From the February 2009 issue of Investment Advisor • Subscribe!

February 1, 2009

Taking Advantage of a Down Economy

Clients can reduce taxes when transferring assets to their children

Difficult economic times can provide an excellent opportunity for affluent clients to make strategic moves that can help reduce taxes and more efficiently transfer assets to their children. Your clients can freeze significant assets at lower levels for gift and estate tax purposes when the market values of stocks, real estate, and family businesses are down. As your client locks in the lower value of these equity interests, most of the appreciation that comes later will pass to the children with little or no estate or gift taxes.

In particular, the levels of two important numbers can greatly improve a client's ability to transfer assets in a tax-advantaged way. Even relatively small movements in the 7520 Rate, which is set monthly by the IRS, and the Volatility Index (VIX,) reported throughout the trading day by the CBOE, can alter the amount of assets going to the kids vs. to the government.

Depending on the kind of trust that may be right for your client and the planning strategy, the low rates can work to your advantage. GRATs (Grantor Retained Annuity Trusts), family loans, or the sale of business to an Intentionally Defective Grantor Trust (IDGT) work especially well during these times.

Transfer Assets While Values Are Low

In the last year, the value of stocks, bonds, and real estate have dropped to levels that have transformed both the reality and perception of Wall St. as a financial and pop-cultural institution. For HNW clients, it's an advantageous time to consider transferring assets to heirs. When the executive of a public company owns 20,000 shares of a stock averaging in the high $80s two years ago--and hovering around $20 today--there's a great opportunity to reduce the size of his potential estate tax obligation by transferring many more shares now, especially if the price is expected to recover.

If your client owns a business, then it's likely that its value has decreased in the last year (unless he/she is lucky enough to operate in a sector with very strong growth expectations or one that moves counter to the major market cycle).

A tightened lending environment can cause even an otherwise healthy company to brake in its daily operations and make it harder to find a buyer for the business. In addition, expectations for lower profits and perception of risk all work to drive business values down.

"When values are very low, it's an excellent time to start transferring wealth to the next generation," notes Michael Bekas, a tax partner with Marks Paneth & Shron LLP, in New York, who specializes in estate planning for HNW clients and their families. "There are a number of ways to make those transfers without using full value. When you take all of these different things and put them together, you can get incredible discounts from fair market value for transfer tax purposes."

A client takes what is now a million dollars worth of stock in a closely held business and through his advanced planning team puts them into a GRAT. With the Volatility Index and the low 7520 rate, the client can get discounts of maybe 25% or 30% on these stocks.

Bekas uses another step to enhance the benefits. He sets up a FLP (Family Limited Partnership). The client owns some real estate holdings that provide good rental income but whose market value is greatly depressed. The client then places the real estate in the FLP. Instead of the kids directly becoming the partners and beneficiaries of the FLP, a GRAT for each of them is the legal partner. Each GRAT gets a minority interest discount in the real estate. Since the client is giving away minority shares in the business that are not highly marketable because a third party is unlikely to pay full value, the client can realize an additional discount on the overall value of the transfer. Bekas sees discounts of 40% to 50% based on recent cases.

"What ends up happening is that we can discount the value of an asset significantly," observes Bekas. "We've transferred these assets to the children at very low, possibly zero transfer tax cost. When the market turns, all of the appreciation is going to the kids."

Estate Taxes and GRATs

If the client lives through the term of the GRAT, the trust expires and the remaining principle will be distributed to the children without any estate tax implications for the client. On the other hand, should the client die during the GRAT's operation, the entire value of property in the trust becomes part of his or her estate at fair market value at the time of death. (Some aggressive legal strategies suggest that the value can be discounted to some extent.) To cover the potential additional estate taxes caused by the grantor's premature death, advisors use life insurance in a trust. Since the GRAT's existence is set to a fixed number of years, inexpensive term insurance serves this purpose well.

