Like most of America, you have watched your lifetime wealth shrink due to the uncertainty of todays economy. Real estate and marketable security values continue to decline as well as interest rates. Although your wealth has decreased, your estate may be subject to estate tax. The current estate tax exemption is $3.5 million. The current estate tax rate is 45%. The estate tax is scheduled to sunset in 2010 and revert back to $1 million exemption and a 55% tax rate in 2011. However, it is believed that Congress will not allow there to be a year without estate tax. Instead many believe that Congress will keep the current exemption amount and rate for years to come. With that in mind, now may be the best time to update your estate plan. Described below are some estate planning techniques that may be utilized in todays economy of depressed values and low interest rates.

1. Intra-Family Loans. With the collapse of the real estate market it has become a buyers market. However, it is harder for potential first time home buyers to obtain financing in addition to being able to make a 20% down payment. One alternative is for that potential home buyer to obtain an Intra-Family Loan. The loan could be a short term or long term loan depending on the borrowers needs. An Intra-Family Loan can also be a useful tool to help a family member purchase a business or to consolidate debt at a low interest rate. The lender is likely to be a senior family member, normally a parent or grandparent. These loans are especially helpful if the senior family member makes periodic annual gifts of cash to the junior family member in an amount equal to the current annual gift tax exclusion, which is currently $13,000 ¹ .

Here is an example of how the Intra-Family Loan would work: the senior family member, a parent, agrees to help his daughter purchase her first home with an Intra-Family Loan by a promissory note that is secured by the real property for a term of years. The interest rate must be equal to or higher than the applicable federal rates ² compounded semiannually, otherwise the loan would be considered a loan gift. These loan rates are at an all time low especially when compared to rates 10 years ago due to the current economy. Payments must be made at least semi-annually and must have a specified maturity date. If the parent continues to make annual gifts, the gifts could be applied to the loan each year but the child should not rely on these gifts to make payments. By using an Intra-Family Loan, the parent is able to help his child purchase her first home at a low interest rate without using any of his lifetime gift tax exemption ³ or unified credit.

¹Each person is able to gift $13,000 per person tax free each year. If a married couple decides to gift money to someone, they could each gift $13,00O ($26,000 total) to each child each year. If they want to a child and his or her spouse, they could each gift $26,000 ($52,000 total).
²Current applicable federal rates: short-term (3 years of less) 0.83%, mid-term (more than 3 years less than 9) 2.78%, long-term (more than 9 years) 4.22%.
³2009 lifetime gift tax exemption is $1 million.

Income and estate taxes should also be considered when entering into an Intra-Family Loan. The parent will most likely be required to recognize the interest income from the loan in his or her taxable income. However, the child will generally not be able to deduct the interest paid from his or her taxable income. The balance of the loan will also be included in the senior family members estate unless the loan contains a self-cancelling provision.

Intra-Family Loan Summary

• Provides credit for descendants without using any gift or estate exemption;
• Locks in today’s low interest rates; and
• May be structured to reduce estate tax and/or repayment obligation.

5. Qualified Personal Residents Trust (“QPRT”). The value of your principal residence (or vacation home) may have decreased due to the current economic climate. This decrease in value may be used to your estate planning advantage. For many, a personal residence is one of the most valuable assets owned. Some may plan for their children to inherit the residence in the future. A homeowner could, during his or her lifetime, transfer his or her interest in the personal residence to a child through a Qualified Personal Residence Trust (QPRT). A QPRT is an irrevocable trust for a term of years. The Settlor transfers his ownership interest in his residence to the trust. During the trust term, the Settlor would be responsible for all of the expenses of the home, including real estate taxes, maintenance fees, and the cost of ordinary repairs. The Settlor would not notice any change in his day to day routine. At the end of the trust term, the residence will transfer to the child free of estate tax. The purpose of the QPRT is to transfer the residence out of the Settlors estate with minimal tax consequences.

Example: Wanda is a 68 year old widow who lives alone in a large Scottsdale residence she purchased as community property with her deceased husband in the early 1960's. Upon her husbands death the residence received a step-up in basis to $2,200,000. Today the value of the residence has decreased to $1,450,000. In addition to the residence, Wanda inherited an IRA with a value of about $1,500,000. She also has cash, securities and other various assets totaling $1,800,000. Her entire estate is worth $4,750,000. If Wanda passed away today her estate would owe approximately $562,500 in estate tax, but if the real estate market turns around in the near future, her estate could potentially pay much more in estate taxes without utilizing a QPRT.

