Family Limited
Partnerships
Advanced
Wealth
Transfer
(FLPS)
Strategies
The American Taxpayer Relief Act of 2012 established a permanent gift and estate tax exemption of
$5 million, which is adjusted annually for inflation. For many individuals, the inflation adjusted gift and estate
tax exemption amount of $5.43 million for 2015 is likely to eliminate most, if not all of their potential estate
tax liability. But individuals with larger estates, or those who would like to continue receiving income from the
assets they ultimately wish to transfer, may need something more. A number of more sophisticated wealth
transfer strategies enable you to transfer assets at reduced values for gift and estate tax purposes—often
enabling you to remove assets worth well in excess of $5.43 million from your estate without triggering gift or
estate taxes. Many of these strategies also provide a predictable income stream. Their interest rate sensitivity
makes it advantageous to consider these strategies now, while interest rates are low.
Grantor retained annuity trusts
Example
Grantor retained annuity trusts (GRATs) are an “estate freeze”
technique that enable you to remove future appreciation from
your taxable estate. They are particularly useful to individuals
who have assets that:
Kathryn, age 50, is a senior executive at a company that is
contemplating going public through an initial public offering
(IPO). Several years ago, she used her full gift exemption to
establish a trust for her son, but she would like to transfer some
of the company stock she owns out of her estate before the IPO.
• can benefit from a valuation discount, such as a minority stake
in a private company or LLC,
• may appreciate substantially in value, such as ownership in a
company that may be sold or taken public, or
• generate strong cash flow, such as commercial real estate.
With a GRAT, you gift property to a trust that makes periodic
payments to you. The present value of the payments you
receive is taken into consideration in valuing your gift for gift
tax purposes. The payments may be “in-kind” (such as a portion
of any securities you have gifted) or in cash and, if set at a level
that is high enough, they can possibly reduce the value of the
gift for gift tax purposes to zero. As long as you outlive the
GRAT, when it terminates, any property remaining in the trust
passes to the remainder beneficiaries without any additional gift
or estate tax consequences.
She sets up a 3-year GRAT that names her son as remainder
beneficiary, and contributes shares valued at $10 million. The
valuation on the shares includes a 35% discount for lack of
marketability and control—placing the value before the discount
at $15,384,615. By having the GRAT pay her $3,508,156 each
year, she is able to reduce the value of the $10 million gift to
zero for gift tax purposes—eliminating the need to pay any
federal gift tax.
If the GRAT makes the payments in-kind and the value of the
shares increases 10% each year, the GRAT will hold shares with
an aggregate market value of $2,612,313 after making the final
payment. If the stock goes public at the end of the GRAT’s term
at a price that is 10% higher, the GRAT will hold shares valued
at $2,873,544.
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GRAT: IPO at 10% Premium
Kathryn
Pre-IPO shares valued
at $10,000,000
Shares valued at $3,508,156
each year for three years
GRAT $10,000,000
10% growth/year
after IPO
Sales to intentionally defective grantor trusts
Selling assets to an intentionally defective grantor trust (IDGT)
can be a particularly attractive strategy for leveraging your
federal gift and GST exemptions. Similar to a GRAT, an IDGT is
useful for transferring assets that
• can benefit from a valuation discount,
• may appreciate substantially in value, or
• generate strong cash flow.
Chris
Gift Tax Free
GRAT Remainder
$2,873,544
(after payments to Kathryn)
GRAT: IPO at 20% Premium
Kathryn
Chris
Pre-IPO shares valued
at $10,000,000
GRAT $10,000,000
Shares valued at $3,508,156
each year for three years
10% growth/year
after IPO
Gift Tax Free
GRAT Remainder
$3,134,755
(after payments to Kathryn)
These figures and illustrations are based on a discount rate of 2.6%. This rate,
set by the IRS, varies monthly and must be used in determining the gift value of
a GRAT. A higher or lower price for the IPO or price appreciation thereafter would
change the final value of the trust property but would not affect the gift-tax
consequences.
If the IPO price is 20% higher, the value of the shares held by
the GRAT will be $3,134,755.
