Estate tax planning structures that have performed well for years might need to be unwound to generate fast cash as wealthy taxpayers grapple with the economic effects of the coronavirus, practitioners say.
“These days, given the COVID-19 crisis and all that’s going on, cash is king,” David Scott Sloan of Holland & Knight LLP said on an April 23 webinar sponsored by the American Bar Association Section of Real Property, Trust, and Estate Law. “Values are down in the marketplace across the board. People may be looking at their estate plan and thinking, ‘You know, this was a great idea, but right now, I want to keep what I have.’”
Sloan noted that one of his clients had that issue recently. The client wasn’t facing an imminent issue or a sale that would trigger a taxable gain; rather, based on their own financial forecast and some breathing room when it came to the estate and gift tax exemption, the client decided that the planning was no longer necessary and that boosting cash flow was preferable, he said.
Some clients have had other reasons for expressing interest in unwinding their prior estate tax planning involving grantor trusts, Sloan continued. They might have seen their planning structure, like an intentionally defective grantor trust, experience a surprising increase in value, and now they’re facing a realization event that is so big that the capital gains taxes they’ll have to pay are much higher than anticipated, and the donor doesn’t want to have to pay those taxes, he explained.
Those clients are victims of “the law of unintended consequences,” according to Sloan, in which the planning structure performed too well — to the point that the grantor must sell some of their own stock just to pay the trust’s capital gains tax bill.
In that situation, the client will want to release the trust powers that make it a grantor to turn it into a non-grantor trust, but it’s also important to first consider what kinds of assets are in the trust, Sloan said.
“If real estate is involved in the trust and there’s negative basis, you have an income tax problem,” Sloan said, explaining that there will be income tax liability recognized once the grantor trust powers are released. “We see this with a lot of our clients that are involved in real estate that might have commercial real estate out there,” he said.
Charitable Planning
Estate planners’ clients might also be looking at early terminations of charitable remainder trusts (CRTs).
Emily A. Plocki of Venable LLP explained that a client could decide that he no longer needs the income stream he had been receiving as the income beneficiary of a trust. Or the charity could have an immediate need for the funds and be unable to afford to wait until the end of the trust’s term or the death of the income beneficiary, which “really might be a relevant point right now during the current pandemic,” she said.
Similarly, the trust’s income beneficiary might have an immediate need for a lump sum share of the trust assets rather than the ability or desire to wait for a stream of payments spread out over years, Plocki said.
Taxpayers have a few options when it comes to unwinding a CRT, Plocki continued. For example, the income beneficiary can assign their income interest to the charity that is the remainder beneficiary. That would be deemed a gift of a capital asset and entitle the income beneficiary to an income tax deduction and gift tax charitable deduction, she said.
A client might be interested in that option if the CRT’s value has significantly declined, so that continued payments by the trust to the income beneficiary would exhaust the trust and leave nothing for charity, Plocki noted.
Plocki added that the income beneficiary and the charity can jointly agree to terminate the CRT and divide the trust assets pro rata based on the value of their actuarial interests in the trust, which would be treated by the IRS as a sale of a capital asset by the income beneficiary to the charity.
Another option would be for the income beneficiary to sell their income interest in the CRT to a third party, Plocki said. In that case, the trust doesn’t terminate; rather, the income stream is directed to the purchaser of the interest, she said, although she added that it’s important to ensure that the sale is to an unrelated third party in a bona fide arm’s-length transaction.
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