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Taxpayer Planning Opportunities During a Down Market

Posted by : , and on : March 23, 2020 | 8:00 am

Although the dramatic changes to the financial markets have created a great deal of anxiety, these changes have also provided some opportunities that many of our clients may wish to consider. Provided below is a brief summary of available strategies.


Gift Planning


1. Outright gifts. A successful gifting program depends heavily on the future performance of the gifted assets. With the current state of the stock market, gifts of marketable securities should be considered, particularly if there is an expectation of future appreciation in those securities.


a. Choosing the right assets. The tax basis received by the donee is the lower of the donor’s basis or the fair market value (“FMV”) of the asset upon date of gift. It is important to choose assets with a FMV higher than the donor’s cost basis to preserve the donor’s tax basis, particularly if there’s an anticipated sale of the donated asset.


b. Gifts to children. As stated above, transfers made now may reap tremendous rewards upon a market rebound. Provided below is additional insight regarding gifts made to minor children.


i. Transfers made to Section 529 plans. Clients may wish to consider making substantial contributions to these plans to capture a market rebound. Each spouse can contribute up to $75,000 to each minor child absent of gift tax consequences (known as a back-loaded 529 plan). This results in substantial value being provided to meet an important parental need.


ii. Uniform Transfer to Minors Act (UTMA) gifts. These gifts allow the transfer of property to a minor, subject to the management of a custodian. In Illinois, it provides the power to manage a particular piece of property on behalf of the minor until the minor reaches age 21.  The transfer is an irrevocable gift, and the minor receives legal title to the custodial property.  However, this may be problematic if age 21 is considered too young for receipt of this property.


iii. Gifts in trusts. Minors’ trusts (also known as Section 2503(c) trusts) provide grantors with better control over access to the trust assets. These trusts can be designed to meet needs beyond education and are commonly used to ensure that the grantor’s “legacy” on behalf of the trust beneficiaries is managed according to the grantor’s wishes. These are particularly excellent vehicles for gifts made to grandchildren.


2. Split interest trusts. These trusts provide a fixed annuity either to the grantor (grantor retained annuity trusts or “GRATs”) or to a charity (charitable lead annuity trusts or “CLATs”). With a low interest rate environment, there is an opportunity to take advantage of investment arbitrage, particularly if there is confidence that a market rebound will take place.  With a low Section 7520 rate (the April 2020 Section 7520 rate will be 1.2 percent), it creates a low threshold needed to provide value to the family upon the conclusion of the GRAT or CLAT term. Simply stated, if the split-interest trust can beat a 1.2 percent after-tax investment return, then the excess can pass to designated beneficiaries free of gift tax.


a. Zero-out GRATS. The value of a gift to this trust is the amount transferred less the present value of the annuity retained by the grantor. Zero-out GRATs have the present value of the grantor annuity equal the amount transferred to the GRAT.


This results in the grantor being treated as having made no taxable gift to the ultimate beneficiaries of the GRAT; thus, having the full investment arbitrage (i.e., the trust’s investment performance above the 1.2 percent discount rate) pass to the beneficiaries completely free of gift tax.


b. CLATs and an income tax charitable deduction. Properly drafted CLATs will provide donors with the opportunity to claim the full charitable deduction for income tax purposes upon the funding of the CLAT. This, in turn, creates an opportunity to accelerate this charitable deduction for amounts earmarked to the designated charity in future years.


c. IMPORTANT: the Grantor defect. An administrative “substitution defect” would be a recommended provision in either GRATs or CLATs.


i. This defect would empower the grantor/donor to bank favorable market performance and enhance the investment arbitrage by permitting the exchange of appreciated stock held in trust for cash if there is a “dead cat bounce” in the market (i.e., a short-term market rally).


ii. Furthermore, trust investment performance is taxed to the grantor which further leverages the gifts made to GRATs.


iii. As stated above, the grantor defect provides an acceleration of a charitable deduction; however, the CLAT income would be taxed to the grantor each year. The donor would consult with the tax advisors to mitigate any tax repercussion of a CLAT.  

3. Loans to family. In lieu of gifts, the low interest rate environment provides an opportunity to make loans to family at a minimal interest rate cost for things like acquiring a home. The lender can also forgive a part of the loan each year without a gift tax consequence, usually the annual gift tax exclusion amount, because the forgiveness of loans constitutes a “cash gift”, which is easy to report on the requisite gift tax forms.  


4. Generation skipping trusts. This gift tax strategy provides great value for transfers made to multiple generation trust vehicles.  


a. Grandchildren trusts. As stated above, a well-drafted minor’s trust (i.e., Sec. 2503(c) trusts) can be structured to qualify for both the $15,000 annual gift tax exclusion and the $15,000 Generation Skipping Tax (“GST”) annual exclusion providing great benefits at no transfer tax cost. A trust vehicle will ensure that the personal “legacy” held by the grantor is enforced through the trust instrument.  


b. Dynasty trusts. These trusts provide strong trust beneficiary rights without having the trust estate taxable to any of the trust beneficiaries. These trusts are designed to stay in force for each generation until the trust estate is exhausted.  


