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Financial Planning > Trusts and Estates > Trust Planning

How Well Are Your Clients Prepared To Transfer Their Wealth?

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When it comes to transferring wealth from one generation to the next, Americans are woefully unprepared.

Two out of three closely held family businesses do not make it to the next generation, according to an October 2003 report by the Small Business Administration. Often, the businesses are liquidated by default because the owners failed to plan for the orderly transfer of their business assets, either to family members or a partner.

The World Wealth Report released by Merrill Lynch in June 2004 indicated that two out of three taxpayers with estates of $5 million or more do not have an estate tax savings plan. And a Hartford Financial Services Group survey from April 2004 found that two out of three households with annual incomes of $100,000 or more do not have a will.

Why are so many ill-prepared for asset distribution planning? Why do so many fail to plan and therefore plan to fail? Their situation is unfortunate and often tragic because several cost- and tax-effective planning strategies are available to help businesses and individuals distribute, protect and enhance wealth.

High-net-worth clients may consider wealth transfer as a three-step process, including: (1) asset devaluation to minimize or avoid gift taxes when lifetime gifts are made; (2) stacking and enhancing the allowable annual exclusion and exemption equivalent amounts with those devalued assets; and (3) leveraging the transferred assets and/or the income generated from them into a family fortune with a dynasty trust funded with life insurance.

Step 1: Minimizing or avoiding transfer tax consequences. Among the most effective techniques to accomplish this strategy is to use a “devaluation trust” to reduce an asset’s fair market value for gift tax purposes. Grantor retained annuity trusts (GRATs), charitable lead trusts (CLTs) and qualified personal residence trusts (QPRTs) can be used as devaluation trusts.

These vehicles reduce the gift value of an asset that a grantor transfers to a devaluation trust beneficiary using one of three calculations: (1) the present value of the income stream the grantor retains from the GRAT; (2) the present value of the income stream that a charity may receive from a CLT; or (3) by the present value of a grantor’s computed rental value interest when he or she continues to live in a home that has been gifted to a QPRT.

The size of the discount relates to the number of years that a given trust will last and to the applicable federal discount rate of IRC Section 7520 that determines the present value discount. Assets may be discounted or devalued for gift tax purposes by up to 50% or more.

The Walton Tax Court case (Walton v. Comm., 115 TC, No.41 (2000)) affirmed that a GRAT can be designed to maximize discounting. However, the estate tax inclusion of a GRAT if the grantor dies during the GRAT term remains an unsolved issue.

Gift devaluation also can be accomplished by transferring business, investment or income-producing assets to a family limited partnership (FLP) in exchange for limited partnership interests. When FLP interests are subsequently gifted or sold to a third party, they may be discounted as minority interests that have limited marketability. Gifting FLP interests to either GRAT or CLT devaluation trusts can enhance the valuation discounts since FLP discounts are added to GRAT/CLT income interest discounts.

Step 2: Stacking the available annual gift tax exclusion and the lifetime gift tax exemption amounts with assets devalued by the GRAT, CLT or FLP. For example, an income-producing asset or business interest exchanged for an FLP interest can be discounted for gift tax purposes by 40 percent.

That means an $18,888 limited partnership interest can be transferred under the $11,000 annual exclusion umbrella ($18,888 discounted by up to 40% equals $11,000). That same 40% discount allows up to $1.6 million of a partnership interest to be gifted under the $1 million lifetime gift tax exemption umbrella.

With proper planning, devaluation can allow higher valued assets to be excluded and exempt from gift taxation.

Step 3: Naming a family dynasty trust as the beneficiary of the GRAT, the CLT, or as the transferee of an FLP interest. Trust provisions can give the trustee of the family trust the discretion to leverage the transferred assets and/or the income from these assets into a multimillion-dollar legacy for the trust beneficiaries through the purchase of life insurance.

When trust income is used to purchase life insurance on the grantor’s life or the life of his or her spouse, trust income taxation is passed through to the grantor. There is no taxation at the trust level. Result: more asset preservation at the trust level. Any income taxes paid by the grantor are the equivalent of additional tax-free gifts to the trust beneficiaries.

This completes the wealth transfer cycle of using devalued assets to stack the annual exemption and lifetime exemption amounts that are used to leverage a multimillion-dollar legacy in a family dynasty trust. High-net-worth taxpayers can reach their wealth distribution objectives in a most cost- and tax-effective way if they proactively begin the process now with lifetime transfers.

John S. Budihas, CLU, ChFC, CFP, is a business, estate and trust planning consultant for the individual life division of Hartford Life Insurance Co., a subsidiary of The Hartford Financial Services Group, Inc. He can be reached at [email protected].


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