Although taxes may be inevitable, the person or entity paying the tax can take actions to reduce the overall amount of estate taxes eventually paid. The notion of “tax burning” – the payment of income tax by an older, wealthier person in order to reduce his or her taxable estate – can be an effective estate planning tool under certain circumstances.
Consider the following illustration: Mr. and Mrs. Smith are in their late 80’s; they own a sizeable farm and have $1,000,000 in cash and other assets. They originally purchased the farm 50 years ago for $200,000. Suburban sprawl has resulted in the farm being a prime target for real estate developers, and its market value is now approximately $7,000,000. If Mr. and Mrs. Smith sell the farm, the capital gain and Illinois income tax (a combined 18%) would be approximately $1,225,000. Without any other tax planning, the estate tax on their remaining cash after the sale of the farm will be approximately $750,000. The clients desire to reduce as much as possible the effect of capital gain and estate taxes. The clients have a modest lifestyle.
With the advice of their attorneys and tax accountants, the clients implement the following plan: They first create an irrevocable grantor trust (the “Trust”) naming their children as beneficiaries, and then transfer $400,000 to the Trust. Next, they establish a limited liability company (“LLC”) and transfer the farmland (excluding their home) to the LLC. The value of the LLC interests is reduced by 40% for lack of marketability and lack of control and, thus, has an appraised value of $4,200,000. The clients then sell their LLC interests to the Trust for $4,200,000; the purchase price is represented by an interest-only demand note payable from the Trust to the clients.
The Trust now is the owner of the LLC interests. When the farm is sold to a developer for $7,000,000, the clients are required by the grantor trust rules to pay the $1,225,000 capital gain tax on the sale of the farm. The clients then make demand on the Trust for payment of the $4,200,000 note. After paying the capital gain tax, the clients invest the balance of $2,975,000 in income producing securities which will provide them sufficient income to maintain their modest lifestyle. Because the clients’ gross estate is now only $3,800,000, there will be no estate taxes due upon their deaths because each of them is entitled to a $2,000,000 estate tax exclusion. The assets in the Trust, consisting of the $400,000 initial cash contribution and the $2,800,000 balance of the proceeds from the sale of the farm after payment of the demand note – a total of $3,200,000 – will remain in the Trust for the benefit of the clients’ children and will escape inclusion in the clients’ taxable estates upon their deaths.
In this illustration, by implementing a grantor trust and paying the capital gain tax themselves, the clients were able to reduce their gross estate to an amount less than their combined estate tax exclusions ($4,000,000 total), so that no estate tax will be due upon their deaths. This strategy received an implicit validation when a recent private letter ruling from the IRS confirmed that the payment of the capital gain tax by the parents is not a gift to the beneficiaries of the grantor trust.
If you have any questions regarding the use of tax burning strategies in your estate plan, please do not hesitate to telephone us.