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.