Illustration By Christophe Vorlet
The estate planning business is doing quite well, thank you very much, especially with folks from 40 to 60 years of age. "The estate tax is becoming a hot button particularly for those who have experienced significant increases in portfolios because of stock options or company holdings," says Dan West, with the planning firm Moneta Group, in St. Louis. "Historically the concern for a typical 40-year-old was either education funding or retirement planning. Now they're getting to the estate planning process earlier." The nouveaux riches, West says, are quicker to gift to children and charity than their Depression-era parents, who stockpile assets because they remember being penniless. "Younger people don't think that way. They view that they have enough, so they're inclined to make gifts earlier. That is a trend."
Given the nature of the estate planning beast, practitioners take a range of approaches. Some daringly operate out on the fringe - "We cross our fingers for three years until the statute of limitations for audits runs out," admits one aggressive attorney - while others practice comfortably with methods tried and true. It's hard to say which approach works better for your clients - or for you. That's the gamble you take when using, or ignoring, the cutting edge.
Regardless of threshold for confrontation with the Feds, estate planning pros agree that the device du jour is the family limited partnership. "Family partnership victories by taxpayers in the last year have been significant," observes Atlanta attorney Stephen E. Parker. With an FLP, a donor places assets in a limited partnership, gives limited partner interests to family members while retaining a small percentage of ownership as the controlling general partner, then takes a discount on the value of the gift - paying less gift tax in the process - since limited partners lack control over the entity. Two recent court cases, Kerr and Church, confirm that taxpayers can take sizeable discounts when gifting through a family limited partnership. "Because of those cases, people are really focussed on [FLPs] as the core planning vehicle," says Parker, with Lefkoff, Duncan, Grimes & Miller, P.C. "Everything is off a partnership wrapper right now."
Like the charitable limited partnership, for example. The char FLP (that's "char" as in broiled, "flip"), as it's called, is a state-of-the-art tweak merging FLP discounts with charitable giving. First, an attorney drafts the articles of partnership to provide that if a charitable institution owns any limited partner interests (don't worry; one will) the charity has the right, after a specified time, to "put" those interests back to the FLP - i.e., the partnership must buy back the limited partner interests at their then-current value if the charity desires to cash out.
Then the donor contributes, say, $1 million of market value assets to the family partnership and takes a 40% discount (assuming that's what the expert appraisals deem appropriate) for gifting the LP interests. "So the $1 million becomes $600,000 for gift tax purposes," says attorney Myron Kove, in the New York office of Kove and Kosakow. "The donor has four children and he makes gifts of 1% to each of them" - 1% of $600,000 is well under the gift tax-free annual exclusion of $10,000 per donee - "and the general partner, which is controlled by the parent, retains a 1% interest."
Next step: Give the remaining 95% ownership, in the form of partner interests, to a public charity, and reap an income tax deduction, albeit one based on the discounted value, for doing so. ("You've got to be consistent with the discount," says Kove.)
The char FLP technique is predicated upon appreciation in the partnership's assets. "It's a question of arithmetic, and the math works much better if the assets in the partnership grow in value," says Kove. "Suppose the $1 million initially contributed to the partnership is worth, after a specified time, $2 million. We have to use the same 40% discount when the charity puts its 95% limited partnership interests to the FLP." So the partnership pays $1.14 million (to buy back 95% of $2 million, less 40%) to the charity, leaving $860,000 ($2 million, minus $1.14 million) in the family partnership. After the charity redeems its interest, who owns 99% of the FLP? "The four kids," says Kove. "You've wound up transferring $860,000 [99% of it, anyway] to the kids at no gift tax cost, and after the charity is bought out, that continues to grow outside the grantor's estate."
"And don't forget," Kove adds, "the parent, with a 1% general partner interest, still controls everything - distributions, what the investments are going to be - even though he's given away 99% of the partnership."
Looks good on paper, but in actual practice, things could go awry. For one thing, the assets may not grow as anticipated. (Seen stock prices lately?) For another, you can't control whether the charity will exercise its right - it has no obligation - to put the LP interests, and if it doesn't, the charity snags 95% of any distributions made. "If you do it with, say, Harvard University, they'll sit on the partnership and wait 50 years until you make distributions. They've got an endowment fund to pay for everything in the meantime," says attorney David A. Handler, a partner in the Chicago office of Kirkland and Ellis. "I'm not a huge fan of charitable family limited partnerships because whenever you mix charity and estate planning, the IRS tends to look at you a little more closely." Indeed, some char FLP players have been caught sopping out odious salaries for managing the partnership and/or redeeming the charity at pennies on the buck.
Perhaps the absolute newest estate planning device is something that Handler called the guaranteed GRAT in a December 1999 article he penned for the trade journal Trusts & Estates. Oddly, the technique doesn't come courtesy of new legislation or the latest IRS ruling. It's simply the result of creatively combing the tax law for the exception to the exception that somehow slips through.
To fully understand the guaranteed GRAT, you need to understand garden variety grantor retained annuity trusts. They're explained in "Letting Go," (July 1998 p. 63), but the short of it is that a GRAT, which can get assets out of the estate, is established for a term certain, although if the grantor doesn't live that long, the assets swish back into the estate. The guaranteed GRAT guarantees that doesn't happen. "You will avoid estate tax even if you don't survive the term," Handler says.
