate generation-skipping tax exemption to the remainder interest without regard to any ETIP under section 2642(f) of the Code because parent has not made an inter vivos transfer of property that would be included in parent’s estate immediately after the transfer. The amount allocated would be equal to the fair market value of the remainder interest. Where the GRAT term is 10 years (or longer), and is back-weighted, the remainder value will remain a comparatively small percentage of the GRAT for the first several years of the term. Upstream GRATs will, in general, have longer terms that GRATs that are designed to transfer assets immediately to children. Commentators have speculated that a GRAT may be created with a vested interest in a child, with that child immediately transferring the remainder interest to that child’s children and allocating that child’s GST exemption at the time of transfer. There is no authority on whether such a transaction achieves the intended result. PLR 200107015 ruled negatively on the assignment of a remainder interest in a charitable lead annuity trust primarily on the grounds that section 2642(e) of the Code is specifically designed to limit the ability to leverage generation skipping tax exemption by using a charitable lead annuity trust. Here the GRAT remainder is not being transferred at the time of its creation, but rather at its fair market value at a later time (the death of the parent owner). Use of an Upstream GRAT presents several advantages compared with a child’s assignment of a remainder interest to grandchildren. Because GST exemption that would otherwise be wasted is being used there is no, or certainly less, pressure to keep the remainder interest in parent’s estate at zero or a de minimis value and the value changes depending on when parent dies (a date that in almost all instances will be uncertain). If a concern is that the value of the remainder interest could exceed the threshold beyond which parent’s estate would be required to pay Federal estate tax (or file an estate tax return), then the amount vested in parent could be fixed by a formula tied to the remaining assets in parent’s estate. Suppose a 10 year GRAT is funded with $1,000,000 with annual payments that increase at 20% per year is created in a month when the section 7520 rate is 2.0%. The annual payments required to zero-out the GRAT are $44,125. Further, suppose that parent dies at the end of year 5 when the section 7520 rate is 5.0% and the value of the trust assets have grown at 6% per year. The value of the GRAT will be $975,740 with five years of payments remaining and the value of the remainder will be about $403,000.
Income Tax Benefits
Assets included in a parent’s estate for estate tax purposes obtain a new income tax basis under §1014(b)(9) but not if assets acquired by the parent from a child by gift within one year of the parent’s death pass back to the child or the child’s spouse (§1014(e)).
Creditor Protection for Child
Assets that a parent transfers in trust to a child may be insulated from the child’s creditors so long as the child’s rights in the trust are properly limited. The sine qua non is that parent must make the transfer into the trust for state law purposes.
The lapse of a Crummey withdrawal right may be a state law transfer, although most practitioners and trustees do not treat it as such, except in those states which provide specifically to the contrary. A safer approach would be to have parent exercise parent’s power of appointment in favor of a new trust for the benefit of child. If the power is general the parent should become the grantor of the trust for state law purposes.
Limiting Parent’s Ability to Divert Assets
The strategies called for require that parent have a testamentary general power of appointment. A power limited to the appointment of assets to the creditors of a parent’s estate will be a general power under section 2041(b)(1). If it is desirable that a parent have additional discretion the parent could be given a power to appoint to descendants, with or without charities, and such additional powers could be conditioned on the consent of child or others because all that is required in order to capture the tax benefits is the limited testamentary general power.
If a child desires to receive an interest in the assets transferred to parent back from parent (e.g. parent transfers the assets into a trust for child and child’s descendants that is not available to child’s creditors), then giving parent a power that is broader than a power to appoint to the creditors of parent’s estate may be desirable. For example, a parent could be given a power to appoint to parent’s children and the creditors of parent’s estate. Child could ensure that assets were not diverted to a sibling by purchasing from the siblings an assignment of any rights the siblings receive in assets appointed by parent that originated with child. The assignment would be independent of parent but would limit the ability of a creditor (or the government) to argue that the child transferred the assets to parent in a manner that did not give parent any true control. The ability to reach such an agreement with minors is limited.
A parent who has or is likely to have creditors will not be a good candidate for these sorts of transactions. Creditors could include health-care providers or Medicaid, tort victims (is parent still driving would be a key consideration), and beneficiaries of legally binding charitable pledges.
In addition, by definition, a parent who is married to someone who is not also child’s parent has a potential creditor at death although in limited instances marriage agreements coupled with state law limitations on the rights of a surviving spouse to take property over which a decedent has a testamentary general power of appointment may make these transactions feasible.