A high-net-worth individual who invests in a qualified opportunity fund (QOF) may be interested in exploring ways to incorporate that investment into his or her overall estate and gift tax planning. While it is certainly possible to do some effective wealth transfer planning with QOFs, these assets provide a narrower bandwidth for planning than many other types of assets. The following is an overview of the essential estate and gift tax planning aspects of QOFs. The overview is based in part on the guidance provided by the proposed regulations issued by the IRS on April 17, 2019. We should note that the IRS has received comments on the proposed regulations and may well amend some of the guidance as it moves to finalize the regulations.
Before we broach the topic of estate planning with QOFs, it will be helpful to establish a baseline of the operative rules for the income taxation of the QOF. What’s more, it will be helpful to keep in mind that, from a tax perspective, there are actually two component parts to keep track of when an individual sells an investment for a capital gain and then reinvests all or part of the capital gain into a QOF. One component is the capital gains tax that would otherwise be due on the sale of the original investment. The other is the potential appreciation in the QOF investment itself. They are separate, but as we will discuss, interrelated.
Let’s assume that Sue sells appreciated stock that has a zero basis for $1 million on Jan. 2, 2019. Rather than pay the capital gains tax in 2019, she invests the $1 million in a QOF on June 1, 2019. By meeting the 180-day required timeframe for reinvestment of the gain into the QOF, Sue will be able to defer recognition of the gain and payment of the capital gains tax until the earlier of Dec. 31, 2026, or the date she sells the QOF. If she holds the QOF for at least five years, 10 percent of the deferred gain is eliminated and if she holds it for at least seven years, another five percent of the deferred gain is eliminated. On Dec. 31, 2026, the capital gains tax on the remaining 85 percent of the deferred gain will be triggered and she will have to pay the tax. When the gain is triggered, Sue will report the amount by which the lesser of the deferred gain or the fair market value of the QOF at that time exceeds her basis in the QOF. Section 1400Z-2(b)(2). The good news is that, separately, she will be entitled to increase her basis in the QOF by the amount of capital gain that she recognized. The potentially not-so-good news is that unless she has sold the QOF, she will have to find the cash to pay the tax from her other resources.
Now, if Sue holds the QOF for at least 10 years (from June 1, 2019), she will eliminate all of the gains on the eventual sale of the QOF. That is because her basis in the QOF will be ‘stepped-up’ to the fair market value of the QOF as of the date of the sale. Clearly, valuation will play an important role here, as it will when Sue turns to estate planning for the QOF.
With the baseline case established, we will now explore the opportunities for wealth transfer planning with QOFs.
A good place to begin this conversation is actually at the end, meaning at Sue’s death. If she passes away before Dec. 31, 2026, owning the QOF, her death is not an inclusion event, i.e., it does not trigger the deferred gain. Reg. section 1.1400Z2(b)-1(c)(4)(i). In fact, the deferral is initially preserved for the beneficiaries of the estate or the trust that inherit the QOF when Sue passes away. Most of the steps typically taken in the administration of the estate or trust will not trigger the gain. However, the gain could be triggered by a subsequent event in the course of the administration of the estate or trust. For example, the gain would not be triggered when the QOF is transferred to Sue’s estate or distributed by the estate or trust to the beneficiary. The gain would also not be triggered if the QOF passed to a surviving joint owner by operation of law, e.g., to a joint tenant with rights of survivorship. However, if the estate, trust, or beneficiary sells the QOF, then the sale would trigger the gain. Reg. section 1.1400Z2(b)-1(c)(3).
While it is now clear that death is not an inclusion event, there is somewhat less clarity about the basis that Sue’s heirs would take in the QOF. The proposed regulations do not squarely address the matter. Therefore, for the time being, at least, QOF investors (and their tax advisors) will have to take what the proposed regulations do provide on the subject and apply it in the context of the general provisions for step-up on the basis of inherited property under section 1014. Once again, it is helpful to distinguish between the two components, i.e., the deferred gain and the QOF.
The deferred gain is technically an item of income in respect of a decedent (IRD), which means that the beneficiary essentially steps into the shoes of the deceased investor and recognizes the gain just as the investor would have if he or she had lived. section 691. This is a point not to be overlooked. If the gain were triggered before the fund pays out or is otherwise liquidated, perhaps because Dec. 31, 2026, arrives before that time, there would be a tax event. However, the cash to pay the tax may not be available.
With respect to the QOF, it would appear that the income tax basis of the QOF in the hands of the beneficiary should be its fair market value at the date of death less the amount of IRD. Once the gain is triggered on or before Dec. 31, 2026, and the new owner pays the tax, the basis from that time until the expiration of the 10-year holding period will be the full fair market value. Finally, once the 10-year holding period requirement is met, the basis in the QOF will be stepped-up to the fair market value of the QOF as of the date of the sale. Fortunately, the beneficiary does not have to start all over again for that purpose. Sue’s holding period tacks, meaning that her beneficiary is considered to have owned the QOF for the same period of time that she did. This makes it easier for the beneficiary to qualify for the five, seven, and 10-year timeframes for reduction of the deferred gain.
