Effective Estate Planning Strategies by John C. Andrews

            The current economic and political climates have adversely impacted the net worth of many individuals, including the affluent.  A positive development from these conditions is the opportunity to transfer wealth under historically favorable terms which results from a combination of the following factors:

1.         Depressed asset values;

2.         Very low applicable IRS interest rates; and

3.         Availability of discounting devices for wealth transfers, such as Grantor Retained Annuity Trusts and family limited partnerships, which may be eliminated by Congress soon.

            The existence of these conditions means there has seldom, if ever, been a better time for wealth transfer planning, and the following discussion focuses on the particular planning tools best suited to take advantage of this opportunity.  For example, the applicable federal interest rate (AFR) published by the IRS for estate and gift tax valuation purposes has varied during recent years from a high of 6.2% (August 2007) to a low of 2% (February 2009).  Similarly, the AFR for midterm loans has varied during that same time frame from 5.09% to 1.65%.  The estate planning consequences of these varying interest rates alone are substantial, as discussed below.

Grantor Retained Annuity Trust (GRAT)

            One estate planning device that works very well in today's environment is a GRAT, which is an irrevocable trust that provides a specified beneficial interest for the trust creator, the grantor, for a fixed period of time.  The beneficial interest retained by the grantor is the right to receive a fixed annuity payment, either as a stated sum (e.g., $100,000 per year) or a stated percentage of the value of the property contributed (e.g., 10%).  When a GRAT is created, the grantor makes a gift of whatever is left in the trust after the fixed term to the named remainder beneficiaries. The value of this gift for tax purposes is determined by subtracting the value of the fixed annuity payment retained by the grantor from the value of the property transferred to the trust.  For this purpose, the value of the retained annuity payment is calculated by applying normal time value of money principles using IRS published interest rates for discounting purposes.  Because the current IRS interest rates are at historic lows, the retained annuity has a larger calculated value, therefore reducing the gift amount and making GRATs even more attractive gifting devices.

            Primarily implemented as a tool to transfer wealth, GRATs provide many benefits, including: (i) reducing the value of the gift for tax purposes (potentially down to zero); (ii) providing a continued payment stream to the grantor; and (iii) removing post-contribution appreciation from the grantor's estate.

Charitable Lead Annuity Trust (CLAT)

            Similar to a GRAT, a CLAT is also a split interest trust, under which a chosen charity receives a fixed annuity payment from the trust for the specified term of years, and at the end of that term the assets in the trust are transferred to the non-charitable remainder beneficiaries chosen by the grantor.

            Like a GRAT, a CLAT allows a discounted gift to be made to the remainder beneficiaries.  The value of the gift is determined at the time the trust is created, based on the value of the assets contributed to the CLAT reduced by the actuarial value of the annuity provided to the charity, also determined under applicable IRS interest rates.  Therefore, as a general matter, the larger the charity's interest, the smaller the taxable gift to the remainder beneficiaries.  For this purpose, the charity's interest can be made larger by increasing the annuity amount, making the term longer, gifting while applicable IRS interest rates are low, or a combination of these.

            When the charity's interest expires and the assets in the trust are transferred to the remainder beneficiaries, any appreciation on the value of the assets is then also passed along to those remainder beneficiaries, free of either gift or estate taxation.

Sales in Exchange for Installment Notes

            One alternative to the gifting strategies described above is a sale in exchange for an installment note. In such a transaction, an individual sells certain property, such as interests in a family limited partnership or other closely held business, to a grantor trust established for the seller's children or other chosen beneficiaries, often at a discounted price.  In exchange, the seller receives a promissory note payable by the trust.  As a result, the seller has removed the underlying asset from his or her estate, frozen its value for estate and gift tax purposes, locked in the low current applicable IRS interest rate, and retained for him or herself a continuing payment stream in the form of the note payments.  All future growth in the value of the property sold, in excess of the stated interest rate of the note, will accumulate estate and gift tax free in the trust.

             Because the buyer of the assets is a grantor trust, the seller will recognize no gain or loss on the sale of the assets and the note payments the seller receives will have no current income tax consequences to the seller.  As recognized by the IRS, because the seller is treated as the owner of the trust property for income tax purposes under the grantor trust rules, transactions between the seller and the trust are disregarded. 

 Conclusion

            Although many personal balance sheets have been adversely affected by events during the last year, wise families recognize the planning opportunities presented in the current economic environment.  At Andrews Barth & Harrison, we have the experience and knowledge to help individuals take advantage of these opportunities.