EFTA01103621.pdf

Estate Planning in Changing (and Challenging) Financial Times Mickey R. Davis Bracewell & Giuliani LLP 711 Louisiana, Suite 2300 Houston Texas 77002 San Antonio Estate Planners Council December 15, 2009 EFTA01103621  TABLE OF CONTENTS Page I. Introduction II. What's Going On? A. Financial Issues 1. Investments 1 2. Interest Rates 1 B. Tax Issues I. Estate Tax Exemption 1 2. Income Tax Issue 2 a. Rates 2 b. Basis 2 III. What Works Now? 3 A. Inter-Family Loans 3 B. Sale to An Intentionally Defective Grantor Trust 6 C. Grantor Retained Annuity Trusts 9 D. Charitable Lead Annuity Trusts E. Outright Gifting 15 F. SCINs and Private Annuities 17 G. Sale to "Accidentally Perfect Non-Grantor" Trusts 20 IV. What is Out? 22 A. Irrevocable Life Insurance Trusts 22 B. Qualified Personal Residence Trusts 23 C. Charitable Remainder Unitrusts and Annuity Trusts 23 V. Undoing What We've Done 24 A. Unwinding Irrevocable Trusts 25 I. Cashing In 25 2. Fiduciary Duties of the Trustee 25 B. Failure to Fund 25 C. The Role of Trusts 26 D. Rethinking the Role of the Bypass Trusts 26 I. No Trusts But For Estate Tax 27 a. Use of Disclaimer Planning 27 b. The "Maximum Benefit" Bypass Trust 28 c. The Formula General Power 29 2. Reasons Not to Limit Bypass Trusts 29 E. Modifying and Terminating Trusts 29 1. Modifications Under Common Law 29 2. Texas Trust Code Section 112.054 30 a. Statutory Language 31 b. Application of the Statute 31 3. Reformation and Rescission 33 a. Reformation 33 b. Rescission 33 4. Termination by Agreement of Settlor and Beneficiaries 34 EFTA01103622  TABLE OF CONTENTS (continued) Page 5. Trust Combinations and "Mergers" 34 a. No Impairment 34 b. No Consent Required 35 6. Sale of Assets to New Trust 35 a. The Prudent Investor Rule 35 b. Income Tax Issues 35 7. "Decanting"—The New Kid in Town 35 a. Discretionary Authority Required 36 b. Statutory Provisions 36 c. An Example: The South Dakota Statute 36 d. Is Decanting for You? 37 VI. Problem Areas In Trust Modifications and Terminations 17 A. Tax Issues 37 1. Gift Tax Issues 37 a. General Gift Issues 38 b. Exercise, Release or Lapse of General Power of Appointment 38 2. Income Tax Issues 38 a. Distributions and DNI 38 b. Gains 39 c. Basis Disregarded 39 3. Estate Tax Issues 40 4. Generation-Skipping Transfer Tax Issues 40 B. Charitable Beneficiaries 40 1. Cy Pres 40 2. Involvement of the Attorney General 41 VII. Conclusion 41 EFTA01103623  Estate Planning in Changing (and Challenging) Financial Times I. Introduction. A dramatic drop in investment values coupled with historically low interest rates and a 75% increase in the federal estate tax exemption, all in the course of just a few months, may have created a perfect storm for estate planners. Can we still use the tools and techniques that estate planners have grown to know so well to plan for wealthy individuals? For clients of more modest means, how will the focus of our estate planning change to take new estate planning realities into consideration? And what about clients who may now see the estate planning that we have done in the past as "over-planning"? Are there new (or not-so-new) tools and techniques available to allow us to undo what we may have already done? In view of the volatile estate planning landscape, coupled with important non-tax factors, is it wise to assist our clients in attempting to undo prior planning? The goal of this outline is to address these issues in the context of the current financial and legal environment. II. What's Going On? A. Financial Issues. According to the October, 18, 2008 Wall Street Journal, "[t]he economy is a mess, home prices are reeling, and stocks have plunged. But for those likely to become ensnared in the estate tax, there's a silver lining: These troubled times offer some of the best opportunities in years to transfer wealth to younger generations, without triggering much or any inheritance tax along the way." 1. Investments. Many of our clients have seen their investment portfolios plunge in value. While the media may be responsible for much of the gloom and doom, we all remember not-so-distant times when the Dow Jones Industrial Average was thousands of points above where it stands today. Real estate prices, especially in areas like California and Florida that once regularly experienced rapid inflation, have dropped precipitously. While Texans, who missed much of the run-up, have also been spared much of the fall, the general sense is that property values are still below long-term market expectations. 2. Interest Rates. Our clients may be less likely to follow current interest rates. As advisors, we know that these rates (such as the Section 7520 rate) can have a big impact upon which estate planning tools work best. Attached as an Exhibit is a chart depicting the Section 7520 rate from January, 1991 through August, 2009. As the exhibit shows, throughout the '90s, this rate hovered between 6 and 10%. As recently as 2007, the Section 7520 rate began to drop steadily. In January, 2008 it fell below 5%. In February, 2009 it dropped to 2%, an all-time low, forcing the IRS to re-publish its tables (which previously began at 2.2%). B. Tax Issues. 