Overview

High net worth and income taxpayers find themselves in a world of hurt following tax reform at the end of 2012. The top marginal bracket for taxpayers with more than $400,000 (single and $450,000 married) increased to 39.6 percent. Taxpayers with adjusted gross income in excess of $250,000 will pick up an additional 3.8 percent on unearned income raising the top marginal bracket to 43.4 percent.

These same taxpayers will also be exposed to the phase out of personal exemptions and miscellaneous deductions. These phase outs effectively raise the marginal bracket by 1-2 percent. Taxpayers in the top marginal bracket will end up with a top federal bracket of 45.4 percent. High income states such as New York and California add an additional 8-10 percent bringing taxpayers to a combined marginal tax bracket of 53-56 percent.

While the federal estate tax exemption did not fall to $1 million, the federal estate tax is alive and well with an increase in the top rate to forty percent. The income taxation of trusts adds additional pain to the taxpayer with investment  income during the settlor’s lifetime  taxed to the settlor and  at the death of the settlor when the trust loses its grantor trust status, a trust reaches the top marginal tax bracket with only $11,950 of income.

This article focuses on the Intra-Family Loan,  an tax and estate planning technique that is not well known and even less frequently implemented. The common notion of the Intra – Family Loan is the lending of cash by the senior generation to a junior generation. As a practical matter assets other than cash can be the focus on an Intra – Family Loan. How many times did you borrow something other than cash from a brother or sister (with or without interest depending upon whether or not it was a big brother or sister.

Intra-Family Loans

The typical intra-family loan is a cash loan between family members. Usually the loan is between the senior generation as lender to a junior generation as the borrower. The loan arrangement is captured in a promissory note with or without security for the loan.

In order to avoid the tax rules for below market interest rate loans under IRC Sec 7872, the minimum interest rate for the loan must be equal to or greater than  the applicable federal  rate based upon the length of the loan. The current AFR for short term; mid-term and long term loans for March 2013 is as follows:

                        Term                          Time Period                                  Rate

                        Short Term              3 years or less                                .22%

                        Mid-Term                Less than 9yrs (greater than3)      1.09%

                        Long Term               More than 9 yrs                             2.63%

The low interest rate environment makes the Intra Family Loan an ideal estate planning strategy.

The traditional advanced estate planning technique of a “ Sale to an Intentionally Defective Trust”  is related to the Intra-Family Loan. The strategy is a highly effective estate freeze technique. The technique typically involves the down payment of an asset by the trustee of an irrevocable family trust and purchase of a capital asset on an installment basis.

The interest rate on the installment note is equal to at least the AFR. The sale is not taxable to the grantor because of the application of the grantor trust rules. Additionally, the interest payments under the installment note are non-taxable.

The Intra-family loan may be a more accessible technique to certain types of asset classes than the sale to a grantor trust. Certainly, it could be used to finance the purchase of a family start up business or to finance the purchase of a home by a child. Why couldn’t a high net worth taxpayer make a loan of an “in kind asset” such as land or an art portfolio.

The Intra Family Loan could provide for the capitalization of the interest and principal that can be repaid at death. The purchase of life insurance might be considered as a mechanism to provide the liquidity for repayment upon the death of either the lender or borrower..

The potential leverage between historically low AFRs and the rate of return of an asset or portfolio makes the Intra Family Loan a simple and straight-forward estate freeze technique.

The technique is further enhanced when private placement insurance products are thrown into the planning mix.

Strategy Example #1

Facts

John Smith, age 60, is a high net worth investor. His portfolio has generated an 8 percent annual return over the last ten years. He has $10 million invested in hedge fund strategies and would like to maximize the tax advantage of his investments for both income and estate tax purposes. He is an a combined marginal tax bracket of 50 percent (39.6 Fed+3.8% Medicare +7% state). John and his wife utilized both of their estate tax exemptions in 2012.

Strategy

John makes a loan to his Family Trust. The terms of the loan provide for a loan of $5 million at the long term AFR for March 2013 – 2.63%. The loan is a 29 year loan that provides for the capitalization of interest and principal, i.e. any accumulated interest and principal will be paid at the end of the loan term. The loan will be an unsecured loan.

Additionally, the loan has a self-canceling feature. The self-canceling feature adds an additional risk premium of $4.85 million that will be added to the principal at the time of repayment at death or repayment. Additionally, the accumulated interest due at repayment in Year 29 is  $11.2.  million. The total repayment is $26.05 in Year 29.

The trustee of the Family Trust purchases a single premium PPLI contract insuring John’s life. The initial premium is $10 million and the initial death benefit is $35 million. The policy is a MEC. In Year 29, the projected cash value assuming a net return of 8 percent within the policy is $71.5 million. The projected death benefit is $73 million which will be paid to the Trust income and estate tax free to the family trust.

