Some financial advisers are relying on an old strategy called a grantor-retained annuity trust to help rich clients who want to pass their assets on to their children free of estate tax.
With the future of the federal estate tax still undetermined, advisers are dusting off GRATs as a way to help clients deal with taxes on their gifts, advisers say.
“With a Democratic Congress and the possibility of having a Democratic president, more people are thinking nowadays that the technique should be used,” said Michael C. Foltz, a principal of Balasa Dinverno & Foltz LLC in Itasca, Ill.
This year, the exemption for the estate tax sits at $2 million a person, and the rate at 45%. Although the estates of those who die in 2010 won’t have to contend with the so-called death tax, as of Jan. 1, 2011, the exemption level will go back to $1 million a person, barring the enactment of legislation to end the tax permanently.
Irrevocable trust
A GRAT is an irrevocable trust that can help clients save on transfer taxes when they want to pass certain assets, such as a small business, on to their children. The assets are expected to appreciate during the duration of the trust term — usually a minimum of two years — and provide the grantor with an annual income.
Both the capital gains and the income are taxable for the grantor, but at the end of the trust term the beneficiaries get the assets free of gift tax.
The strategy is an elaborate one that clients may overlook unless advisers point out a situation where it would work, advisers say.
“There are many clients in a holding pattern, who just won’t take on more complicated techniques until they know how Congress will deal with the estate tax changes,” Mr. Foltz said. But even in less-uncertain times, investors won’t ask for GRATs because they aren’t aware that they exist.
“Most of my clients think that a trust is a mysterious vehicle, and you’ll have to explain it to them,” said Gary L. Flotron, principal of G.L. Flotron & Associates in St. Louis. “You’ll always have people who think they’ll go broke and that they’ll need all of the assets in the trust.”
Well-executed GRATs call for a team effort from a client, an adviser and an estate-planning attorney: The investor creates the terms of the GRAT, while the attorney drafts the trust.
But advisers are the ones who recognize which assets would work for the vehicle.
“You want highly appreciating property,” Mr. Flotron said. “There’s a downside if your business is so up and down that you can’t generate the income.”
Battered stocks that are due for an upswing may also make sense, said Matthew Gordon, managing director of financial planning at Lenox Advisors Inc. of New York.
“There’s a great deal of demand from clients with stocks that they don’t want to sell because they believe they’re poised for good appreciation in the future,” he said.
A home with substantial value also makes an attractive asset if a grantor wants to reduce his taxable estate, Mr. Foltz pointed out. But the terms change.
“Instead of an income, your annuity portion would be your use and enjoyment of the home in the time period,” Mr. Foltz said. “You’re getting value, and at the end, the ownership transfers to your beneficiaries.”
Naturally, there are limits to the benefits for investors.
“As a practitioner, it’s incumbent upon you to tell clients what will happen,” Mr. Foltz added. “Advance their thinking by five to 10 years and let them know that the technique is irrevocable: You get your payment every year, but if there are assets remaining at the end, they’re no longer yours.”
Some drawbacks
One major downside for investors to keep in mind is the fact that the annuity distribution will chew up the value of the principal if the assets in the trust falter.
Also, the grantor gets the tax benefit as long as he outlives the trust term or all the assets get pulled back into the estate and become subject to taxes.
Complicated estate planning strategies will call for larger teams of professionals, but advisers predict that demand for GRATs will increase as practitioners and clients become more aware of the prospect of higher taxes. The deadline is still more than three years away, but this is the time to prepare.
“If they have assets they want to pass on, it becomes part of the objective: If we want to transfer the most wealth we can, we better start the process now,” Mr. Flotron said.
Darla Mercado can be reached at
[email protected].