1. Estate Tax Exemption. It is a striking contrast that in a year that the Dow dropped from 13,264 (December, 2007) to 6,440 (March, 2009), the estate tax exemption increased from $2 million per person to $3.5 million per person. This 75% increase in exemption is by far the largest in recent memory. While the fate of the estate tax is still uncertain, most commentators and political pundits assume that Candidate Obama's pledge to freeze the estate tax at 2009 levels will be implemented by President Obama and the Democratic Congress, at least long enough to prevent a "repeal" of the estate tax in 2010. Whether the exemption will remain at $3.5 million, return to $1 million, or take some other form is anyone's guess. The chart on the next page contrasts the changes in net worth with the estate tax exemptions that would be available to a hypothetical married couple who had about $3 million -1- EFTA01103624 invested in the S&P 500 Index in January, 2000. It is small wonder that many of our "wealthy" clients are now so little concerned with estate tax exposure. 2. Income Tax Issue. a. Rates. While most people are beginning to view the estate tax world with 2009 glasses, the same can't be said for income tax rates. President Obama has recently renewed his vow not to raise income tax rates on those earning less than $200,000 (or $250,000 for married couples). See New York Times, August 4, 2009, p. Al2 (New York ed.). This vow brings little comfort to those of our clients whose income far exceeds this amount. Their fears are heightened by the deficit projections brought about by the economic downturn, bipartisan efforts to spend tax dollars to revive the economy, and the projected cost of health care reform. Clients understand that the government will have to pay for this spending, and if taxes on the poor and middle class are fixed, there is only one place for this payment to come from b. Basis. In the days of soaring stock market values and real estate prices, many of our clients had large built-in gains. While many have taken comfort in a capital gain rate equal to what many people pay for good service at a restaurant, there is a real concern that this rate will not stay around for long. On the other hand, plunging prices have brought many portfolios down to the point where values once again approach (or have fallen below) basis. Those entering the market at an opportune time, and who expect a rapid rise in values (the Dow rose an astounding 47% from its March, 2009 low to its close in late August, 2009), may begin to worry again about capital gain tax exposure. ,.a.w flat Ow ,.a.w. Ita•co, 1400.00) natal Ratan PAN <cm Net Worth vs. Estate Tax Exemption III. What Works Now? A. Inter-Family Loans. One of the most attractive wealth-transfer strategies is also one of the simplest-a family loan. The IRS permits relatives to lend money to one another at the -2- EFTA01103625 "Applicable Federal Rate," which the IRS sets monthly. With these loans, relatives can charge far less than a bank. For example, in July, 2009, when Bankrate.com quoted the rate on a 30- year mortgage at around 5.5%, the Applicable Federal Rate ranged from 0.82% to 4.36%, depending on the loan's term. The Technique. With banks tightening credit standards, the appeal of The Bank of Mom & Dad is obvious. These loans and their super-low interest rates are also great estate-planning opportunities. If the borrower (say, your child) invests the loan's proceeds wisely, he or she will have something left over after repaying the lender (say, you). This net gain acts like a tax-free gift to the borrower. Example: In June, 2009, Mom loans $400,000 to her daughter and son-in-law to purchase a home. In this real estate market, the couple is able to buy a great house. Mom structures the loan with a thirty year amortization, but with a balloon payment due at the end of nine years. Because the couple was able to lock in an interest rate of just 2.25% over the next nine years instead of the 5% offered by their bank, the couple will save nearly $11,000 in interest costs the first year alone, while reducing their monthly payments from $2,147 to $1,529. The young couple will profit as long as the home appreciates by more than the modest cost of interest. To further reduce the cost of the loan, and put even more potential profits in her kids' pockets, Mom might use another estate-planning technique. She and her husband can use the $13,000 each is able to give tax-free to their daughter and son-in-law every year to pay down the loan's principal. (See Outright Gifting, below). By reducing the size of the loan, this tactic would slash the total amount of interest the young couple will owe on this debt. By helping the couple retire its $400,000 debt to her, Mom will also reduce her estate by as much as $400,000. That can cut her estate tax bill by $180,000. Specifics. Family loans are governed by Section 7872 of the Internal Revenue Code (the "Code"). This section of the Code generally deals with interest-free or "below-market" loans between related taxpayers. For family loans, it provides that a below-market loan will be treated as a gift loan, resulting in the imputation of a gift from the lender to the borrower in an amount equal to the foregone interest. In addition, a below-market loan results in a deemed payment of interest by the borrower to the lender for income tax purposes. Section 7872 not only spells out the consequences of a "below-market" loan, but also requires the IRS to set the "market" rate for loans each month. With IRS interest rates at historically low levels, there is no need for families to make "below-market" loans. A loan at the market rate set by the IRS works just fine. I. Term Loans. A term loan will not be treated as a gift loan as long as the interest rate applicable to the term loan equals or exceeds the Applicable Federal Rate promulgated by the IRS as of the day on which the loan was made, compounded semi-annually. The interest rate depends on the term of the note. For a promissory note with a maturity of three years or less, the federal short-term rate must be used. For a promissory note with a maturity in excess of three years but not more than nine years, the federal mid-term rate must be used. For a promissory note with a maturity in excess of nine years, the federal long-term rate must be used. These rates are the floor used to avoid any adverse results. IRC § 7872(e). 