The GRAT enables Kathryn to transfer stock valued at over $2.8
million to a trust for her son without paying any federal gift tax.
By establishing a new GRAT each year using the shares that
are returned to her, Kathryn may be able to transfer additional
shares free of gift and estate tax.
GRATs are particularly useful for individuals who want to
transfer appreciation on an asset, but may want to continue
receiving some benefit from it. They are often structured with
a relatively short term because the tax benefits are lost unless
you outlive the GRAT. The interest rate used to value the annuity
payments is determined by the IRS at the time the GRAT is
established. Lower interest rates increase the present value of
the annuity payments and therefore reduce the gift tax value,
making the GRAT more attractive. The current low interest rates
make it advantageous for anyone with appreciating assets to
consider a GRAT now.
2
ADVANCED WEALTH TRANSFER STRATEGIES
With this strategy, you make an initial taxable “seed gift” to
the trust. The trust then purchases additional assets from you
that can be valued at up to nine times the value of seed gift by
issuing an installment note. If you have not already used your
$5.43 million 2015 federal gift tax exemption, the combined gift
and sale would enable the trust to acquire assets valued at up
to $54.3 million without triggering any federal gift taxes. And,
if you are transferring ownership in a private company or LLC,
selling a minority stake or nonvoting shares may enable you to
take maximum advantage of any available valuation discount and
ultimately transfer even greater value free of federal gift taxes.
In order to avoid federal gift tax consequences, however,
the interest rate on the note must be at least as high as the
rate set by the IRS, but the note can be structured with a
balloon payment to minimize the annual payments. The note
can also be refinanced to defer repayment of principal even
further, if needed.
It is important to note that the sale of the assets to the trust
is not a taxable event. Because the trust is structured to be
“intentionally defective” for income, but not gift tax purposes,
the sale of the assets to the trust is treated as though it were a
sale to yourself. No gain or loss is triggered until the assets are
sold to a third party.
Example
Roger, age 60, owns a closely-held business that he believes
he can eventually sell for $120 million to a company that could
distribute his product more broadly. He recognizes that the
$5.43 million federal gift tax exemption provides him with an
opportunity to transfer an ownership stake, and the potential
price appreciation on it, out of his taxable estate. A valuation
firm has told him that the company is worth $90 million based
on its current cash flow, and indicates that a 35% discount for
lack of control would apply to the value of any non-voting shares.
Incorporating Life Insurance into Your Wealth Transfer Plan
Life insurance can be an attractive addition to most wealth transfer plans because of the beneficial tax treatment it receives—when
properly incorporated into a trust, the proceeds of life insurance are free of both income and estate taxes. This can make insurance
an attractive component for providing liquidity to offset estate taxes or for heirs.
Individuals using GRATs may find insurance particularly useful. A GRAT removes assets from the Grantor’s taxable estate only if the
Grantor outlives the term of the GRAT. As a result, individuals using GRATs often pair the GRAT with a life insurance policy that will
provide funds to offset any estate taxes that might be triggered if the assets are brought back into the Grantor’s taxable estate as a
result of an untimely death.
Roger establishes an IDGT, gifts $5 million to the trust and then
sells non-voting shares valued at $50 million to the trust. The
trust issues a 15-year installment note with an interest rate
equal to the IRS mandated rate of 4.5% to finance the purchase
of $45 million of the stock. Because the note is structured with
a balloon payment, annual payments by the trust are limited
to $2,025,000 for the first 14 years, with cash flow from the
company being more than adequate to cover the payments.
Although Roger will be taxed on any income earned by the trust
assets, he won’t be taxed on the interest payments he receives
from the trust and won’t recognize a capital gain on the sale of
the shares to the trust. He won’t recognize any capital gain on
the transferred shares until they are sold by the trust.
