ELITE ADVISOR BEST PRACTICES

Freeze, Arbitrage and Discounts - Part One

Understanding these three powerful tools is no passing FAD and can give you a competitive edge (first in a series)

By Richard L. Harris

Key Takeaways:

  • Freeze: Locking in a value for an asset today and having the future growth occur outside the estate.
  • Arbitrage: The difference between the rate of return of an asset and the interest rate used in calculating the cost of transfer.
  • Discounts: By transferring an interest in an existing or newly created entity that has restrictions on ownership rights, the value of the interest can be discounted compared with the value of the interests with unrestricted ownership rights.


In order to understand when and how life insurance fits into an estate plan, knowing what the attorney can do is very useful. When an estate planner goes into his or her tool kit, the devices have three common characteristics:

  1. They freeze the value of the asset so that future growth occurs outside the estate.
  2. They use arbitrage to transfer a property using an interest factor that is lower than the rate of return of the asset.
  3. They transfer an interest in an entity or property at a value lower than calculating the fraction transferred and multiplying it by the full price of the asset.

Often more than one of these devices are used at the same time.

Freeze

Using this technique, when an asset is transferred, the value of the transferred asset at the time of the transfer is in the individual’s estate. Any change in value of the asset after the transfer happens in the hands of the recipient, not of the original owner.

Example
Dad owns a business that is a Sub S corporation. The corporation is doing very well, and he wants to give stock worth $1 million to a trust. Dad files a Form 709 Gift Tax Return reporting the transaction to the IRS. The gift uses up $1 million of Dad’s unified credit. Dad dies. The Sub S shares in the trust are worth $2 million. When the executor prepares a Form 706 Estate Tax Return, he reports that $1 million of unified credit had been used for a gift. That $1 million is figured in when calculating the remaining credit available.

What has happened? When Dad made that gift, the value that would be used to calculate Dad’s estate when he died was $1 million. Since the value of the gift is the receivable in Dad’s estate and not the value of the stock, the $1 million increase in the value of the stock value is out of Dad’s estate. The value in Dad’s estate was frozen and could never change.

Arbitrage

Arbitrage occurs when someone can borrow at a lower rate and invest at a higher rate. When making loans between family members, the IRS makes the rules. Section 7872 of the Internal Revenue Code is used to determine whether there is a gift involved based on the loan interest rate used. When loans are made, the IRS has monthly tables determining what the minimum interest rate needs to be on the loan to prevent it from being classified as a gift.

There are four rates established every month, each dependent on the length of term of the loan. These rates are called applicable federal rates (AFRs). The rate for demand loans is the average of the January and July short-term rates. The short-term rate is based on a loan for a period of three years or less. In January 2013, that rate was 0.21 percent. For terms of three to nine years, a midterm rate is used. In January 2013 that was 0.87 percent. For terms longer than nine years, the long-term rate is used. In January 2013 that was 2.31 percent. If interest is charged at a lower rate or is forgiven, the difference between the rate actually charged and the rate appropriate for the term of the loan is considered a gift.

Example
Dad (aka Pops) loans $1 million to daughter (Juniorette). Juniorette uses the cash to invest in an asset. The asset is expected to return 6.5 percent annually over nine years. The loan term is nine years, and, therefore, the interest has to be at least equal to the midterm AFR. The loan interest rate is 0.87 percent, payable annually. At the end of the term when the loan is repaid, she gets to keep the earnings of the investment less the loan interest paid. Assuming that the 6.5 percent earnings rate is met, Juniorette pays $8,700 in interest each year and has $660,503 to keep at the end of the nine years.

What has happened? We have frozen the value of the $1 million in Pop’s estate at $1 million plus simple interest at 0.87 percent annually. The arbitrage between the interest paid and the return earned moved $660,503 to Juniorette and out of Pop’s estate.

Discount

This technique allows someone to transfer an asset to someone else and have the value of the asset that is used for gift or estate tax purposes be less than the value would be if the same interest were part of the whole. For example, a business is worth $10 million. A 10 percent interest is transferred. Because of reasons that follow, an appraiser values that 10 percent interest at $600,000 rather than $1 million.

If an interest in a business has any or all of the following terms—the interest is nonvoting, the interest is a minority with respect to the whole and/or there is a restriction on to whom the interest can be sold—the value to the recipient is less than what that interest represents as a percent of the whole. When valuing an asset, the standard for value is what a willing buyer would pay to a willing seller, with neither buyer nor seller under any compulsion to enter the transaction. When an outside independent appraisal firm puts a value on that restricted interest, that is what they look at.

Example
Mr. Big owns 100 percent of the Big S Corporation. The value of the company is $30 million. He plows a lot of the after-tax earnings back into the business. He is doing estate planning and would like to reduce the taxes that will have to be paid when he dies. Mr. Big’s advisor tells him that he can give away or sell some of the company without giving up control. The advisor also tells him that if structured properly, the value of the company stock transferred will be discounted. Mr. Big wants to give his son, Not Quite So Big (aka Junior), a 10 percent interest in the company.

Since he wants to retain control, Mr. Big creates nonvoting stock. Before the nonvoting stock was issued, Mr. Big owned 100 shares of voting stock. Now he has 100 shares of voting and 100 shares of nonvoting stock. He gives Junior 20 shares of nonvoting stock, which equals 10 percent of the company.

An appraiser is hired to determine the value of Junior’s 20 nonvoting shares. The appraiser takes into account a number of factors:

  • The 20 shares represent a minority interest.
  • The shares are nonvoting shares.
  • As the company is an S corporation, the earnings are taxed directly to the shareholders.

Since Mr. Big wants to continue to invest in the company, the amount distributed to Junior is equal to the income taxes that are due on the earnings. Junior is not going to get a dime he can spend, other than what he needs to pay taxes. Based on all those limiting factors, the appraiser thinks a willing buyer would want a one-third discount. Therefore, Junior’s 10 percent interest in the Big S Corporation is worth not $3 million but $2 million.

In the next installment of this article series, we’ll look at ways to tie these powerful tools together.

Conclusion

The three properties of the tools in the estate planner’s tool kit are the basis for all the transactions recommended by them. Knowing these techniques allows financial planners and life insurance agents to understand the value of what they can offer compared with what attorneys can offer. The specific techniques that use the three tools mentioned above will be discussed in later pieces, along with the strengths and weaknesses of each technique.


About the Author

Richard L. Harris specializes in life insurance sales and consulting for high-net-worth individuals and their advisors. For more than four decades, he has been a trusted expert for accountants, attorneys and trust officers. A life insurance agent, he holds the professional designations of Chartered Life Underwriter, Registered Trust and Estates Practitioner, and Accredited Estate Planner. He may be reached at Richard@rlharrisllc.com or 973-470-5151.