2. Demand Loans. A demand loan will not be treated as a gift loan, provided that the interest rate applicable to the demand loan is at least equal to the short-term Applicable Federal -3- EFTA01103626 Rate for the period in which the loan is outstanding, compounded semi-annually. IRC § 7872(O(2). 3. Note Terms. With regard to a term loan, to ensure that the IRS will respect the validity of the loan, the note evidencing the loan should ideally contain a fixed maturity date, a written repayment schedule, a provision requiring periodic payments of principal and interest and a provision regarding collateral. In addition, actual payments on the note should be made from the junior family member to the senior family member. For demand notes, if the senior family member never demands payments or if the junior family member does not have the ability to satisfy the loan, an inference can be made that the senior family member never intended the loan to be repaid. If the IRS does not respect the note, the transfer of the loan proceeds from the senior family member to the junior family member could be reclassified as a taxable gift as of the date of the loan. See Estate of Lillie Rosen v. Coniner, T.C. Memo 2006-115. 4. Impact of Interest Rates. If the property acquired with funds loaned from the senior family member to the junior family member appreciates at a rate faster than the prevailing interest rate and/or earns income in excess of the prevailing interest rate, then the loan effectively shifts value estate-tax free from one generation to the next. 5. Income Tax Issues. Tax implications for family loans must include consideration of federal (and state) income taxes on senior and junior family members. More specifically, the senior family member will generally have interest income to recognize as part of his or her taxable income, but the junior family member will generally not be able to deduct the interest paid from his or her taxable income unless the interest constitutes investment interest or home mortgage interest to the borrower. IRC § 163(h). 6. Death During Term. If the lender dies during the term of the loan, any unpaid balance will generally be included in the taxable estate of the lender. Note, however, that the value of the note is generally limited to the value of the collateral and the net worth of the borrower, without regard to any amount the borrower might inherit. See Est. of Elizabeth v. Harper., 11 TC 717 (1948); TAM 9240003 ($235,000 note owed to estate of uncle by insolvent nephew properly valued at substantially less than face value despite testamentary forgiveness of debt and $1 million bequest to nephew from uncle). If the junior family members have paid back any portion of the loan, the repaid funds will likewise be included in the lender's estate. It is the earnings from the loan proceeds in excess of the IRS interest rate that escapes estate taxation. Of course, the senior family members may use their gift tax annual exclusion to reduce the outstanding principal balance, thereby reducing estate inclusion at the time of their deaths. 7. Use with Grantor Trusts. To ameliorate the impact of income taxes, instead of a loan from senior family members to junior family members, senior family members could create a "intentionally defective" grantor trust for the benefit of junior family members and make a loan to the grantor trust. a. Borrower Credit-Worthiness. If the senior family member wants to loan money to a grantor trust, the grantor trust should be "seeded" with sufficient assets to make the trust a credit-worthy borrower (most commentators suggest a 10% seed money gift). Without this equity, the IRS might doubt the trust's ability to repay the loan, especially if the trustee _4_ EFTA01103627 invests the loan proceeds in illiquid or volatile investments. If the loan can't be repaid, the IRS might instead treat it as a gift. b. Non-Tax Aspects. It may be advisable for the grantor trust to be structured as a so-called "perpetual" or "dynasty" trust for the senior family member's descendants, leaving giving the trustee broad discretion to make distributions, rather than mandating any distributions. These trusts have substantial non-tax benefits. For example, if the client's descendants have problems with creditors, the creditors can attach assets that are distributed to them outright. In contrast, trust assets are generally exempt from attachment as long as the trust has "spendthrift" language. Similarly, a spouse of a descendant may become a creditor in a divorce situation. Outright distributions that are commingled with a spouse could be classified as community property, subject to division by a divorce court. Properly maintained trust assets cannot be commingled. Also, outright distributions may allow assets to be given away to individuals outside of the senior family member's bloodline. With a trust, the senior generation can choose to put limits on the people that will benefit from the gift. In addition, upon the death of a beneficiary, if an outright distribution is made, the beneficiary's share would be included in his or her gross estate for federal estate tax purposes. If, however, the grantor trust is exempt from the generation-skipping transfer tax ("GSTI") (i.e., the senior family member's