Three years later, when the company is sold for $120 million,
the trust repays the $45 million outstanding on the note and
is left with $57,564,103 in cash.1 Roger receives a combined
$62,435,897 from the sale of his remaining 14.5% stake in
the company and the repayment of the $45 million note. 2 He
uses a portion of those funds to pay the tax on the capital gain
triggered by the sale of the company. The strategy enables
him to transfer over $55 million in value to his children over a
three year period by using just $5 million of his $5.43 million gift
tax exemption.
Given the amount of assets that can be transferred to an IDGT
without triggering federal gift taxes, it is often advantageous
to allocate your GST exemption to the gift to the extent practical.
This enables the trust to make tax-free distributions to grandchildren
and future generations.
Sale to an IDGT
Transfer of Shares
Gift $5,000,000
Roger
Sale of shares valued at
$50,000,000
Intentionally Defective
Grantor Trust
$45,000,000 Installment Note with annual interest
payments of $2,025,000 and principal payment of
$45,000,000 at end of year 15
(Grantor is taxed on trust income)
Sale of Company Three Years Later
Purchaser of Company
$102,564,103
Roger
Repayment of Installment
Note for $45,000,000
Shares
Intentionally Defective
Grantor Trust
$57,564,103
(after sale and repayment
of Installment Note)
Illustration assumes an interest rate on the installment note of 4.5%. This rate,
set by the IRS, varies monthly. A higher or lower sale price for the company
($120 million) would change the final value of the trust property but would not
affect the gift tax consequences.
Establishing the IDGT in a state such as Delaware, that does not
limit the duration of a trust, can help you extend the term of
the trust and its ability to provide tax-free payments to future
generations.
Sale to an IDGT is often an advantageous way to leverage your
gift tax exemption and remove appreciation from your taxable
estate, while continuing to receive income from the transferred
assets. IDGTs also offer greater flexibility than GRATs—the
term can be much longer because there is no requirement that
you outlive the IDGT, the repayment schedule can use a balloon
structure, and the note can be repaid at any time. The minimum
ADVANCED WEALTH TRANSFER STRATEGIES
3
interest rate on the note is mandated by the IRS and varies with
the note’s term but is generally lower than the GRAT hurdle rate.
Current low interest rates make a sale to an IDGT an attractive
alternative for anyone who is interested in removing future
appreciation from their taxable estate.
Qualified personal residence trusts
For individuals with a primary residence or vacation home that
they would like to leave to family members, a qualified personal
residence trust (QPRT) can be a useful strategy for transferring
ownership in a tax-advantaged manner. With a QPRT, you
transfer a personal residence to a trust, but retain the right to
occupy it for a fixed period. At the end of the period, ownership
passes to your designated beneficiaries. Although the transfer to
the trust is a taxable gift, the value for federal gift tax purposes
is reduced by your “retained interest”—the value assigned to
your ability to use the residence during the stated term. As a
result, the amount of the taxable gift is generally well below the
fair market value of the home. And, you can use any remaining
lifetime gift tax exemption amount to offset some, or all, of the
federal gift tax.
Example
Linda, age 60, transfers her vacation home, valued at $2 million,
to a qualified personal residence trust set up to last 10 years.
Over that period, the home appreciates 2% a year. When the
trust ends, it’s worth $2,437,989, and the ownership of the
home is transferred to Linda’s daughter. Assuming an IRS
mandated interest rate of 3%, Linda can potentially realize
estate tax savings of nearly $466,916.
What about gift tax? Linda’s top gift tax rate would be 40%. If
Linda gave her home to her daughter outright, the value of the
transfer for gift tax purposes would be $2,000,000. If she had
already used her $5.43 million lifetime gift tax exemption, she
would have to pay $800,000 in gift tax.
In contrast, gifting the home in trust with the right to live in the
residence for ten years reduces the taxable value of her gift to
$1,270,700. As a result, the maximum amount of federal gift tax
that Linda would have to pay would be $508,280—a savings of
over $291,720.
It’s important to remember that from a legal perspective, you
are giving away your home. The trust can provide a degree
of flexibility, but your overall control over the residence is
effectively terminated when the trust term ends. You do have
the ability to include a provision in the trust agreement that
allows you to continue living in the residence after the term
4
ADVANCED WEALTH TRANSFER STRATEGIES
QPRT
Grantor irrevocably transfers residence to a trust. The transfer is
subject to gift tax, but all of the tax will be offset by partial use of
the grantor’s gift tax exemptions.
