The Big Freeze

At the end of the GRAT’s term, appreciation earned in excess of the 7520 rate is passed to your client’s heirs free of gift tax. That is, all income and appreciation in excess of the amount that’s required to pay the annuity will accumulate for the benefit of the remainder beneficiary or beneficiaries.

Consequently, it may be possible to transfer assets to beneficiaries when the trust terminates with amounts that far exceed their original values, and more importantly, that far exceed the gift tax value of the transferred assets.

A key point to consider is that if the donor dies during the term of the GRAT, the trust’s assets become subject to estate taxation. For this reason, the term of the trust is typically less than the donor’s remaining life expectancy.

Charitable Lead Annuity Trusts

A CLAT works similarly to a GRAT. However, instead of the annuity cash flow being paid to your client it is paid to a charity. Again, at the end of the term the remaining trust principal is transferred to the beneficiaries of the trust. This allows a client to transfer a future amount today at a discounted value, while paying an annual income to a charity.

A CLAT is an effective tool for helping a good cause as well as benefiting a family member. Since the GRAT and the CLAT are first cousins, the steps and the numerics will generally be very similar. Instead of your client receiving the annuity payment, a charity would, with the remainder going to your client’s beneficiaries gift tax-free.

Intentionally Defective Grantor Trusts

With an IDGT, the client sells an asset to an irrevocable trust in return for a note, typically for the fair market value of the asset, plus interest at the current AFR. This allows the client to transfer all the income and appreciation in excess of the note payable with minimal or no gift taxes.

This is called an intentionally defective grantor trust because it is flawed in a manner that results in an income tax inclusion but not estate tax inclusion. The difference in treatment between the income tax laws and the estate tax laws presents planning opportunities for your clients.

In establishing an IDGT, the grantor makes an arm’s-length sale of assets to a grantor trust in exchange for a promissory note bearing interest at the current AFR. Because the grantor is treated as the owner of the trust property, the sale is ignored for income tax purposes, and no gain or loss is recognized upon the sale to the trust. Before selling assets to the IDGT, the grantor should initially contribute property having a value equal to about 10% of the fair market value of the assets to be sold, or should have other property in the trust. By doing so, the income and principal of the property can be used to service the note. This is done to avoid having the sold assets constitute the sole source of payment for the note and to avoid scrutiny by the IRS.

With respect to the sold assets, there are typically no gift tax consequences since there is no gift or generation-skipping transfer. The contributed assets represent a taxable gift to the remainder persons for which the $11,000 annual gift tax exclusion is not available, since the contribution is a gift of a future interest. If the sale were at a price less than fair market value, then there would be a gift of the difference. It is therefore important that a qualified appraisal be obtained.

Principal repayment of the note may be structured as a balloon payment due at termination. Interest on the note may also be accrued. Further, the grantor will not be taxed on the interest paid by the trust in respect to the note, but the grantor will be taxed on income and capital gains realized by the grantor trust.

Finally, the remaining assets are passed to the beneficiaries. The effect is to freeze the value of the asset transferred for transfer tax purposes. Also, if income earned by the trust property exceeds the interest payments, the excess income passes to the benefit of the trust beneficiaries, even though the grantor was taxed on the income.

Intra-Family Loans

These loans are similar to the sale to a defective grantor trust in objective. They differ in that instead of selling the assets to the trust in exchange for a note issued by the trust, the grantor just lends cash to the grantor trust to invest in exchange for a note. This is a very basic freeze strategy, in that it enables clients to provide liquidity to their heirs, perhaps at a time of their lives when they might not otherwise qualify for borrowing on a standalone basis. To the extent the client’s children invest the assets–perhaps using the borrowed funds as seed money for a new investment that earns a return in excess of the rate on the note–the client has transferred wealth to his children without having incurred any transfer tax.

As we’ve seen, there are a number of strategies that allow you to help your clients transfer wealth with minimal tax implications. While the future of the estate tax is unclear, taking steps now to develop a sound wealth transfer strategy can go a long way toward managing your clients’ tax exposure and providing a lasting legacy.