Build a More Tax-Efficient Trust with a Generational Asset Transfer

Michael J. Winn, Managing Director, First Republic Securities Company

August 25, 2016

High-net-worth individuals tend to use all the estate-planning tools at their disposal to ensure the bulk of their wealth is passed on to their heirs. But sometimes those tools aren’t enough to keep their assets from exposure to large estate taxes. After maximizing their lifetime gift exemption, some may still be passing on a potentially hefty estate-tax bill to their heirs.

To minimize a family’s estate tax burden, a General Asset Transfer (GAT) may be an option. This tool lets clients remove value from their estate while still retaining control of their assets and income. For those who face a looming estate tax despite having used all other planning options to their maximum advantage, this is a unique strategy that allows a client to transfer assets to their heirs free of gift taxes and potentially reduce future estate taxes.

The ideal clients for a GAT are high-net-worth individuals in their mid-70s and above (often sometimes referred to as “Generation 1”). The strategy involves placing life insurance on their middle-age children (Generation 2) or young grandchildren (Generation 3) that they themselves fund.

How it works

Generation 1 will fund a life insurance policy — with either a one-time premium or with premium payments spread out over three years — on the life of their child or children, Generation 2. The policy is owned in a trust set up by Generation 1 that’s separate from the estates of both parents and children. Generation 1 will have an interest in the policy’s cash value and death benefit equal to the loan amount, plus accrued interest. Essentially, Generation 1 is loaning money to the trust, and taking it back as a long-term note.

The note isn’t redeemable for either at least 30 years or the life expectancy of Generation 2, whichever is greater. The interest rate is fixed for 30 years at the applicable Federal rate. The policy is designed to provide the lowest possible death benefit and a high cash value; in most instances, the policy’s cash surrender value will exceed the premium paid by the third year after the policy was purchased.

Applying the tool

For illustrative purposes, let’s assume Generation 1 is an 80-year-old man living in California who has maximized his wealth transfer to his two daughters (Generation 2), used all of his lifetime exemptions and still has $30 million of assets left in his estate. That means his heirs could potentially be hit with a $12 million tax bill, eating up all the liquid assets in his estate.

Using the GAT strategy, $30 million of life insurance coverage would be placed on the lives of his daughters. The policies would be owned by a trust and Generation 1 would loan $10 million to the trust to pay the premium. That means Generation 1 has liability in his estate of $10 million, but additionally has an offsetting asset of the note receivable, also $10 million. For estate tax purposes, the liability is valued at its face amount but the note is subject to a Fair Market Value appraisal. If there’s a difference between those two values, there’s a potential estate tax savings.

Upon the death of Generation 1, all assets must be appraised. If the appraiser looks at the face value of the note and deems it worth only $5 million, there’s a 50 percent discount, and only $5 million is taxed instead of $10 million, meaning the daughters save $2 million in estate taxes.

The GAT strategy also works while Generation 1 is still living. If Generation 1 is still alive after three to five years, when the benefits of this strategy are realized, the assets can be transferred from the trust holding the promissory note to his two daughters, and the assets are free of estate and gift taxes.

An innovative strategy

GAT is a creative strategy that takes advantage of the “Fair Market Value” principles the IRS allows to lower the estate-tax burden. But it also provides another benefit: the added security of life insurance for younger generations. If this is something that might be of value to you and your family, consider taking the time to explore the GAT strategy in greater detail. 

The strategies mentioned in this article may often have tax and legal consequences; therefore, it is important to bear in mind that First Republic does not provide tax or legal advice. Investors' tax and legal affairs are their own responsibility and readers should consult their own attorneys or other tax advisors in order to understand the tax and legal consequences of any strategies mentioned in this document.

The information in this article is presented as is.

©First Republic Bank 2016