The Big Freeze

Given the length and severity of the equity market's decline, it may be hard to get motivated to call your clients. But this is precisely the time to stay "top of mind" with clients and continue adding value. In doing so, you'll help to solidify client relationships and increase retention rates.

Just as savvy financial advisors know that bear markets can be used to position their clients for future wealth accumulation, weak markets also present wealth transfer opportunities for clients with sizable assets. While some affluent clients are undoubtedly now more interested in wealth preservation, current market conditions allow wealth to be transferred with great tax efficiency.

The Estate Tax: Still With Us

Why should you consider wealth transfer strategies, given the possibility that the estate tax may soon be eliminated? To paraphrase Mark Twain, reports of the death of the estate tax have been greatly exaggerated. While its present structure may change, it's unlikely that lawmakers will entirely dispense of all taxes related to estate transfers.

Lost in all the talk about an estate tax repeal is the fact that the gift tax remains. Further, the sunset provision that comes into play in 2011 will eliminate estate tax reform or repeal, unless the situation is changed through an act of Congress.

Based on the 2002 midterm elections, it's anyone's guess whether the repeal will be eliminated. The most likely scenario is that some portions of the law will be modified, other portions repealed, and others made permanent.

However the estate tax debate shakes out, transferring wealth will always be an issue for wealthy clients. As such, you should have an arsenal of strategies at your disposal.

I will assume that you're familiar with some of the more popular wealth transfer strategies, such as the $11,000-per-person annual tax exclusion on gifts. In this article we'll focus on several more sophisticated strategies, namely GRATs, CLATs, IDGTs, and intra-family loans.

Transfer Time

These strategies are sometimes called "estate freeze" transactions because, in essence, wealth or appreciation is transferred without incurring any additional gift tax by arbitraging the difference between the rate of return the IRS assumes for an asset (the applicable federal or Section 7520 rate) and the rate the client actually realizes. The applicable federal rate (AFR) is the minimum rate of return the IRS states must be charged on loans to avoid imputed interest income. The 7520 rate is 120% of the mid-term AFR.

Last year, the 7520 rate fell to its lowest level in 15 years. For example, the rate for October, November, and December 2002 was 4.2%, 3.6%, and 4%, respectively. By contrast, it was 11.6% in April 1989. This rock-bottom rate, coupled with current low investment values, creates significant opportunities for those of your clients who are considering the transfer of wealth.

Grantor Retained Annuity Trusts

In its simplest form, a GRAT is an irrevocable trust in which the grantor retains the right to receive fixed annuity payments at least annually for a set number of years. At the end of the term, the remaining trust principal is transferred to the beneficiaries to the extent that the actual rate of return on the investments held by the GRAT is greater than the 7520 rate. When properly structured, the remaining assets are transferred to the beneficiaries at a reduced transfer tax. Following is a summary of how you establish a GRAT.

First, you ideally want to consider transferring a client's assets that have depressed values but have the potential to appreciate in the future.

Next, determine the gift tax. You do this via the subtraction method. The annuity interest is deducted from the value of the property transferred to the GRAT to determine the taxable gift, which is the present value of the amount expected to be left in the trust when it terminates. Typically the annuity rate is selected so that by the end of the trust term, the value of the annuity stream will be expected to equal the value of the original contribution plus appreciation at the 7520 rate, using a formula dictated by the Internal Revenue Service. This is called zeroing out the GRAT so the present value of the remainder is zero and no gift tax is incurred.

The GRAT is a grantor trust for income tax purposes. This means that the transferor/annuitant is taxed on income and realized gains on the trust's assets, even if these amounts are greater than the trust's annuity payments. This further enhances this particular strategy's effectiveness, as tax-free gifts of the income taxes are really attributable to assets backing the remainder beneficiary's interest in the trust.

