Given the length and severity of the equity market’s decline, it may be hard to get motivated to call your clients. But this is precisely the time to stay “top of mind” with clients and continue adding value. In doing so, you’ll help to solidify client relationships and increase retention rates.
Just as savvy financial advisors know that bear markets can be used to position their clients for future wealth accumulation, weak markets also present wealth transfer opportunities for clients with sizable assets. While some affluent clients are undoubtedly now more interested in wealth preservation, current market conditions allow wealth to be transferred with great tax efficiency.
The Estate Tax: Still With Us
Why should you consider wealth transfer strategies, given the possibility that the estate tax may soon be eliminated? To paraphrase Mark Twain, reports of the death of the estate tax have been greatly exaggerated. While its present structure may change, it’s unlikely that lawmakers will entirely dispense of all taxes related to estate transfers.
Lost in all the talk about an estate tax repeal is the fact that the gift tax remains. Further, the sunset provision that comes into play in 2011 will eliminate estate tax reform or repeal, unless the situation is changed through an act of Congress.
Based on the 2002 midterm elections, it’s anyone’s guess whether the repeal will be eliminated. The most likely scenario is that some portions of the law will be modified, other portions repealed, and others made permanent.
However the estate tax debate shakes out, transferring wealth will always be an issue for wealthy clients. As such, you should have an arsenal of strategies at your disposal.
I will assume that you’re familiar with some of the more popular wealth transfer strategies, such as the $11,000-per-person annual tax exclusion on gifts. In this article we’ll focus on several more sophisticated strategies, namely GRATs, CLATs, IDGTs, and intra-family loans.
These strategies are sometimes called “estate freeze” transactions because, in essence, wealth or appreciation is transferred without incurring any additional gift tax by arbitraging the difference between the rate of return the IRS assumes for an asset (the applicable federal or Section 7520 rate) and the rate the client actually realizes. The applicable federal rate (AFR) is the minimum rate of return the IRS states must be charged on loans to avoid imputed interest income. The 7520 rate is 120% of the mid-term AFR.
Last year, the 7520 rate fell to its lowest level in 15 years. For example, the rate for October, November, and December 2002 was 4.2%, 3.6%, and 4%, respectively. By contrast, it was 11.6% in April 1989. This rock-bottom rate, coupled with current low investment values, creates significant opportunities for those of your clients who are considering the transfer of wealth.
Grantor Retained Annuity Trusts
In its simplest form, a GRAT is an irrevocable trust in which the grantor retains the right to receive fixed annuity payments at least annually for a set number of years. At the end of the term, the remaining trust principal is transferred to the beneficiaries to the extent that the actual rate of return on the investments held by the GRAT is greater than the 7520 rate. When properly structured, the remaining assets are transferred to the beneficiaries at a reduced transfer tax. Following is a summary of how you establish a GRAT.
First, you ideally want to consider transferring a client’s assets that have depressed values but have the potential to appreciate in the future.
Next, determine the gift tax. You do this via the subtraction method. The annuity interest is deducted from the value of the property transferred to the GRAT to determine the taxable gift, which is the present value of the amount expected to be left in the trust when it terminates. Typically the annuity rate is selected so that by the end of the trust term, the value of the annuity stream will be expected to equal the value of the original contribution plus appreciation at the 7520 rate, using a formula dictated by the Internal Revenue Service. This is called zeroing out the GRAT so the present value of the remainder is zero and no gift tax is incurred.
The GRAT is a grantor trust for income tax purposes. This means that the transferor/annuitant is taxed on income and realized gains on the trust’s assets, even if these amounts are greater than the trust’s annuity payments. This further enhances this particular strategy’s effectiveness, as tax-free gifts of the income taxes are really attributable to assets backing the remainder beneficiary’s interest in the trust.