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Oxford Financial Group, LTD


Oxford Financial Group, LTD


Expert Perspective

News, research and market insights from our team of experts.


Current Issue | December 20, 2018

The Tax Burn Strategy – A Unique “Tax-Free” Gifting Option (Relevant Under Current Tax Law)

By: Julia S. Weaver, J.D., Director, Family Office Services & The Trust Company of Oxford

The Gift of... Taxes?
Many taxpayers do not realize that gifts are, generally, taxable. As with all transfers of wealth (with very few exceptions) the IRS imposes a tax on gifts, not to the recipient but to the donor (a/k/a "grantors") of the gift. In fact, an entire Section of our Internal Revenue Code is dedicated to the taxation of gifts.

Many financial advisors, attorneys and CPAs dedicate their professional lives to helping clients with the most tax-efficient transfers of wealth to future generations. We are assured by Judge Learned Hand, in his often cited words:

"Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one's taxes... for nobody owes any public duty to pay more than the law demands." Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff'd, 293 U.S. 465 (1935)

As such, when a strategy enables our clients to largely avoid taxation on transfers of wealth, this generates much excitement in the world of tax mitigation. Such an opportunity is the subject of this article.

A Prologue to the “Tax-Burn” Strategy: Lifetime Exemption, Annual Exclusion and “Med-Ed” Gifting
Gifting of assets to future generations is a key planning technique to minimize the gross estate for federal estate tax purposes. These strategies are most impactful when there is current or anticipated exposure to this tax.

The Lifetime Federal Estate and Gift Tax Exemption
For 2016, a “taxable gross estate” is one in excess of $5.45 million per person, or $10.9 million per married couple. These amounts comprise the lifetime exemption under current law, above which transfers of wealth (including gifts) will be taxed at the rate of 40%i. It is worth mentioning that exemptions and tax rates are, and will likely remain, constantly moving targets and ongoing fodder for political debate.

As levels of wealth change throughout our lifecycles, appreciating in high earning years and commonly declining throughout retirement, a wealth accumulation analysis provides needed data in advance of any estate planning technique. However, once there is current or anticipated federal estate tax exposure, “gifting” is typically one of the first strategies to consider.

The Annual Gift Tax Exclusion (and Med-Ed Exemption)
Other than (1) the lifetime gift tax exemption, as discussed above, and (2) gifts to a spouse which are generally covered by the marital deduction (provided he or she is a U.S. citizen), there are only a few other types of gifts that are excluded from taxation.

First, there is a $14,000 annual gift tax exclusion allowed per donee. Couples can combine their annual exclusions to double this amount, meaning they can give $28,000 per donee per year to anyone. Even if only one spouse technically makes the gift, as long as both spouses consent, it is considered by the IRS to have come from bothii.

While annual exclusion gifting can enhance a family’s gifting impact, the dollar limitations are restrictive for many high net worth families. Additionally, the annual gift tax exclusion is a “use it or lose it” exclusion, with no carry over to future years. Any annual gifts in excess of the allowable exclusion amounts will apply against the lifetime $5.45 million exemption, which is not the desired result in many instancesiii.

The “med-ed” exclusion is one of the other very limited gift tax exclusions. This provides that tuition and certain medical expenses, when paid directly to the educational organization or health care provider, receive an exclusion against gift tax. While popular, this narrow exemption is also limiting as far as its impact on the amount of wealth that can be shifted to heirs free of gift taxation.

"Tax-Free" Gifting Turbocharged: The Tax-Burn
Another significant opportunity exists to gift wealth to heirs free of gift or transfer tax, referred to as the "tax-burn" strategy. This opportunity arises in conjunction with the estate planning technique referred as an Intentionally Defective Grantor Trust (“IDGT”, pronounced "idget"). By selling assets to such a trust in return for a note, future appreciation in the assets occurs outside of the grantor's taxable estate, while the non-appreciating note remains in the grantor's estate.

The IDGT essentially capitalizes upon the disparities between our two different tax codes: the income tax code and the estate and gift tax code. Such a trust is typically drafted to hold assets until the grantor's death and is irrevocable for transfer tax purposes (thereby avoiding estate taxation), but is "defective" for income tax purposes (i.e., as a "Grantor" trust). As such, the grantor and the IDGT remain "one-in-the-same" for income tax purposes and no capital gain is triggered upon the "sale" of assets to the IDGT.

