Posted by Martin Heller Potempa & Sheppard, PLLC on November 9, 2021
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Over our past two blogs, we covered the estate tax saving strategy of Discounting. Now, we will take the time to cover an Estate Freeze. One comment about Discounting and Estate Freezing – these are only needed for clients who already have, or are concerned about having in the future, a taxable estate. The estate planning lawyers at Martin Heller Potempa & Sheppard, PLLC are here to help you learn more about estate taxes.
What is an Estate Freeze?
An Estate Freeze is what it sounds like. The strategy “freezes” the value of certain assets in the client’s estate for future estate tax calculations. Essentially, at the client’s death, the asset’s “now” current value is reported on the estate tax return, not the “then” future value at the time of the client’s death. This means that all the asset’s growth and appreciation from (1) the time the Freeze occurs, until (2) the client’s death passes to the family without any estate tax.
For instance, an asset’s current value is $600,000. Client does a Freeze with the asset. Client dies 20 years later after the asset has grown on average 5% a year. The asset’s value at Client’s death is now about $1,516,000. With a Freeze, the asset’s value entered onto Client’s estate tax return is the original $600,000, not the actual current value of $1,516,000. This takes $916,000 out of the estate tax calculation. At a 40% estate tax rate, this saves the family about $366,450 in estate taxes.
How Does Estate Freezing Work?
Here is a look at how Freezing works, step by step:
Client sets up an irrevocable gift trust for the family. The trust is designed to keep any asset it holds outside of the Client’s taxable estate.
Client sells the asset to the trust for a promissory note having a set interest rate. The lowest interest rate a promissory note in a Freeze can use is set by the IRS each month. This month, the lowest rate is .38%, which is incredibly low.
At the end of the transaction, the asset is owned by the trust and the client holds the promissory note.
Later, when Client dies, the promissory note, not the asset, is listed on Client’s estate tax return.
The essence of a Freeze is that a promissory note does not appreciate over time. A promissory note with a face value of $600,000 still has a face value in the future of $600,000. The client is swapping an appreciating asset outside of the taxable estate in return for a promissory note which does not appreciate. Hence, the current value of the asset is “frozen,” as represented by the non-appreciating promissory note, while the actual asset continues to appreciate in the trust outside of the client’s estate.
A comment about the interest rate to use: Each month, the IRS publishes a notice specifying the lowest interest rate that can be used for an intra-family transaction in that month. For instance, for a transaction done in October 2020, the lowest interest rate that can be charged on the promissory note is .38%. This current rate is considered to be very low. As a comparison, three years ago in October 2018, the interest rate was set at 2.83%. Still, it is certainly lower than what is available through a bank or other commercial loan.
Find Out More About Estate Freezing
In our next blog, we will discuss the Freeze strategy with an example to show its power to save estate taxes. Continue to check in with Martin Heller Potempa & Sheppard, PLLC over the coming weeks, as we will cover how combining Discount and Freezing work together to produce the most estate tax savings.
If you have any questions about your estate, contact us for help!
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