Endangered trusts: Bring them up with clients now

The budget introduced by the Obama Administration in April of this year primarily focused on federal spending changes, but hidden in the fine print were recommended changes that also could possibly curtail trust options that financial advisors and their clients have been using for years. Grantor retained annuity trusts, or GRATs, would have severe limits put on their duration, and dynasty trusts would be altered beyond recognition if the budget comes to fruition.

In both cases, though, the scenario is that any extant trusts would be grandfathered in as they currently exist. So if you have clients who might benefit from either of these trusts, it might behoove you to bring it up now and get one established before their usefulness is limited. Even if they don't ultimately set up a trust, it's a nice way to let clients know you're on top of the latest developments in estate planning.

Here's a quick look at who might best make use of these trusts:

A GRAT allows someone to put assets into an irrevocable trust while still retaining the right to receive distributions back over the term of the trust. The person putting assets into the trust gets back an annuity, which pays a fixed amount each year. If the grantor dies before the trust expires, the assets from the trust fall back into the taxable estate, and the beneficiary receives nothing. If the grantor outlives the terms of the trust, the remaining assets go straight to the beneficiary, tax free, although they are required to pay gift tax on the initial value of the assets.

So obviously, a GRAT works best as a short-term trust, one the grantor is likely to outlive. But the proposed budget would require that the term last at least 10 years (and the maximum term would be 10 years longer than the grantor's life expectancy).

It would make sense, then, for older clients looking for a way to move assets out of their taxable estates to consider establishing a GRAT now. Anyone with a reasonable life expectancy of 10 years or less can no longer expect to outlive a GRAT. Younger clients — say, those in their 50s — shouldn't expect to be unduly affected by the new regulations.

Dynasty trusts, on the other hand, would basically be done away with altogether in the Obama budget, although existing trust would be grandfathered in. As it stands now, a grantor can set up a dynasty trust with assets that are shielded from estate and gift taxes for the life of the trust, which basically means in perpetuity. Income generated by the trust is subjected to normal taxes, but the underlying assets remain tax free. The real benefit of a dynasty trust is that it is not even subject to the generation-skipping transfer tax.

But the Obama plan invokes an old common-law principle that no trust should last more than 90 years. This was called the Rule of Perpetuities, but many states worked around it in the 1990s to allow dynasty trusts that would theoretically never end. Thus, the proposal calls for the generation-skipping tax to come due every 90 years on what once was a perpetual dynasty trust. Again, this doesn't apply yet — and may never apply. But if the proposed change ever becomes reality, any existing dynasty trusts would be entitled to operate under the old rules.

Obviously, it's the rare client who has assets sizable enough that they need to be shielded from taxes for a century or more. These trusts have never been in widespread use. They're legal in only about half the states, although one doesn't need to be a resident to establish a trust in that state.

But they're still worth bringing up with clients. It's not just that it presents you as an advisor who is familiar with the current lay of the land and also keeping an eye on the future. It also flatters clients to think they may need asset protection that lasts for several generations.

For either of these trusts to be altered, it would require passage not just from the Obama-aligned, Democratic-controlled Senate but the Republican-controlled House of Representatives as well. That means enactment is a long way from imminent. But ideas have a way of simmering quietly, long before they come to fruition, and the careful financial advisor would be wise to keep an eye on these proposals.

For more on estate planning, see:

5 ways to help middle-class clients with estate planning

Did portability kill the credit shelter trust?

The coming storm in trust-owned life insurance — and how you can cope