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Are There Still Wealth Transfer Opportunities for Clients?

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The acute phase of the credit crisis, which “officially” began with the collapse of Lehman Brothers just over one year ago, appears to have been successfully navigated to avoid the end-of-the-world scenarios so commonly predicted. And although there is still uncertainty over how the U.S. economy will move forward in light of growing unemployment and a crushing deficit, the paralysis that gripped the financial industry has noticeably thawed. Clients, bolstered by a rebound in equities, have returned to their advisors looking for guidance about how to move forward.

The perfect storm for wealth transfer planning is not over yet
In the heat of the meltdown, I wrote about good wealth transfer strategies for the economic climate of the day–for the “perfect storm” resulting from reduced asset values and historically low interest rates. (For more, please see “A Silver Lining” from the January 2009 Wealth Manager. At the time, however, no matter what their level of wealth, clients were having a hard time grasping the notion of giving away assets to reduce estate values and their associated tax liabilities while their net worth was being cut in half.

Although I cannot provide supporting statistics, recently I have seen an increase in the number of clients ready to resume wealth transfer planning. Moreover, the perfect storm I referred to is not over. There are still plenty of opportunities to implement very effective wealth transfer strategies in conditions that remain favorable. Equity markets may have roared back from their March lows, but, as you know, client estates are not composed solely of equity positions. Assets like real estate and closely held business interests have not enjoyed the impressive recovery in value that publicly traded equities have experienced. So clients are coming out of their bomb shelters to look for planning advice.

GRATS: an effective strategy for our times
Among the best wealth transfer strategies for times like these–when asset values are depressed and interest rates are low–are charitable lead annuity trusts (CLATs), self-cancelling installment notes (SCINs), sales to intentionally defective grantor trusts (IDGTs), and grantor retained annuity trusts (GRATs). Though each vehicle has its own merits, I am focusing on GRATs because the possible enactment of new legislative proposals may significantly alter how and when we use them in the future.

How GRATs work
A GRAT is an irrevocable trust to which a grantor transfers ownership of a property but in which he or she retains an annuity interest. Over the GRAT term, the grantor receives an annual payment from the trust; at the end of the term, the property passes to the trust beneficiaries or is retained in trust for their benefit.

A transfer of property to an irrevocable trust is a taxable gift, but in the case of a transfer to a GRAT, as a result of the grantor’s retained interest, the value of the property for gift tax purposes is reduced. The benefit associated with a GRAT is in the expectation that the property within the trust appreciates significantly during the trust term. All of the appreciation occurs outside of the estate and passes to the trust beneficiaries free of additional gift tax.

Today’s economic environment has not only led to depressed values for client assets, but it has also provided for advantageous interest rates as they apply to GRAT design. The applicable federal rate (AFR), a factor in determining the amount of the taxable gift, remains historically low, at 3.40% (September 2009). The lower the AFR, the higher the value of the grantor’s retained interest; therefore, the remainder interest that passes eventually to trust beneficiaries is reduced.

Clients who could benefit most from establishing a GRAT
Funding a GRAT takes careful consideration when it comes to determining which assets to transfer to the trust. Previously, I mentioned the rally in equity prices versus the slump in the value of real estate and business assets. In reviewing your client base, you may find opportunities to implement a GRAT among owners of closely-held businesses and real estate investors because reduced revenues and falling profit margins have led to significant reductions in value as determined by qualified appraisals.

Business owner clients who anticipate a liquidation event in the next few years could transfer business interests to the GRAT before the event and transfer any appreciation to beneficiaries with a reduced transfer cost. Similarly, clients with real estate investments may benefit from using a GRAT; look for assets that could quickly appreciate over a short period.

Legislative changes on the horizon?
In a typical GRAT, the trust is set up so that the grantor’s retained interest throughout the trust term equals the value of the assets transferred to the trust. This type of GRAT is commonly referred to as “zeroed out” because the projected value to pass to beneficiaries when the trust is initially funded is zero; therefore, there is no gift tax liability to the grantor. The idea behind this design is that GRAT assets will appreciate much more than the AFR applied to the initial calculation of the retained and remainder interests. Here is a hypothetical example:

A client transfers an asset valued at $1 million to a two-year, zeroed-out GRAT with an AFR of 3.4%. Over the two-year term, the asset appreciates at an annual rate of 12%. The client, as the grantor, receives two annual payments of $525,651.80; however, the asset appreciates at a rate that provides a remainder interest of $140,018.18 to pass to beneficiaries, free of gift tax. The zeroed-out GRAT works very effectively in transferring value out of the estate with no transfer costs.

So the zeroed-out GRAT can be an excellent wealth transfer tool–but perhaps too good a deal for taxpayers from the point of view of the U.S. Department of Treasury (Treasury).

In May 2009, Treasury submitted several tax proposals to Congress, among them, a requirement that the terms for GRATs be extended to a minimum of 10 years. This proposal, if passed, would drastically change the landscape of wealth transfer planning using GRATs. The ability to zero out a GRAT would still be possible, but the practicality of doing so would be greatly diminished. In order for a GRAT to be effective, the grantor must survive the term of the trust or the trust assets must revert to the grantor’s estate at his or her death instead of shifting out of the estate to trust beneficiaries. Requiring a 10-year term would raise the risk of the GRAT becoming wholly ineffective because of the increased possibility of the grantor dying before the term of the trust is up.

Look to act now–before the perfect storm passes
GRATs can be extremely effective in removing assets from a client’s estate with reduced or no transfer costs. Proposed legislation emphasizes that planners may have a limited window of opportunity to take advantage of the current flexibility we currently enjoy in designing GRAT strategies. Revisit your client base to determine who is in a position to take advantage of a GRAT before the period of depressed values, low interest rates, and design flexibility that have created the perfect storm passes.

Gavin Morrissey is the director of advanced planning at Commonwealth Financial Network, member FINRA/SIPC, a registered investment adviser in San Diego, California. He can be reached at [email protected].


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