By pairing intrafamily loans with trusts, wealthy families are turbocharging their estate planning strategies. One business owner hit all the right notes when he sold a $30 million family limited partnership to a trust. Tax rules currently permit illiquid shares in a family partnership to be transferred to a trust at a discount of about a third. This was an extremely efficient way to transfer ownership of the business to his children. There’s no gift tax because the transaction is treated like a sale. The former business owner got a note from the trust in return for the sale, and the interest payments of a few million dollars provides him with cash for living expenses. It must be said that this is a highly complex strategy and requires the assistance of an experienced estate planning attorney.
The win-win in this scenario, as described in a recent issue of Barron’s, “How Family Loans and Trusts Can Create Big Wins,” doesn’t stop there. That note has a fixed value, no matter how big the underlying asset grows. So the business owner’s net worth remains frozen. The asset does not have to appreciate much to make this low-cost loan work for all involved. In the meantime, his business, now worth $250 million, is growing tax-free inside the trust for the benefit of his heirs. The savings are a mind-boggling $40 million to $60 million in estate taxes today, and, should he lives to his actuarial age, a lifetime savings of more than $100 million.
With low interest rates, families with taxable estates can benefit from structured trusts and intrafamily loans. Not that these intrafamily loans have their own rates and rules – the rates on intrafamily loans allow parents to lend their children cash at rates far lower than a comparable commercial loan. Plus, they can be part of a broader wealth-transfer strategy.
For instance, an aging millionaire can fund a trust for his children’s benefit with a $100,000 gift. He then loans it $900,000 at the allowable 1.82% interest rate for five years, which the trust invests. The trust makes regular payments on the loan and then repays the principal in full at the term’s end. Any investment gains over that extremely low interest rate are tax-free in the trust for the next generation – it’s all legal and great planning.
There are added benefits for using this trust – the oddly named intentionally defective grantor trust. It’s considered an irrevocable complex trust for estate-tax purposes (the assets transferred to it are out of the individual’s estate) and a grantor trust for income-tax purposes. By paying the income taxes on the trust’s income, more is left for the next generation.
Be sure that the loans are just that: they are loans. If they’re determined to be gifts by the IRS, you could owe gift tax at 40% (but the annual gift-tax exclusion is $14,000, and the lifetime gift-tax exemption is $5.43 million). Make sure it’s a loan with the proper documents, terms and interest rate. Payments must be made on time. When you’re planning your wealth transfer, consider a loan and a trust, but do it right with the help of a qualified estate planning attorney.
Reference: Barron’s (September 26, 2015) “How Family Loans and Trusts Can Create Big Wins”