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.