The client must receive a fixed annual annuity payment throughout the term of the GRAT. If the assets in the trust don't perform as expected and the income in any year is less than the promised annuity, the trustee can distribute the necessary amount from the assets if liquid (such as stock) or an interest in the assets if they are not liquid (such as a family business). Alternatively, the trustee can borrow against the trust assets and secure a loan to make the obligation.

GRAT Income and Taxes for the Client

The income generated by assets residing in the GRAT is potentially taxable to the grantor (client) who created the trust. If the annual income generated by the GRAT is greater than annuity payments due the grantor, the client will pay income tax on both the portion received and the remainder that stays within the trust.

If the GRAT generates income in the first three years of $120,000, $130,000, and $140,000, for example, and the annual annuity payments are $100,000, the client will pay income tax on these amounts while only receiving say $100,000 each year.

Depending on the particular planning strategy, payment of the income tax on the extra income ($20,000, $30,000, and $40,000 in the above example), can follow two paths. The GRAT could allow the trustee to distribute funds above the annuity payment to cover the income tax on the extra income, which would lessen the out-of-pocket tax payment by the client but also deplete the GRAT principle.

Alternatively, the client paying the income tax on total GRAT income allows the principle to grow larger with more available to transfer to children at the end of the term of the GRAT. For a client with already sizable taxable estate, paying the income tax could be the wise route to follow.

Sale vs. GRAT

The client can also sell a business, for example, to a trust (an IDGT) for the benefit of the children. As with the GRAT, the value freezes when the trust first acquires the asset. The client would still have the obligation to pay income taxes on any income the business generates, although he or she isn't receiving any income from the trust. The trust gives the client an interest-only note at a low rate. By absorbing the income taxes, the client has made the equivalent of a tax-free gift to the trust. Since the client has paid the taxes on the trust income, the asset value grows without income tax, again increasing what the children ultimately receive. Also, the sale allows the use of the AFR rate, which is lower than the 7520 rate. The client can realize some estate tax savings without outliving the trust, unlike the GRAT.

While GRATs are a very effective strategy when valuations and interest rates are low, they're right for certain client circumstances, but not all. Advanced planning teams consider the use of a GRAT by itself or in combination with other planning tools in the context of other available options such as gifting or a sale to the children or a third party. Once a business, for example, is placed in a GRAT, those other options aren't possible.

A client can also use a family loan to transfer money to children. The children need to invest the money in some way that will garner income or profit so they can pay back the client. The loan could fund the purchase of an asset that the client owns, such as family business or income-producing real estate. If the investment return exceeds the loan payments, the children can keep the difference. These family loans use the AFR, which is even lower than the 7520 rate required in the GRAT calculations.

Other devices that work better when rates are low include Dynasty Trust, CLATs (Charitable Lead Annuity Trusts), and SCINs (Self-Cancelling Installment Notes).

High Rates and Other Trusts

In contrast, certain favorite tools of advanced planning teams offer advantages when rates are high and aren't particularly helpful when they're low. For example:

o QPRTs (Qualified Personal Residence Trusts)--With a QPRT, the client gifts a house to the trust and lives in it for the specified term, such as 10 years. When the trust expires, the children own the house. While market conditions can depress real estate values and a QPRT can freeze a lower valuation of a home, deep discounting occurs when the 7520 rate is higher rather than lower. The rate determines how much discounting of the gift value is available.

o CRATs (Charitable Remainder Annuity Trusts)--CRATs work very well when the client has a large chunk of highly appreciated assets, such as company stock, that would result in sizable capital gains tax if sold. By gifting the stock to a CRAT, the client eliminates the tax obligation since the charitable trust can sell the stock without a capital gains tax implication. The tax deduction that the client receives is based on the trust remainder that goes to the charity. When interest rates are high at the creation of the CRAT, the amount that goes to charity is assumed to be higher since earnings are assumed to be larger at the time of distribution, therefore the deduction is greater than when rates are low.

While affluent clients may face challenges caused by economic conditions, advanced planning teams can provide a long-term perspective and strategy that brings some significant benefits during these times.

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