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Financial and tax options for individuals in an economic downturn

May 07, 2020

Frank Graziano - Personal Financial Services Leader, PwC US - Email
Don Delf - Private Wealth Advisory Leader, PwC US - Email

As the US government continues to take action to curb the effects the COVID-19 crisis is having on the economy, the Coronavirus Aid, Relief and Economic Security (CARES) Act presents many considerations for high-net-worth individuals, families, trusts and family offices.

Low-interest-rate environment

When the Federal Reserve made two emergency rate cuts in March, the low interest rate was designed to stimulate the economy by making it easier for individuals and businesses to borrow money.

Refinance or borrow
Consider renegotiating or replacing higher-interest-rate loans or new borrowing, even for investing purposes. Just be aware of the interest tracing rules, so you can maximize deductible interest for the debt used in business or investing purposes.

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Family member loans
Leverage intra-entity and intra-family loans to help enhance wealth transfer planning, which is designed to reduce tax and free up cash flow. Each month, the federal government releases a list of interest rates that may be used for various transactions, and the current rates are at historic lows.

Fund trusts
Various trusts can be leveraged in a low-interest-rate environment.

  • Grantor Retained Annuity Trusts (GRATs) are used to transfer into a trust for future generations the asset appreciation that’s in excess of a government safe harbor rate. They also retain an annuity stream for a period of years that’s based on the fair market value of assets. If the value of assets transferred to a GRAT grows in excess of today’s depressed value, the excess appreciation will go to the beneficiary(ies) or a trust for their benefit.
  • Charitable Lead Annuity Trusts (CLATs) can be used to leverage a gift into annual transfers to a charity, with minimal transfer-tax implications. At the end of a client-specified term, the value of CLAT assets are shifted to client-named beneficiaries — usually downstream heirs.
  • Intentionally Defective Grantor Trusts (IDGTs): The use of IDGTs, also known as intentionally defective irrevocable trusts (IDITs), are wealth-transfer planning tools most commonly funded by gifts. The grantor makes an irrevocable, completed gift of the desired assets to the trust. Gifting appreciating assets reaps the most benefit because the income can be retained by the trust and passed to the beneficiaries. The grantor may avoid additional transfer taxes on the asset, even if there is a significant increase in value. While this is powerful, it is important to tailor a bespoke trust design and the complementary transactions to feed and manage the trust.

Tax possibilities

There are numerous potential tax considerations in the current environment.

Swap depressed assets
Evaluate whether to swap depressed assets into or out of GRATs and other irrevocable grantor trusts in exchange for other assets. Doing so may transfer more wealth outside the transfer tax system and may also improve the cash flow of the grantor and/or the trust. Swapping high-basis assets of the grantor for low- or negative-basis) assets of an irrevocable grantor trust that includes a swap power (the power to reacquire assets) could produce significant capital gain tax savings in the event of a future sale of the swapped assets. And, depending on the legal location of the trust with which assets are swapped, event timing and other trust term factors, the state-level capital gain tax may also be reduced or eliminated.

Modeling the effect of swapping assets can identify the most effective combination of assets to swap. Depressed value assets that are swapped back to the grantor may be a good candidate for contribution to newly created GRATs (for the benefit of the next generation) or gifts to further downstream heirs or trusts for their benefit.

While fraught with assumptions, consideration should be given to contributing derivatives to help create economic leverage that’s designed to shift higher amounts of upside growth of currently depressed asset values.

Transfer Tax Exclusions
There are multiple ways to make gifts that are exempt from gift taxes. One such method is the Basic Exclusion Amount for lifetime gifts, estate and generation-skipping transfers. The amount is currently $11.58 million per donor, but it will sunset back to the 2011 exemption amount of $5 million plus inflation, which will approximate $5.5 million at the end of 2025. At this time, individuals can take advantage of the increased estate and gift tax lifetime exemption, assuming there are no intervening legislative changes.

Transferring assets from one generation to another
In some instances, when a senior-generation family member pays gift taxes now, the family at large may benefit. Transferring reduced-value assets to another individual or trust may result in an immediate tax on the current value. Post-transfer growth in those assets can potentially escape estate, gift and generation-skipping transfer taxes. Remember that even though the tax rate on a transfer at death (estate tax) and the tax rate on a lifetime transfer (gift tax) are the same 40% rate, the manner in which the tax is calculated is different. This difference may result in a better economic result for lifetime gifts.

Also, taxable gifts made within three years of death are brought back into the estate, but the appreciation from the date of the gift will escape an additional transfer tax. This is why gifting depressed value assets may be attractive, even for the elderly. Ultra-high-net-worth taxpayers should consider making transfers in trust rather than outright to individuals. Under current law, doing so may enable them to remove assets from the transfer tax system in perpetuity.

Roth IRA conversions
Many retirement accounts have declined in value due to the current economic downturn. When you convert your traditional IRA to a Roth IRA, you have to pay income tax on the value of the converted assets immediately, but you do not have to pay income tax on the money you withdraw later during retirement. Since asset values have declined in the current market, your tax cost could be greatly reduced if you pay the tax now versus later.

Life insurance
A downturn in the economy may cause eventual policy lapses. Life insurance policies are highly dependent on contract assumptions related to projected investment performance and mortality costs necessary to confirm the expected death benefit will pay off. An analysis related to the economics of each policy, the manner in which it is owned and the manner in which it is funded often reveals that a policy may not pay off at death or may severely underperform.

This is a good time to discuss both actual contract performance, by reviewing in-force illustrations, and the projection of future performance with realistic economic assumptions to confirm your policy is set up in the most advantageous way. It’s also a good time to determine if your method of funding considers gift planning and is owned to confirm that death proceeds are not included in your taxable estate.

PwC is continuing to monitor the latest information about the impacts from COVID-19 and is helping privately held businesses and individuals understand how they specifically are being affected.

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