Linda
Linda uses rent
free for term of trust
Grantor pays fair market value
rent once trust term ends.
Potential estate
tax savings =
Family / Other
Beneficiary
$466,916
Value at transfer to
QPRT $2,000,000
2% appreciation
for 10 years
Value at end
of trust term
$2,437,989
Ownership of residence is transferred to family
member or other beneficiary when trust term ends
These figures and illustration are based on an IRS mandated rate of 3.0% and a
federal estate tax rate of 40%, and assume the grantor is age 60 when the trust
is created. The discount rate, set by the IRS, varies monthly and must be used
in determining the gift value of a qualified personal residence trust. A higher or
lower actual appreciation (than the 2% illustrated) would change the final value
of the trust property and potential estate tax savings but would not affect the
gift-tax consequences.
Outright Gift vs. Gift in Trust
Outright Gift
Gift in Trust
Taxable Gift
$2,000,000
Taxable Gift
$1,270,700
Gift Tax Cost
Use $2,000,000 of
exemption or pay
Gift Tax Cost
Use $1,270,700 of
exemption or pay
$800,000
$508,280
ends, but you must pay fair market rent to the new owner in
order to avoid adverse tax consequences. Should you fail to
survive the trust term, the value of the residence would be
included in your estate. You should avoid using a QPRT on
any property that has an outstanding mortgage as mortgage
payments would be considered additional gifts to the trust.
With real estate prices reduced in many regions across the
country, now may be an opportune time to consider establishing
a QPRT. It should be noted, however, that with a QPRT, lower
interest rates actually increase the size of the taxable gift.
Charitable lead annuity trusts
Individuals who are interested in philanthropy and who would
like to transfer assets to beneficiaries at a reduced valuation
for gift tax purposes may find a charitable lead annuity trust
(CLAT) useful. With a CLAT, you gift assets to a trust that makes
annual payments to charities of your choice for a designated
period. The present value of the charitable payments is taken
into consideration when calculating the gift tax value of the
assets you transfer to the CLAT. At the end of the trust’s term,
any assets remaining in the trust pass to your designated
remainder beneficiaries without triggering any additional federal
gift or estate taxes. A low discount rate coupled with a high
payout rate can substantially reduce the gift tax value of the
remainder interest.
CLAT: $200,000 Annual Charitable Gift
Carlos
Grantor taxed on trust income
Charitable Lead Trust
$5,000,000
$200,000 a year
for 15 years =
$3,000,000
Charity
7.5% growth
for 15 years
Value at end of trust term
$9,570,714
Children or
Other Heirs
(after payments to charity)
Taxable gift of $2,612,420 results in transfer of $9,570,714 to heirs
Example
Carlos would like to leave a portion of his securities portfolio
to his son, but has already used his lifetime gift exemption. He
creates a CLAT with $5 million worth of appreciating securities
and names his son as the remainder beneficiary. The CLAT will
pay his favorite charity $200,000 a year for 15 years for a total
contribution of $3,000,000. If the IRS mandated discount rate
is 3%, the charitable payments will reduce the taxable value of
his gift to the trust to just $2,612,420. Assuming the trust earns
an annual return of 7.5%, at the end of the 15-year term, the
assets remaining in the CLAT that will pass to his son will be
worth $9,570,714.
CLAT: $293,500 Annual Charitable Gift
Carlos
Grantor taxed on trust income
Charitable Lead Trust
$5,000,000
Charity
7.5% growth
for 15 years
Value at end of trust term
$7,128,647
(after payments to charity)
If Carlos still has $1,500,000 of his lifetime gift tax exemption
remaining how much could he transfer to the trust without
triggering gift taxes? If he increases the annual charitable
payments to $293,500, the taxable value of the portfolio will be
reduced to just under $1,500,000 for federal gift tax purposes
and his son will receive the $7,128,647 remaining when the
trust terminates without triggering additional federal gift or
estate taxes.
