Freeze, Arbitrage and Discounts - Part Two

Put these powerful estate planning tools together and distinguish yourself from other advisors (second 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.
  • Knowing these techniques allows financial planners and life insurance agents to distinguish their value to clients from what attorneys can offer.

Freezing, arbitraging and discounting assets are techniques that are typically used in combination with each other, not in isolation. Here’s an example of how that can work.

Mrs. Right wants to do estate planning and give a 20 percent interest in the Right Company LLC to her daughter, Ms. Right. The Right Company owns a commercial building (the Right Building) valued at $15 million. It produces a 6.5 percent annual return.

Mrs. Right gets an appraisal of a 20 percent nonmanaging interest in the LLC. An appraisal firm comes in and says that this is a minority interest that has no say in how the LLC is operated and it should be discounted 33.33 percent. Therefore, in their estimation a nonrelated buyer would be willing to buy that interest only for a one-third discount. In other words, the amount sold based on the value of the whole is $3 million. A 33.33 percent discount results in a value of $2 million. A 20 percent interest is therefore worth $2 million.

Mrs. Right gifts to her daughter stock equal to 2 percent of the company. A gift tax return is filed. Mrs. Right then loans Ms. Right $1.8 million. The terms of the loan are interest-only for 20 years with a balloon payment at the end. Because the loan term is more than nine years, in order for the interest not to be considered a gift, the minimum interest rate has to be at least equal to the long-term AFR. At the time of the transaction, that rate was 2.31 percent. Ms. Right uses the $1.8 million to buy an additional 18 percent of interest in the company. The return to Ms. Right on the 20 percent interest is 9.75 percent using the $2 million value.

What was accomplished?
  • Discount: Mrs. Right transferred ownership interests worth $3 million and valued at $2 million.
  • Freeze: What’s left in Mrs. Right’s estate is the note for $1.8 million.
  • Arbitrage: She loaned her daughter money at 2.31 percent. The daughter invested in an asset that based on its discounted value returns 9.75 percent.

These three properties of the tools in the estate planner’s tool kit are the basis for all the transactions they recommend. Knowing these techniques allows financial planners or life insurance agents to understand the value of what they can offer compared to 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.