Tax Opportunities – Tax Planning in a Post-Brexit World

Although the long-term impact of Britain’s exiting the EU cannot be known, the prudent course of action remains one of steadiness over the coming weeks and months as the ramifications of Brexit begin to unfold. 

That said, it is understandably difficult to ignore significant volatility in the financial markets, whether from the British decision to exit the EU or from other causes, and taxpayers often ask: Is there anything that can or should be done today?

Sometimes, the answer is yes. Volatility and what an investor determines to be temporarily depressed asset values may present a prime opportunity for beneficial tax planning. In the June issue of For the Record, the article Tax Planning Opportunities During a Market Decline identifies certainly planning ideas for turbulent markets. In this article, the focus will be on some transactions that harness economic volatility while still limiting downside exposure should there be further decline. 

When the value of an asset suddenly drops due to what the investor believes are exogenous circumstances, rather than fundamental factors inherent in the asset itself there can be an opportunity to reap significant transfer tax savings. Simply stated, one can transfer more of an asset when its value is low than when it is high for the same gift cost. While there is risk of further loss in value after the transfer, if the overall plan is for the donee individual or trust to hold the asset long-term, the greater the chance the asset’s future value will exceed, possibly significantly, its transfer value. 

Another possibility is to simply make a cash gift, thereby allowing the donee individual or trust to purchase assets at a lower value. This type of transfer allows for the targeting of a specific asset if it is believed that it has been particularly impacted by current financial conditions and therefore has greater buy-low potential. In addition, transferring cash can avoid the dual-basis trap that can occur when transferring a depreciated asset. 

The dual-basis rules look to prevent a taxpayer from transferring a tax loss to another. If depreciated property is gifted, its basis becomes fair market value if that asset is sold when the value is less than the transferor’s original basis. If a taxpayer wants to gift a specific depreciated asset, then it should be done through a grantor trust. Because the grantor trust rules impute income tax ownership of an asset back to the grantor, this dual-basis rule wouldn’t apply and the loss would be preserved if it were ultimately decided to sell the asset at the lower value.

Another transaction that can be particularly powerful in an economic climate where asset values are temporarily depressed is a grantor retained annuity trust (GRAT). Because a GRAT is designed to leverage low values and transfer future appreciation with little to no gift tax impact and therefore no depreciation risk, it can be an ideal transfer vehicle under such conditions. As discussed in the June issue, in this transaction an asset is transferred irrevocably to a trust that pays an annuity back to the grantor for a term of years. At the end of the trust term, any remainder interest goes to the trust beneficiaries. Because the present interest value of the annuity is equal to 100% of the asset value plus the Sec. 7520 interest rate (1.8% in June and July), at transfer the remainder interest is valued at close to zero and therefore there is little to no gift tax ramifications. If the asset appreciates at a rate exceeding that 1.8% interest rate and the grantor outlives the trust term, that appreciation is transferred to beneficiaries free of any gift tax.

In addition, most economic analysis indicates that short-term GRATs (most practitioners believe the shortest permissible term is two years) holding volatile assets tend to perform the best. Part of the reasoning behind this analysis is that because the annuity payments are fixed based on the asset value at the time of transfer, sudden value spikes after transfer can increase the GRAT’s effectiveness. If an asset value is depressed due to outside factors, there may be greater potential for that value spike. The key in maximizing GRAT efficiency is the ability to harness asset volatility and catch the asset at these value high-points. One way to achieve this result is through what is known as a GRAT freeze.

In a GRAT freeze, if it is believed that an asset has reached a value high-point, a taxpayer would substitute in an asset with a relatively fixed value (such as a bond) in exchange for the more volatile asset. By doing so the GRAT value is now frozen at this high-point thereby guaranteeing its success. The taxpayer would then be free to re-GRAT that asset and capture additional growth, if any.

Finally, since there is little or no gift-tax cost with respect to GRATs, taxpayers can set up as many as they want and fund them with as much as they want. If an asset continues to decline in value so that the total annuity payments exceed the trust value, the worst that happens is the GRAT busts, and 100% of the asset is returned to the grantor. Because there is significant potential upside with little to no downside, GRATs can be an extremely attractive option under the right circumstances, which might be now. 

In the wake of the Brexit vote, the only thing clear is uncertainty. Although this uncertainly and its impact on markets has understandably made taxpayers nervous, it has also created potential tax planning opportunities that can result in significant savings. Now is a good time to discuss these and other opportunities with one’s tax and financial advisors.