The guaranteed GRAT is a play that involves esoteric legal concepts as well as complex tax ones, and the grantor selling something akin to the trust's reversion to family members. "We sell what we call the reversion equivalent," says Handler. "Instead of selling you the reversion whereby the trust property would go to you if I die before the term ends, I contractually agree to pay to you whatever I receive by reason of the reversion. So if I die in year eight of a 10-year GRAT, all the property comes back into my estate, but I'm contractually bound, and so is my estate, to turn over to you whatever I received." Bottom line, the GRAT property is included in the grantor's estate, but the claim by whomever bought the reversion equivalent yields a deduction for the same amount. The fabulous result: It all washes out on the estate tax return.
Implementing a guaranteed GRAT is relatively easy. There's no special wording the trust document need include. "You draft a GRAT as you normally would," Handler says, "and with the GRAT in place, I call up my kids and say, 'Look, if I die before the term ends, it's going to come back to me. Would you be willing to pay me X thousand dollars so that if I die, you'll have a claim against my estate?' It's really just a side agreement, outside of the GRAT document itself. We consider this every time we look at a GRAT," says the Kirkland and Ellis partner, "and it enables us to consider using a longer-term GRAT."
In the past, with a client in his or her 60s, say, Handler would write a 3- or 5-year GRAT, afraid that the grantor might not survive a longer term (and therefore the trust property would pop back into the estate). But capping the length of a GRAT means less payout to your client during its term. "Now we're looking more at doing longer GRATs," Handler says, "knowing that whether the grantor survives or not, we're going to get the benefit of removing the trust assets from the estate."
The biggest stumbling block to the guaranteed GRAT is the cost of the reversion, which is needlessly incurred if the grantor ultimately outlives the trust term (and the trust assets end up outside the estate with no help from the strategy). "The cost of the reversion is based on the likelihood of the grantor dying during the term of the GRAT, so it's worth a lot more when the grantor is older," Handler explains.
Take a $1 million, 10-year, zeroed-out GRAT. For a 75-year-old, the reversion has a value of $196,000 (using the Applicable Federal Rate effective for March). "If that person were 55, it would be $42,000; at 85, it's $389,000," Handler says, adding that a key factor in deciding whether to do a guaranteed GRAT is the potential estate tax savings to be realized by ensuring that the trust property stays outside the estate. (Actually, even if the grantor outlives the trust term, rendering the guaranteed GRAT device all for naught, the children aren't out the full amount they paid for the reversion, assuming they're in the will. The amount paid is in Dad's estate, which is subject to a maximum 55% federal death tax. "So they'll get back 45%.")
The children, of course, don't have to be the ones buying the reversion. You can sell it to anyone. "In fact, if you have a trust for your kids, you can sell the reversion to that trust," Handler says. "Use some of those funds so that the kids don't have to come out of pocket, or at least out of their own pocket."
Thanks to the bull market and techniques like guaranteed GRATS, trusts are better-funded and longer-lived these days. That's leading some pros to increasingly utilize special trust positions variously known as trust protectors, trust advisors, and special trustees. "Written into a revocable trust document that I recently reviewed for a client was the position of special trustee," reports financial planner Kyra Morris, of Morris Financial Concepts in Mt. Pleasant, South Carolina. "After the incapacity or death of the grantor, the special trustee could actually modify the trust document in case of tax law or family changes."
With a large, multi-generational trust, decades of tax reform could thwart the deceased grantor's original intent. Or descendants could find themselves in situations the trust's creator never visualized. A special trustee can modify the trust document to align it more closely with the grantor's intent. "That's a crucial point," says Morris. "You're still trying to maintain the original integrity and intent of the grantor, but you are allowed some flexibility."
Denver tax and estate planning attorney Nancy Crow has written trust documents that name a trust advisor. "It's not my routine drafting technique," Crow says, "but it's something that some clients very much like. The trust advisor keeps an eye on what the trustee is doing and second guesses the trustee." If that second guess differs from what the trustee has done, the trust advisor can boot the trustee and name a new one.
Similar to a trust advisor is a trust protector. Generally associated with offshore asset protection trusts, the trust protector concept works well with U.S.-based trusts, too, points out Crow, with Pendleton, Friedberg, Wilson & Hennessey, P.C. "A trust protector is someone who is not actually a fiduciary, so doesn't have quite as much liability, but has the power to remove the situs of the trust to some other jurisdiction."
There can also be tax advantages to naming a trust protector, observes Manhattan estate planning specialist William D. Zabel, with the law firm Schulte Roth & Zabel. "If you create a trust that lets you decide who gets what distributions and when, it'll come back into your estate when you die," Zabel says. "But if you create a trust where an independent protector - he may be your lawyer, or your accountant, or your best friend - can do those things, that does not cause a bad estate tax effect. We've used protectors from time to time because it's a very effective way to create a lot of flexibility in a trust."
Suppose, for example, a trust dictates an outright payment to a child at age 35. What if she's in the middle of a messy divorce at that time? "The protector can change the actual dispositive provisions of the trust and expand the age of distribution to 40 or beyond," says Zabel.
To be sure, there are uncertainties surrounding the use of domestic trust protectors. Gail Cohen, chief trust counsel at Fiduciary Trust International in New York, says, "The downside is that if the protector doesn't do a good job, can you sue the protector? And the answer is, 'What does the trust document say about that?' Chances are the trust document is going to say you can't sue the protector, although there's no established law on that. There's not even a lot of law on this in the offshore world, where they've had this role for many decades. So there are question marks about what the legal responsibilities and the parameters are."
Indeed, unanswered questions, and attendant risks, are what turn cutting-edge techniques into a double-edged sword. Of course you want to help your client. Of course you want to avoid legal and IRS problems.
How do you balance the two? "If someone knew a precise answer to that," says Zabel, "they'd be the best estate planner in the country."