$293,500 a year
for 15 years =
$4,402,500
Children or
Other Heirs
Tax free with use of approximately $1,500,000
of gift tax exemption amount
These figures and illustrations are based on discount rate of 3.0%. The discount
rate, set by the IRS, varies monthly. A higher or lower actual return (than the
7.5% illustrated) would change the final value of the trust property but would not
affect the gift-tax consequences.
By carefully planning and managing your giving through a CLAT,
you can effectively reduce or even eliminate the federal gift
tax liability on assets transferred to beneficiaries. This makes
it an effective strategy for transferring appreciating assets if
you have already utilized all or a portion of your lifetime gift tax
exemption and are making, or plan on making gifts to charity.
ADVANCED WEALTH TRANSFER STRATEGIES
5
Intra-family loans
Intra-family loans offer an additional way to transfer future
appreciation on assets without triggering gift taxes. With this
strategy, you loan money to another family member, typically an
adult child or grandchild, enabling him/her to purchase assets.
The borrower agrees in writing to repay the principal plus
interest at a rate equal to the IRS mandated rate in effect when
the loan is made—a rate that is typically lower than the rates on
commercial loans.
Because you are loaning and not gifting the money, a properly
structured intra-family loan is not subject to gift tax, and any
appreciation on assets purchased with the loan remains outside
of your estate for estate tax purposes. You might also have the
ability to reduce overall family income tax, since any income
produced by the assets purchased with the loan proceeds will
be taxable to the borrower—typically a child or grandchild, who
may be in a lower income tax bracket than you are. However, you
must include the interest payments you receive in your taxable
income, so this is a benefit only to the extent that the income
produced by the assets is greater than the interest paid.
Some families find intra-family loans an effective way to
encourage younger family members to become actively engaged
in and learn about investing. An intra-family loan allows the
borrower to retain any income generated in excess of the loan
rate, giving them incentive to become more knowledgeable
about markets and skilled in their investment selections.
Example
Alex, age 72, is interested in encouraging his 21-year-old
granddaughter to take a more active interest in investing. He
loans Sarah $500,000 in exchange for a Note that requires her
to pay interest at the 3.5% annual rate established by the IRS
and repay the principal at the end of the 5-year term. If Sarah’s
investments appreciate 7.5% annually, she will have $116,168
left after making the interest and principal payments on the
Note. Alex will have to recognize the annual interest payments as
income and Sarah will have to recognize any annual income from
the portfolio in excess of the annual interest payment.
6
ADVANCED WEALTH TRANSFER STRATEGIES
Intra-Family Loan
Alex
$500,000
Sarah
5-year Note with annual
interest payments of
$17,500 and principal
payment of $500,000 $500,000
at end of term
Donor pays tax on interest
income from Note.
Donee pays tax on
investment income in
excess of Note payments.
Annual
withdrawals
equal to
payments
on Note
Investment Portfolio
$116,168
after loan payments assuming
a 7.5% annual growth
These figures and illustration are based on an IRS mandated interest rate of
3.5%. The rate varies monthly. A higher IRS mandated rate on the note or a lower
return on investment portfolio would change the final value remaining in the
investment portfolio after repayment of the note.
Private annuities
Private annuities offer another potential way to transfer assets
without gift tax consequences. Assets are sold in exchange for
a private annuity—a promise to make periodic payments for the
remainder of the seller’s life. As long as the present value of the
expected annuity payments under IRS valuation tables equals
the fair market value of the assets, the transaction is free of
federal gift tax consequences. This enables the seller to remove
the assets, together with any subsequent appreciation on
them, from his or her taxable estate. The amount actually paid
depends on the length of time the seller lives.
Example
Edna is a 65 year-old widow with an actuarial life expectancy
of 19.5 years. Due to some recent significant health concerns,
Edna does not expect to live to the age of 85. With that in mind,
she decides to transfer $1,000,000 worth of securities to her
daughter, Melissa. In exchange for the securities, Melissa agrees
to pay Edna an annuity of $77,259 per year, representing the fair
market value of the shares calculated using the IRS mandated
interest rate of 3%.