At the end of the GRAT's term, appreciation earned in excess of the 7520 rate is passed to your client's heirs free of gift tax. That is, all income and appreciation in excess of the amount that's required to pay the annuity will accumulate for the benefit of the remainder beneficiary or beneficiaries.

Consequently, it may be possible to transfer assets to beneficiaries when the trust terminates with amounts that far exceed their original values, and more importantly, that far exceed the gift tax value of the transferred assets.

A key point to consider is that if the donor dies during the term of the GRAT, the trust's assets become subject to estate taxation. For this reason, the term of the trust is typically less than the donor's remaining life expectancy.

Charitable Lead Annuity Trusts

A CLAT works similarly to a GRAT. However, instead of the annuity cash flow being paid to your client it is paid to a charity. Again, at the end of the term the remaining trust principal is transferred to the beneficiaries of the trust. This allows a client to transfer a future amount today at a discounted value, while paying an annual income to a charity.

A CLAT is an effective tool for helping a good cause as well as benefiting a family member. Since the GRAT and the CLAT are first cousins, the steps and the numerics will generally be very similar. Instead of your client receiving the annuity payment, a charity would, with the remainder going to your client's beneficiaries gift tax-free.

Intentionally Defective Grantor Trusts

With an IDGT, the client sells an asset to an irrevocable trust in return for a note, typically for the fair market value of the asset, plus interest at the current AFR. This allows the client to transfer all the income and appreciation in excess of the note payable with minimal or no gift taxes.

This is called an intentionally defective grantor trust because it is flawed in a manner that results in an income tax inclusion but not estate tax inclusion. The difference in treatment between the income tax laws and the estate tax laws presents planning opportunities for your clients.

In establishing an IDGT, the grantor makes an arm's-length sale of assets to a grantor trust in exchange for a promissory note bearing interest at the current AFR. Because the grantor is treated as the owner of the trust property, the sale is ignored for income tax purposes, and no gain or loss is recognized upon the sale to the trust. Before selling assets to the IDGT, the grantor should initially contribute property having a value equal to about 10% of the fair market value of the assets to be sold, or should have other property in the trust. By doing so, the income and principal of the property can be used to service the note. This is done to avoid having the sold assets constitute the sole source of payment for the note and to avoid scrutiny by the IRS.

With respect to the sold assets, there are typically no gift tax consequences since there is no gift or generation-skipping transfer. The contributed assets represent a taxable gift to the remainder persons for which the $11,000 annual gift tax exclusion is not available, since the contribution is a gift of a future interest. If the sale were at a price less than fair market value, then there would be a gift of the difference. It is therefore important that a qualified appraisal be obtained.

Principal repayment of the note may be structured as a balloon payment due at termination. Interest on the note may also be accrued. Further, the grantor will not be taxed on the interest paid by the trust in respect to the note, but the grantor will be taxed on income and capital gains realized by the grantor trust.

Finally, the remaining assets are passed to the beneficiaries. The effect is to freeze the value of the asset transferred for transfer tax purposes. Also, if income earned by the trust property exceeds the interest payments, the excess income passes to the benefit of the trust beneficiaries, even though the grantor was taxed on the income.

Intra-Family Loans

These loans are similar to the sale to a defective grantor trust in objective. They differ in that instead of selling the assets to the trust in exchange for a note issued by the trust, the grantor just lends cash to the grantor trust to invest in exchange for a note. This is a very basic freeze strategy, in that it enables clients to provide liquidity to their heirs, perhaps at a time of their lives when they might not otherwise qualify for borrowing on a standalone basis. To the extent the client's children invest the assets–perhaps using the borrowed funds as seed money for a new investment that earns a return in excess of the rate on the note–the client has transferred wealth to his children without having incurred any transfer tax.

As we've seen, there are a number of strategies that allow you to help your clients transfer wealth with minimal tax implications. While the future of the estate tax is unclear, taking steps now to develop a sound wealth transfer strategy can go a long way toward managing your clients' tax exposure and providing a lasting legacy.

The Big Freeze

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