Wanda decides to transfer the house to her only child, Sam, who has been living with her to help take care of the house. She creates a QPRT with a 6 year term, which results in a taxable gift of $995,498, using almost all of her lifetime gift tax exemption so that no gift tax is payable. During the 6 year term, the value of the property increases to $1,900,000. By removing the residence from her estate she has potentially saved $407,026 in estate tax. Certain rules apply if Wanda dies before the expiration of the term or decides to stay in the residence after the expiration of the term.

QPRT Summary
_ Passes ownership of an appreciating asset to descendants at reduced estate tax cost.

7. Grantor Retained Annuity Trust (“GRAT”). A Grantor Retained Annuity Trust (GRAT) is an irrevocable trust in which the Settlor receives a fix annuity payment during the Settlors lifetime or for a specific number of years. The remaining beneficiaries of the GRAT will receive the remaining balance at the end of the GRATs term. A GRAT is a great estate planning tool to transfer appreciating or income producing assets to the next generation with little or no gift tax. The value of the gift is determined by using Section 7520 ⁴ discount rate (the “discount rate”).

For example, a Settlor, who is currently 55 years old, owns $1,000,000 in shares of stock that distributes 5% in dividends each year. The Settlor transfers the stock to a GRAT for a term of 10 years. The GRAT receives $50,000 in dividend interest each year and the Settlor receives his/her annual annuity of 10% (i.e. $100,000) from the GRAT. The current discount rate is 3.40%. During the 10 year GRAT term, the stock increases in value by 2% each year. At the end of the term the remaining beneficiaries will receive approximately $591,450. The taxable gift is equal to $164,130 and would save up $192,294 in estate tax.

⁴ 7520 of the Internal Revenue Code of 1986, as amended, is used to discount the values of life estates, annuities and remainders of present value. The rate is adjusted on a monthly basis and is equal to 120% of 1274(d), federal mid-term rate.

If this GRAT were created 10 years ago, the taxable gift would be almost double that amount ⁵ . By utilizing todays record low discount rates you are able to transfer some of your lifetime wealth to family members with little tax consequences.

(Please keep in mind that the gift would not qualify for the annual exclusion because the gift is a future interest.)

3. Charitable Lead Annuity Trust (“CLAT”). A Charitable Lead Annuity Trust (CLAT) is a great way for persons with substantial wealth to donate to their favorite charity while being able to transfer assets to family members at a later date. A CLAT is an irrevocable trust which provides an income interest (an annuity) for either a term of years, a measuring life, or a combination of both, to a charitable beneficiary and the remainder to a non-charitable beneficiary. Unlike charitable remainder trusts, a CLAT generally results in no income tax deductions for the Settlor, but the remainder value will be a taxable gift. The benefit of the CLAT is that the charitable beneficiary reduces the value of the taxable gift. A CLAT may also be created at the death of the Settlor but for purposes of this memo this discussion will only deal with CLATs created during a Settlors lifetime. Similar to a GRAT, described above, the value of the gift depends on the terms of the trust and the discount rate ⁶ used. The amount of the gift also depends on the Settlors charitable intent. If the Settlor wishes to provide a substantial gift to the charity each year, then the annuity payment would be higher and the taxable gift would be smaller and vice versa.

For this example well use the same the same stock to fund the CLAT as in the GRAT. The CLAT will be for a term of 10 years with a 5% annuity payment and stock has a 2% growth rate. The taxable gift would be $569,105, the charitable beneficiary would receive $500,000 and the remainder beneficiary would receive approximately $1,283,907 ⁷, for an estate tax savings of $321,660. In addition to the decrease in estate tax, the CRAT would report any income generated from the shares of stock, thereby reducing the Settlors taxable income.

⁵In August, 1999 the discount rate was 7.20%
⁶A Settlor may select the lowest rate for a 3 month period up to and including the month the CLAT is created and funded.
⁷Calculation includes 5% annual dividend income and 2% annual growth rate.

CLAT SUMMARY

• Provides annual contributions during the Trust’s term to a charity selected by the Settlor;
• Passes remaining balance of an appreciating and income producing asset to descendants;
• Locks in today’s low discount rate of return; and
• Reduces cost of estate taxes.

CONCLUSION

These are examples of some estate planning techniques that may be utilized due to the decreased values of the real estate and securities market. As a result of the declining markets, we are also witnesses to record low interest rates. including the Section 7520 discount rate and applicable federal interest rates. With the unknown future of estate tax, now is the time to take advantage of these techniques. The particular facts in each case determined the potential benefit in that circumstance. This article is intended for general discussion and not as specific advice.

Contact:

Laura Morrison (lmorrison@mclawfirm.com)

Michael Margrave (mmargrave@mclawfirm.com)