The subject of basis is certainly one that the planning community is raising in its comments, so we will see how the IRS will respond in the next round of regulations.
Turning now to more pro-active wealth transfer planning, Sue might want to make a straightforward gift of the QOF to her children or (or grandchildren) or to a trust for their benefit in order to remove any appreciation in the QOF from her taxable estate. Indeed, she has likely done that with other assets, such as interests in her business. Unfortunately, the gift is an inclusion event that will trigger the deferred gain. Reg. section 1.1400Z2(b)-1(c)(4)(ii).
Transfers to grantor trusts
There is an alternative approach, however, that affords the wealth transfer benefits of the gift without triggering the deferred gain. A transfer to a trust that is a so-called grantor trust for income tax purposes will not be an inclusion event. A grantor trust is a trust whose income or capital gains are taxed to the grantor as though he or she owns the assets generating the income or capital gains in his or her own name. The taxable income of the trust is actually reportable by the grantor. Although the grantor’s payment of the tax on the trust’s income or capital gains clearly benefits the trust and its beneficiaries, the grantor's payment of the trust’s taxes is not a taxable gift under current law.
What types of grantor trusts might be useful in this context? First and most simply, the typical revocable living trust is a grantor trust that Sue could transfer the QOF to without triggering gain. She might do that to remove the QOF from her probate estate. There would be no income, gift, or estate tax implications or advantages to that, however, from a tax perspective, Sue remains the owner of the QOF.
A more wealth transfer-oriented technique would be a transfer to an irrevocable grantor trust. The transfer to that type of trust would be a completed gift that would remove any post-gift appreciation in the value of the transferred asset from Sue’s estate. So long as the trust maintains its status as a grantor trust, the income tax implications of the arrangement, including the treatment of the deferred gain and the investment in the QOF, respectively, are the same as though Sue owned the QOF in her own name or in her revocable living trust. However, if before that time, the irrevocable trust ceases to be a grantor trust for a reason other than Sue’s death, then an inclusion event will occur. Reg. section 1.1400Z2(b)-1(c)(5)(ii) and Reg. section 1.1400Z2(b)-1(c)(4). Hopefully, the 10 years will have elapsed by that time.
A popular variation on the theme of such grantor trusts is the ‘dynasty trust’, which takes advantage of the grantor’s generation-skipping transfer tax exemption to benefit the grantor’s children and subsequent generations without causing the trust’s assets to be included in each succeeding generation’s estates for estate tax purposes.
Another variation on the theme - grantor retained annuity trust
Many high net worth individuals like Sue prefer to transfer appreciating assets to irrevocable grantor trusts for wealth transfer purposes but not use any gift tax exemption. Perhaps they would like to preserve the exemption for other assets that would get a step-up in basis at their death. A grantor retained annuity trust (GRAT) could serve that purpose. If properly structured, a GRAT will enable the grantor to pass some of the QOF’s post-transfer appreciation to the next generation without using gift tax exemption. What’s more, a GRAT is a grantor trust during the GRAT term, meaning the period of time in which the GRAT is paying the annuity to the grantor. However, there will be an inclusion event at the end of the GRAT term when the trust’s assets pass to the children unless the QOF stays in a grantor trust for the benefit of the children.
While Sue can certainly consider a GRAT for her QOF, she should work closely with her planners and her investment team to determine if the QOF is a good match for a GRAT. She and her team should consider the amount, timing, and tax characteristics of the QOF’s anticipated cash flows, the expected appreciation of the QOF, the extent to which the structural characteristics of the QOF will affect the administration of the GRAT and the real-time economic implications to Sue of the GRAT’s grantor trust status after the GRAT term. Of particular concern might be the complexity and expense associated with the valuation of the QOF on the initial transfer to the GRAT as well as during the GRAT term if interests in the QOF have to be used to pay the GRAT annuity. The point is that just because Sue can do a GRAT with the QOF does not mean that she should! In fact, Sue and her planning team should take many of those same considerations into account when they assess the merits of any wealth transfer strategy.
A planning technique that many individuals prefer to a GRAT is an installment sale to a grantor trust. Absent further guidance from the IRS, it is unclear whether a sale, even to a grantor trust, would trigger the gain. That is because the proposed regulations speak in terms of a “contribution” to a grantor trust. Technically, a sale for consideration would not be a “contribution”. This is another point that the planning community is addressing in its comments on the proposed regulations.
Gifts to charity
Finally, like many QOF investors, Sue might be charitably inclined and might consider giving the QOF to charity. Unfortunately, a contribution of the QOF to a charity is an inclusion event, triggering the deferred gain. Reg. section 1.1400Z2(b)-1(c)(3).
It is worth repeating that we have based this overview on guidance that is sure to evolve, though the timing of that evolution is uncertain. We will update the overview when we see the next round of regulations.