Again, this creates a great planning opportunity for gifts which are expected to appreciate in the future.  


Income Tax Planning  


Harvesting tax losses. The market downturn may provide an opportunity to harvest “market losers” in order to restructure the portfolio.  


1. Wash sales. Wash sales prevent the recognition of a capital loss if substantially identical securities are purchased within 30 days before or after the sale of the loss position. Avoid the wash sale rules by purchasing different securities that have the same investment return profile as a taxpayer’s current holdings.  


2. Losses held in non-grantor trusts. Losses held in non-grantor trusts can only be offset by gains held by that trust. Some taxpayers may consider liquidating trusts incurring substantial losses to free up these losses for the benefit of trust beneficiaries.  


3. Gains held in non-grantor trusts. Most states adopt the Principal and Income Act which, as a default rule, prevents the distribution of trust capital gains to trust beneficiaries. However, many trusts have a provision that overrides this act and allows trustees to distribute trust capital gains. Now is the time to review trust documents to ensure that this provision is in the trust. If not, then the use of either a trust protector, where applicable, or trust decanting can create this needed trustee power.  


Employee Benefits Planning


1. Roth conversions.  The dramatic reduction of the market may create an opportunity to make a Roth conversion to mitigate income tax liability in anticipation of a market “pop”.  This would be better suited for taxpayers who are not close to retirement and who are situated to enjoy the favorable tax benefits of a Roth IRA or Roth 401(k). Roth accounts provide the following benefits:


a. Any growth in the Roth account (IRA or 401(k) is tax-free;


b. Distributions upon retirement and Qualified Distributions (i.e., age 59 ½ and have held the account for at least five years) from a Roth account (IRA or 401(k)) are received tax-free;


c. Unlike traditional IRAs, a Roth IRA does not have a required minimum withdrawal for either the plan participant or the spouse for their joint lifetimes, meaning that the account can grow untouched until the death of the surviving spouse; and


d. Upon death, the Roth IRA beneficiaries can continue holding the Roth IRA for a period of ten years before the withdrawal from the Roth IRA is required. Again, the Roth distribution is completely tax free for these beneficiaries as well.


2. Health Savings Account (HSAs). HSAs may serve as a good investment vehicle in a down market. HSAs can provide a vehicle for savings for medical emergencies and provide long term coverage as well.


a. Depending upon the status of the existing HSA, Individuals may be able to contribute up to $3,550 for individual coverage and up to $7,100 for families in 2020.


b. Those over age 55 can contribute an additional $1,000 per year.


c. Many advisors consider HSAs as better savings vehicles for retirement than IRAs, because of the number of tax benefits offered by these accounts.

i. Pre-tax contributions can be made to these plans;

ii. HSAs can grow tax free; and

iii. If the account is used for medical expenses while employed, then the distribution is tax-free. This tax-free benefit can be extended for spousal use as well.


d. In response to the pandemic, in Notice 2020-15, the IRS said that health plans that are deemed high-deductible health plans can pay for coronavirus-related testing and treatment without jeopardizing the favorable tax benefits associated with the plan.


Personal Financial and Asset Protection Planning


1. Mortgage refinance. The low interest rate environment means the need to evaluate current nonrecourse debt to assess whether refinancing makes sense. Rates have already seen a material drop to approximately 3.25 percent. However, we may see a continual drop of these rates in the near-term future.


2. Asset protection. With the downturn of the market, there is certainly a great deal of anxiety leading to a desire to protect assets. There are a number of strategies that can be pursued for asset protection purposes.


a. Revisit asset ownership. This is of particular importance to those states that permit ownership of marital assets as “tenants by the entirety”. Illinois permits this for personal residences. It presumes an indivisible interest held by each spouse. As such, should one spouse be subject to creditor claims, this asset is protected because of the spousal rights.


b. Domestic asset protection trusts. Since the late 1990s, several states have enacted statutes allowing for the creation of Domestic Asset Protection Trusts, or "DAPTs." A DAPT is an irrevocable trust under which (a) the person creating the trust can be a beneficiary and (b) under certain conditions, the assets of the trust cannot be reached by that person's creditors. Illinois does not have DAPT statutes. If there is a need to do this, then states well-suited to provide this asset protection (such as South Dakota and Nevada), would be warranted.


We hope that this guidance provides value to you, particularly during this time of uncertainty. We are here to assist you as you navigate the new market conditions, as even in times of downturn opportunities for successful tax planning present themselves. If we can be of further service, we are always happy to answer any questions you may have.


Charles F. Schultz III



Kamal K. Battu




The summary information in this document is being provided for education purposes only. Recipients may not rely  on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice. We encourage any recipients to contact the authors for any inquiries regarding the contents. FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.


About FGMK


FGMK is a leading professional services firm providing assurance, tax and advisory services to privately held businesses, global public companies, entrepreneurs, high-net-worth individuals and not-for-profit organizations. FGMK is among the largest accounting firms in Chicago and one of the top ranked accounting firms in the United States. For over 50 years, FGMK has recommended strategies that give our clients a competitive edge. Our value proposition is to offer clients a hands-on operating model, with our most senior professionals actively involved in client service delivery.