Eight years later, Edna dies. Assuming that the securities have an
average annual return of 7.5%, and that Melissa paid the annuity
(a total of $618,072) from other assets, at the end of the eight
years, the shares owned by Melissa will be worth $1,783,478. As
for the transfer tax consequences, the transfer is free of both
federal gift and estate tax.
Private Annuity
Securities valued at
Edna
$1,000,000
Annuity with annual
payments of $77,259
Transfer Tax
Consequences
•No gift tax
•No estate tax
Melissa
7.5% growth
for eight years
Value of Shares
$1,783,478
(after payments to Edna)
These figures and illustration are based on discount rate of 3.0%. This rate, set by
the IRS, varies monthly. A higher or lower actual return (than the 7.5% illustrated)
would change the final value of the transaction to the donee but would not affect the
gift-tax consequences.
With a private annuity, the seller recognizes a gain on the sale
of the property. As a result, it may be advantageous to sell
securities that have a cost basis close to the current market value.
By selling the asset to a grantor trust, the seller may be able to
avoid recognition of a gain on the sale. Each year for income
tax purposes, the seller must also recognize the portion of the
annual payment that is not allocated to the gain on the sale or to
return of basis. However, the purchaser is not able to deduct the
corresponding amount as implied interest. Because the present
value of the annuity payments is higher when the IRS mandated
rate is low, the economic benefits of a private annuity are typically
more attractive when interest rates are low.
Summary
Although the $5.43 million federal gift and GST tax exemptions
provide an opportunity for many individuals to eliminate most
if not all of their potential estate tax liability, individuals with
larger taxable estates may find some of these more advanced
wealth transfer techniques useful in minimizing gift and estate
taxes. The interest rate sensitivity of many of these strategies,
combined with the current tax environment make it especially
advantageous to consider these strategies now, while interest
rates are low.
Choosing an appropriate strategy, however, depends on your
individual needs and goals as well as the nature of the assets
you may wish to transfer. Your Financial Advisor, along with an
experienced Trust Specialist, would be pleased to meet with
you, your attorney and other advisors to help assess the various
alternatives and discuss how they may benefit you, your family
and future generations.
If a trust is decided upon, your Financial Advisor and Trust
Specialist will introduce experienced trust professionals from
U.S. Trust.4 As one of the nation’s leading trust organizations,
U.S. Trust brings deep fiduciary knowledge as well as experience
managing a wide range of sophisticated trusts. Your team
of Merrill Lynch and U.S. Trust® professionals will work with
you and your tax and legal advisors from concept through
implementation.
ADVANCED WEALTH TRANSFER STRATEGIES
7
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The case studies are intended to illustrate trust products and services available through Merrill Lynch. They are not intended to serve
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They do not necessarily represent the experience of other clients, nor do they indicate future performance. Investment results may vary.
The strategies presented are not necessarily appropriate for every investor. Individual clients should review with their Financial Advisors
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Assuming a $90 million valuation and a 35% discount for lack of control, the trust is able to acquire non-voting shares that represent an 85.5% ownership stake in
the company. When the company is later sold for $120 million, the 85.5% interest held by the IDGT is sold for $102,564,103. After repaying the $45 million note,
the trust is left with $57,564,103.
1
Assumes that the remaining 14.5% stake is sold for $17,435,897. Roger receives a combined total of $62,435,897 from the sale of the stock and repayment of the
$45 million note.
2
The estate tax savings are based on the difference between the gift tax value of $1,270,700 and the estimated value of the property at the end of the QPRT,
$2,437,989.
3
U.S. Trust is a division of Bank of America, N.A.
4
Trust and fiduciary services are provided by U.S. Trust, a division of Bank of America, N.A., Member FDIC. Insurance products are offered through Merrill Lynch Life Agency Inc. (MLLA),
a licensed insurance agency. Bank of America, N.A., MLPF&S and MLLA are wholly owned subsidiaries of BofA Corp.
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