Captives

Families with business interests can create and utilize their own insurance company to manage risk and insulate and transfer wealth. A captive is usually designed to cover claims not usually covered by traditional insurance policies and/or to supplement existing coverages. Premiums are often income tax deductible and the insurance company reserves accrue tax deferred and can eventually be transitioned to younger generations in a tax efficient manner.

Equity Stripping

Some assets are not suitable for entity ownership. This often includes personal residences, properties with existing mortgages, receivables, etc. If one uses an engineered loan against the asset we can reduce the equity in the asset to such a low level that it would be unattractive to a creditor (this is often referred to as “equity stripping”). Even if a creditor did pursue a claim, in a foreclosure the debt would be paid first and would separate equity from a creditor.

Within the wealth preservation goals is minimizing taxation, both federal and state and along all forms.  Most planning tools offer some form of transfer tax (death and gift) benefits, which we will discuss below.

Wealth Transfer  

The federal government, along with some state governments, impose a transfer tax – a tax on transferring assets when alive (gift tax) or at death (estate tax). There are some basic credits available consisting of (a) the annual gift exclusion of $13,000 per person per done (increases with inflation periodically) and (b) the $1,000,000 lifetime gift exemption.  

The estate tax (on death) has been in existence for decades as a wealth equalization tool. During the Bush administration the credit was gradually increased through December 31, 2009 with the estate tax repealed for 2010. However, the law “sunsets” in one year and reverts in 2011 to the 2001 program ($1 million exemption and 55% tax rate). While the current Obama administration advised it would address this issue, they have failed to do so leaving the country with no federal estate tax for this year, an unclear picture of the future estate tax regime, and many current wills and trusts that may fail to operate as intended (many wills are rigid in that they address asset disposition based on the amount of assets under a “credit shelter” (to capture the federal tax credit), which under some wills would now be unlimited leaving asset disproportionately). The current situation reinforces a recurring flexibility theme; laws and tax rules change and the planning tools must be flexible to change with it or risk a significant negative tax event for an unsuspecting family. Now is an opportune time for family office advisors to review and discuss with clients current wills and trusts for coordination with the changing tax landscape.

Leveraging

As the estate tax will in all likelihood remain a family can make best use of the credits. While modest, the annual and lifetime transfer tax credits can be enhanced through leverage. The governments impose transfer taxes on the asset’s fair market value. To achieve leverage we use techniques to make the fair market value artificially lower. When a family owns assets in most forms (personal, joint, tenants in common, corporate, general partnership, etc.) the fair market value is what the asset would sell for. Alternatively, we can use entities to own assets (often limited liability companies, family limited partnerships, corporations with non-voting stock) which concentrate control and rights into a few shares and the majority of shares are non-voting and have significantly reduced rights. The non-voting shares are worth considerably less due to their lack of vote, lack of marketability, and lack of liquidity. The IRS has acquiesced to the discount and it is common to see discounts of twenty to forty percent thus effectively allowing a family to transfer significantly more, but of equal or greater importance, to also remain in control of the asset (only non-voting shares are transferred).  

An example of a real case: a family owned a small technology company that generated strong reviews for their recent work and was starting to generate interest among buyers. The restricted stock of the company was worth approximately $2 million (documented via business appraisal). There was a good chance that if sold or taken public the value could increase several fold.  We used a family limited partnership to own the technology company stock and achieved a 40% discount (documented by appraisal) for a net transfer value of $1.2 million. We gifted the non-voting portion of the family limited partnership to an asset protection trust using about half the parents lifetime gifting credit. Eight months later the stock restrictions expired and the company went public and garnered $90 million. The result was the parents retained control, the $90 million was outside of their estate, saving $45 million in future death taxes, and in an insulated container.

Freezing

Many estates grow faster than the annual gift exclusions can address and as appreciation of assets increases the value of the estate the death tax problem compounds. “Freezing” refers to techniques that effectively transfer future asset appreciation to the younger generation. Thus, the assets best suited for this technique are those with the greatest chance for appreciation. Most freeze techniques revolve around “grantor” trusts; meaning the transferring party kept some benefit from the trust.

One of the more popular grantor trusts is the Grantor Retained Annuity Trust, which in essence, is the gift of an asset with the caveat that the grantor will retain an annuity (annual cash payment) for a set period of time. From a tax value perspective, the gift value isn’t the asset’s value but rather the value of receiving an asset in the future. This structure is also used to give the senior generation the benefit of continuing income.

Annuity amount and length of time are options – the longer the annuity and/or the greater the annuity the smaller the value of the gift. However, the annuity period is critical to the technique working - if the grantor dies before the annuity period ends the gift unravels and it is treated as if no transfer occurred.  

To reduce mortality risk, shorter annuity periods can be used (while absorbing increased gift size). Another hedge technique is to break out the asset in several pieces and use staggered GRATs (i.e. 20% of limited partnership units in each of five separate GRATs) with varying time periods (a 1 year, a 3 year, a 5 year, a 7 year, and a 9 year). This can assist in the time versus taxable value balance.  Another useful hedging technique is the “rolling GRAT”, in which a series of short term GRATs are created where one is the beneficiary of the next. The annuity payments are structured to be large enough so the tax value of the GRAT is zero. If there is appreciation it was transferred, if not we lost nothing. When used well, rolling GRATs can be a very effective freeze technique with almost no downside risk.

Sales  

Once gifting and freezing options have been explored an often underutilized strategy is the structured sale of assets. As the term sale implies, assets are sold to younger generations in return for a stream of income. Since it is a sale for adequate value there is no gift and the assets are out of the taxable estate day one. The private annuity is most effective for income producing assets. For instance, a family owns an apartment building, it generates income and is appreciating well. The value is too large to give away and the parents don’t wish to sacrifice the income. The family would like to keep the building in the family but none of the children have the financial wherewithal to purchase it. Mechanically, the building is sold to the younger generation in return for annual payments for the remainder of the parents’ lives (IRS tables are used to calculate life expectancy and payment amounts). While alive, the parents enjoy income to support their lifestyle and can even retain control. After the parents’ demise there are no death taxes as they do not own the building. Presuming the parents used the annuity payments for living expenses, there would be no other related asset to tax. Any unrecognized capital gain on the building is forgiven.  The children needed no cash to buy the property as they used building cash flow to support the annuity payments.

Charitable Planning

Many families are charitably inclined but become much more so when charitable tools can integrate into estate planning and reduce actual cost to pennies on the dollar. When we give to a charity an income tax deduction reduces actual cost to about sixty cents on the dollar.  Charitable planning exploits tax rules where actual cost of giving drops from sixty cents to ten cents or less; a tool to be considered when we seek to do well and do good.

Most charitable tools use a trust structure where an asset is transferred to a trust, if non-income producing the asset is sold by the charity without any taxes, the principal is invested and the income benefit and the future principal benefit are divided between the charity and the family. Charitable Lead Trusts (CLT) provide for income to the charity and, at a future point in time selected by the family, the remaining assets pass to the younger generation. The family gets a significant income tax deduction for the value of the income stream the charity receives and the value of the ultimate gift to younger generations is significantly discounted because it is delayed. The income tax deduction often cancels out the gift value resulting in an almost free gift to charity.