Planning for Tax-Efficient Wealth Transfer

Apr 6, 2022 | Insights

It’s sometimes referred to as the “Great Wealth Transfer”. As baby boomers turn 65, their attention turns more towards wealth transfer rather than accumulation. And how much has the baby boom generation accumulated? Estimates vary from as low as $15 trillion to as much as $68 trillion. Whatever the exact number is, it’s a lot of assets that could potentially be taxed unless they are transferred properly.

Perhaps the best-known way of transferring wealth tax-free is by giving money or assets to a qualified charitable organization. There’s no limit to the amount that can be given to a qualified charity. Cash contributions are deductible from adjusted gross income, while non-cash asset contributions are subject to certain deduction limits.

What do you do, though, if you want to transfer wealth to family members or friends down the road? There are strategies that require more time and paperwork than immediately gifting assets, but they can be a valuable tool if your desire is to transfer wealth as tax efficiently as possible. Let’s look at a few of the ways that you can retain an interest in assets while setting things up for those assets to be transferred with minimal tax ramifications.

Grantor Retained Annuity Trust (GRAT)

A grantor retained annuity trust (GRAT) is an irrevocable trust that pays a fixed annuity to the grantor for a defined term, then pays the remainder interest of the trust to a non-charitable beneficiary at the end of the term. The GRAT is funded with a transfer of property, and the annuity can be a stated dollar amount, fixed fraction, or a percent of the initial fair market value of the property.

So how exactly does a GRAT help transfer assets tax efficiently? There are two important factors to consider: the Section 7520 rate, and the expected investment rate of return. The Section 7520 rate is the rate used by the IRS to discount the value of remainders to present value. The expected investment rate of return is the return of the asset that is placed in the GRAT. Giving an example should help to clarify things.

Let’s say that you transfer $1 million to a 10-year GRAT, with the remainder (whatever is left at the end of the 10-year period) going to your daughter. If the Section 7520 rate is 1.2% and you receive annuity payments of $106,718, it would be considered a zero-value gift (since the expected remainder interest would have a value of $0 at the end of 10 years). Therefore, anything left at the end will transfer tax-free to your daughter. For example, if the assets grew by 10% annually, at the end of the term, $892,932 would be transferred with no tax consequences.

There are a couple of things to note with a GRAT. First, its main benefit is when it is funded with assets that appreciate faster than the Section 7520 rate. And second, it only successfully passes assets along if you survive to the end of the term. So, when creating a GRAT, you want to carefully consider what asset to put in and the time period for holding the asset.

Qualified Personal Residence Trust (QPRT)

A qualified personal residence trust (QPRT) is a special form of a grantor retained income trust (GRIT), which is similar to a GRAT. For a QPRT, you contribute a personal residence to a trust and instead of receiving the trust income, you receive use of the personal residence as the income component. At the end of the trust term, the residence passes to the remaindermen, and if you are still living, you may then lease (at fair market value) the property from the remaindermen and continue to use it as your personal residence.

The original transfer of the residence is treated as a gift to the extent that the fair market value of the residence exceeds the present value of the grantor’s retained interest. This is an excellent transfer device when the personal residence is appreciating at a high rate and there is an intent to keep the property in the family for the long-term. Through the use of the annual gift tax exclusion and lifetime estate tax exemption, you can “freeze” the value of your personal residence and transfer it at a discounted rate while paying no gift taxes on the transfer.

Family Limited Partnership (FLP)

In situations where the asset that you want to transfer is a business, a family limited partnership (FLP) might be an option. An FLP is a limited partnership created under state law with the primary purpose of transferring assets to younger generations using valuation discounts. To avoid IRS contestation of the FLP arrangement, the FLP should possess economic substance by having its own checking accounts, tax identification number, payroll, and should not allow family members to withdraw funds at will. There should be a reason for the creation of the partnership, and not just a means to pass along assets.

For a family limited partnership, highly appreciating property is transferred to a limited partnership in return for both 1% general and 99% limited partnership interests. Once the FLP is created, the owner of the general and limited partnership interests values the limited partnership interests. Because there are usually transfer restrictions on the limited partnership interests and the limited partners have little control of the management of the partnership, the limited partnership shares are usually valued at a 20%-40% discount. The grantor can then begin an annual gifting program using the discounts and the gift tax annual exclusion to transfer limited partnership interests to younger generation family members at reduced transfer costs.

How to Get Started

No matter what your stage in life, there are a number of ways to transfer your wealth tax-efficiently. Take the time to plan out your priorities, and once you’ve identified your goals, you can begin the steps to transfer your wealth in the most efficient way possible.

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About Chase Investment Counsel

Chase Investment Counsel is a family and employee-owned boutique wealth management firm that offers personalized investment services. Our clients include career professionals, those nearing or in retirement, and families experiencing financial transitions such as generational wealth transfer, widowhood, divorce, or sale of a business. Chase’s active, disciplined investment management team is focused on selecting individual stocks and bonds targeted to each investor’s specific financial goals and risk tolerance. Established in 1957 in Charlottesville, VA, Chase Investment Counsel manages more than $300 million in assets.