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HAVING YOUR CAKE AND EATING IT TOO

A number of our clients have asked us about making gifts to family members in order to avoid Federal Estate Tax upon the second death.

Currently each spouse can give away either during lifetime or at death, or some combination, $11,580,000 without Gift Tax or Estate Tax. This is known as the Exemption.  The fear is that the Exemption will likely be significantly reduced under the Biden Administration, perhaps to $3,500,000.  In any event, the Exemption is scheduled to be reduced in half under current law on January 1, 2026.

The Federal Estate tax is currently a flat 40%. Biden want to increase the rate, probably to 45%.

An underutilized technique to reduce Estate Tax is the Self-Cancelling Installment Note or “SCIN”.  Here, a couple sell assets to an irrevocable trust for the benefit of their child.  The couple has chosen to sell $900,000 of their assets plus make a gift of $100,000 in cash.  The trust now has $1,000,000 in assets with a $900,000 debt.  The note provides for principal and interest amortization over their joint life expectancy, which is 20 years.  The interest rate can be as low as 0.60% per year to pass IRS muster.  If nothing else, any income earned by the trust above 0.60% inures to the benefit of the child, free of Estate Tax.

However, at death of the second spouse, the unpaid principal and accrued interest of the note is includible for Estate Tax purposes.  The value of the note can be reduced to zero by adding a self-cancelling feature.  This provides that at death of the second spouse, the note is forgiven.  In order for this feature not to be treated as a gift, the note must have an actuarially determined increase in interest rate or an actuarially determined increase in principal. The significance is the value of the note at the second death is zero for Federal Estate Tax purposes as no future payments are due the couple or their estates.

In our example, where a $900,000 sale is made, assume the couple are both age 70.  By increasing the interest rate from 0.60% to 2.399% or by increasing the original principal obligation from $900,000 to $1,074,669, the note is forgiven at the death of the second spouse. The note avoids Estate Tax.  Time to have your cake.

It gets better. The Trust is designed to be a “grantor trust.”  This means the couple is treated as the owner of the trust.  This has two benefits.  One, for Federal Income Tax purposes, you cannot sell assets to yourself.  The effect is that the sale of the $900,000 of assets to the trust is free of Federal Income Tax regardless of the basis of the assets.  Two, the couple and not the trust or the child, will be subject to Federal Income Tax on the taxable income of the trust.  Thus the monies in the trust accumulate tax free for the child and the couple reduces their wealth without using their Estate and Gift Tax exemption.  Time to eat cake.

 

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