A sale of assets to an IDGT is commonly referred to as a SIDGT, and the "hurdle rate" (as required by the IRS) is the Applicable Federal Rate (AFR) that must be charged on the note back to the grantor. All asset appreciation in excess of the hurdle rate grows outside of the taxable estate as “remainder interest” in the IDGT for the benefit of grantor's heirs.

The "tax-burn" advantage of a grantor trust is that the grantor pays taxes on the trust's income. As such, trust assets are not depleted by tax payments, rather the grantor's taxable estate is depleted, commonly referred to as a "tax-burn" (or "burning away" the taxable gross estate).

Many families receive this information with a bit of pause….often asking "WHY would I want to pay the tax on income I am not receiving?" The answer… payment of trust taxes is the equivalent of a tax-free gift to the trust and this wealth will ultimately pass to the benefit of your heirs. This gift of taxes is limited only by the amount of tax due on the trust's income and the transfer of wealth as a result of the tax-burn can be significant.

The Tax-Exhaustion Phenomenon and a (Very) Limited Respite
Grantor trusts may include a provision enabling the trustee to reimburse the grantor for this tax obligation, albeit under limited circumstances. In Revenue Ruling 2004–64, the IRS ruled that such tax payments by the grantor were not considered taxable gifts. The service also considered the ability of such trusts to reimburse grantors for this tax obligation and set forth certain cautions in this regard. Essentially, the IRS allows such reimbursements for taxes provided the trust instrument gives the trustee discretion, and not a mandate, for such reimbursements. Commentators have inferred from this Ruling that these reimbursements should be reserved for more aberrant situations, for example when the grantor needs cash flow relief or in a year with a particularly high tax obligation.

Some commentators also caution against creating any "implied agreement" which could indicate a plan to consistently and methodically reimburse the grantor for such tax costs, finding this would be deemed a retained interest in the trust. The result of such a negative finding could potentially be to include the entire trust in the grantor's taxable gross estate, a most undesirable result.

Another potential relief for "tax-exhaustion" is the ability to toggle-off grantor trust status, whereupon the trust ceases to be one-in-the-same with the grantor for income tax purposes. The compressed tax rates would then apply to the now non-grantor trust. However, this is available to give relief to a taxpayer who finds the cash flow demand of such tax payments outweighs the tax-burn advantage.

A Summary of Key Considerations and the Optimal Candidates for this Strategy
The following is a summary of key considerations and taxpayer attributes that are most advantage for this planning strategy:

  • You have significant federal estate tax exposure and wish to reduce your taxable estate through strategic tax-free gifting.
  • You want to maximize the remainder interest passing to your heirs.
  • You want assets and income held in a trust to have compounded, tax-free growth.
  • You are in a superior position to pay tax compared to your heirs and beneficiaries.
  • You have highly appreciated assets you wish to pass to your heirs without using a large portion of your lifetime exemption (hence favoring a sale transaction) and without triggering capital gain recognition.
  • You wish to reduce your family's overall tax obligation by utilizing your individual tax rates rather than compressed trust tax rates.
  • You have sufficient surplus cash flow to absorb the added expense of such tax payments.

A Team Approach
Low interest rates and highly favorable tax laws combine to make this an excellent time to consider these types of estate planning strategies. Together with your entire team of estate planning attorneys and CPAs, your Oxford advisors stand ready to further discuss the pros and cons of this unique "tax-free" gifting option, as well as other strategies for the most tax-efficient transfer of your wealth and legacy to future generations.

i Note, a gift tax return is required to be filed on any gifts that utilize a portion of this lifetime exemption.
ii Note, "gift splitting", unlike individual gifts, does require the filing of a gift tax return.
iii Also noteworthy, only "present interest" gifts are eligible for this annual exclusion. Gifts of a remainder or restricted interest (as is common with gifts to trust) will not qualify for the exclusion.

The above commentary represents the opinion of the authors as of 12.15.16 and is subject to change at any time due to market or economic conditions or other factors. This information is not intended to serve as tax or legal advice. As always, tax and legal counsel should be engaged before taking any action.