October 9, 2018
By: Edward B. Becker
The new tax law, which took effect on January 1, 2018, doubled the exemptions from federal estate, gift and generation-skipping transfer tax to $11,180,000 per individual, with inflation adjustments going forward and with a reversion to the base $5,000,000 exemption (with inflation adjustment) on January 1, 2026. This temporary increased exemption presents a number of planning opportunities, one of which is to forgive outstanding intra-family debt.
One by-product of the historically low interest rate environment of the past several years is the increased use of intra-family transactions involving promissory notes. These notes play a key role in many estate planning transactions and their prevalence has made them a worthy target for the IRS.
One of the more popular estate planning strategies consists of a sale to a grantor trust whereby the value of the property sold is frozen in the hands of the seller in the form of a promissory note. This transaction can produce substantial estate tax savings to the extent that the property sold to the trust outperforms the interest rate on the promissory note. Since the sale is made to a grantor trust, the transaction is disregarded for income tax purposes. No capital gain is recognized on the sale and the interest paid pursuant to the promissory note is not subject to income tax.
If the seller dies while the promissory note remains outstanding, the note's then value is included in the seller's estate for estate tax purposes. The IRS has yet to adopt a definitive position as to how this scenario is treated for income tax purposes. Some commentators opine that no capital gain is realized and the note's income tax basis is stepped-up to equal its value in the seller's estate. Other commentators maintain that there is no basis step-up and capital gain is recognized to the extent the amount due on the note exceeds the seller's original cost of the asset(s) sold. By choosing to forgive the note now, the potential income tax exposure that may result upon death can be eliminated.
Forgiving the note may unlock other tax planning opportunities. After the debt is eliminated it may be possible to convert the trust to a non-grantor trust. This switch could potentially eliminate state income taxation on the trust's income, an especially welcome result given that the new tax law limits state tax deductions to $10,000 per year. Furthermore, using the additional, but temporary, gift tax exemption to forgive and thereby eliminate intra-family debt can help safeguard existing estate planning transactions from IRS scrutiny.
The decision to utilize gift tax exemption to forgive intra-family debt requires a detailed analysis. We encourage you to discuss these options with one of our estate planning attorneys.