In the event of death before the repayment of the Note in Year 28, the accumulated interest ($11.2 million) is treated as income to John’s estate for its final income tax return. Any unrecovered principal amount and risk premium are taxed to the estate on a capital gain basis.

The interest taxed at ordinary rates (39.6 percent  plus 7 percent state) creates a tax liability of $5.2 million. The taxation of the unrecovered principal amount and premium  is 27 percent rate (20 percent  federal and 7 percent state) creating a tax liability of $4 million. The combined income tax liability is $9.2 million.

The Intra Family Loan leveraged with PPLI has resulted in an income and estate tax free payment of $73 million in Year 30. The leverage in the Intra Family Loan combined with private placement life insurance has created an investment windfall of nearly $65 million over the loan period.

The loan without the benefit of a benefit of PPLI would have accumulated $93 million. The difference is the income tax payments at 46% made by the settlor over the same time period. The tax drain to John and the family in income tax payments due too the grantor trust rules  is substantial over a 29 year period.

The projected tax payments invested at the same investment rate of 8 percent would accumulate to $35-40 million over the same time period. The use of PPLI at a cost of approximately one percent of the investment return provides this level of tax savings for the family over the life of the loan.

Summary

The Intra Family Loan is a technique that receives little attention. In general, it is less complicated than many other advanced estate planning technique. What is not complicated is the idea that if you can borrow money at the long term AFR and earn an investment rate of return on a tax-advantaged bas in excess of the long term AFR, outside of the taxpayer’s estate, the taxpayer wins by a landslide.

The historically low interest rates in the current environment provide unprecedented opportunities to generate and conserve wealth. Combined with the tax-advantaged treatment of life insurance, the Intra-Family Loan is an opportunity to turbo charge the return for both income and estate tax purposes.

1. Taxation of Grantor Trusts

The tax rules for grantor trusts are found in IRC Sec 671-679. Grantor trusts have been a mainstay of advanced tax and estate planning for the last 15-20 years using a number of advanced techniques. Advanced planning has focused on the combination of the use of tax valuation planning techniques such as family limited partnerships and family limited liability companies (LLC) with the sale of those limited partnership or LLC interest to a grantor trust.

Under the grantor trust rules, the trust settlor is considered the owner of trust assets for income tax purposes. As a result, all trust income and losses flow through the trust to the settlor. The trustee is able to accumulated assets without any depletion for income tax purposes. The grantor or settlor’s payment of the income tax liability is not considered an additional gift to the trust.  At the same time, the trust assets are outside of the settlor’s taxable estate.

The sale to a grantor trust is an outstanding estate freezing technique. In the typical sale to a grantor trust, the taxpayer sells capital assets to the grantor trust. The sale results in no gain to the Seller. The Seller is the settlor of the trust. The sale is usually made on an installment basis with the interest rate on the note set at the long term applicable rate. Interest rates have been at historically low rates for the last 5-7 years.. In the event the trust, sells the underlying asset, the taxable gain is reportable to the settlor and paid by the settlor. The settlor’s estate is reduced by the amount of the tax liability. The trust corpus has not been eroded.

Virtually any estate planner on the Planet would agree that the tax results associated with the sale to an intentionally defective trust aka grantor trust, are outstanding. The author agrees with everyone else. However, the author believes that the tax results are greatly enhanced even more if the grantor does not have to reduce his taxable estate by the amount of the annual income tax.

The likelihood of increased marginal tax rates at both the federal and state level along with an increase in the capital gains tax make the benefits of tax-advantaged compounding even more compelling.

2. Taxation of Non-Grantor Trusts

Trusts that are not taxed as grantor trusts are taxed as separate taxable entities. In general, marital trusts and most testamentary trusts are non-grantor trusts. Most asset protection trusts are also non-grantor trusts for income tax purposes. Unfortunately, it takes very little investment income to push a non-grantor trust into the top marginal tax bracket- $11, 200.

Many wealthy families have generation skipping trusts that are taxed as non-grantor trusts. A non-grantor trust is a trust that does not fall within any of the provisions of IRC Sec 671-679. The necessary trust provisions in order to classify a trust as a NGT is retention of a power by the settlor to name new trust beneficiaries or to change the interest of trust beneficiaries except as limited by a special power of appointment (ascertainable standard). The settlor’s transfer to a trust with this power renders the transfer an incomplete gift for gift tax purposes. The second method to avoid grantor trust treatment is to require the consent of an adverse party on any trust distributions.

The major focus of this article is tax-advantaged wealth accumulation across multiple generations. Many wealthy families and family offices have multi-generational planning as a component of their tax planning. It makes a lot of sense to reduce the “drag” of income taxation along with the avoidance of future estate and generation skipping transfer taxation.