available GSTT exemption has been allocated to the grantor trust), these assets can remain in trust and pass to trusts for even more junior family members without being subject to estate or generation- skipping transfer tax. 8. Rates and Yield Curves. Although short-term interest rates are normally lower than the mid-term and long-term rates, there are times when the mid-term interest rates and the long- term interest rates are less than the short-term interest rates. Furthermore, there are periods of time where the spread between short-term rates and long-term rates is minimal. As a result, it can be advantageous to try to time the loans to coincide with favorable interest rates. The IRS generally publishes rates for the following month about ten days in advance. So, for example, they published the September, 2009 rates on August 18ih. Therefore, near the end of a month, planners can preview upcoming rates to time a transaction to take advantage of the most favorable rates. 9. Current Rates. The current annual interest rates (for September, 2009) are as follows: a. Short-term annual interest rate — 0.84% b. Mid-term annual interest rate — 2.87% c. Long-term annual interest rate — 4.38% Rev. Rul. 2009-29, 2009-37 IRB . 10. Using A Balloon Note. As long as the interest rate on the note is less than the return earned by the borrower, it may make sense to maximize the loan for as long as possible. The more principal that is paid back during the term of the note, the less wealth transfer potential there is from senior family members to junior family members. As a result, it may be best to draft the note to provide for the payment of interest only during its term, with principal due only at maturity. While the unpaid principal balance will be included in the lender's estate if he or she dies before the loan is repaid, a note providing for interest-only payments lets junior family -5- EFTA01103628 members use funds as long as possible (and may provide more of an opportunity for senior family members to reduce the principal balance through annual exclusion gifts, if they choose to do so). 11. Payment at Maturity. Upon maturity, junior family members can either repay the loan or renegotiate the terms of the note. If interest rates decline during the term of the note, or if they are lower at maturity, it may be possible to renegotiate at a time when interest rates are favorable. To allow for this option, the promissory note should contain a provision which allows the outstanding principal balance to be repaid at any time without any penalty. See Blattmachr et al., "How Low Can You Go? Some Consequences of Substituting a Lower AFR Note for a Higher AFR Note," 109 J. OF TAXIN 22 (2008). B. Sale to An Intentionally Defective Grantor Trust. Although a popular trust strategy, a sale of an asset to an Intentionally Defective Grantor Trust, or IDGT, can be somewhat complex to explain and expensive to set up. Why bother? For one thing, the payoff is potentially greater than with other strategies. In addition, a sale to an IDGT can provide a tax- advantaged way to pass assets to children and grandchildren while keeping the value of the trust's assets out of the estates of junior family members, as well as out of the estates of senior family members. The Technique. An IDGT is a trust typically established by senior family members for the benefit of junior family members. Senior family members loan the trust money to buy an asset from the senior generation that has the potential to appreciate significantly. Many people use IDGTs to purchase family businesses or homes. Sales of interests in family limited partnerships are also popular. Most commentators agree that to be a credit-worthy borrower, the IDGT must have some assets in excess of the borrowed funds with which to repay the note. "Seed money" in the amount of 10% of the purchase price is typically recommended. In times of low interest rates, some estate planners consider IDGTs to be the ultimate freeze technique. They combine the interest rate benefits of intra-family loans with the discounting benefits of lifetime gifts. As with outright gifts, this technique works especially well if the sale can be consummated when market values are depressed. Example: Clint has established a family limited partnership that holds $12.5 million in cash and securities. Clint has recently had his interest appraised at $10 million (a 20% discount). In August, 2009, Clint establishes an IDGT for the benefit of his children. To buy the limited partnership interest from Clint, the IDGT will need some cash, so Clint gives the trust $1 million. Why $1 million? That's the amount he's allowed to give away free of gift tax during his lifetime. Because Clint wants this trust to endure for generations, he will also use some of the $3.5 million GST exemption he's allowed to shelter from the GST tax. With $1 million in cash, plus a $9 million loan from Clint, the trust will buy Clint's limited partnership interest valued at $10 million. The note from the IDGT to Clint bears interest at the Applicable Federal Rate, which for loans of more than 9 years was 4.26% in August, 2009. Of course, the goal is for the trust's assets to earn enough to cover the loan, while leaving something more for Clint's children and grandchildren. Based on past performance, Clint expects the partnership's investments to appreciate at least 8% a year—that would be more than enough to make the 4.26% interest payments. Over the next 20 years at 8%, Clint can expect -6- EFTA01103629 that the $12,500,000 owned by the partnership will to grow to around $41 million, even after paying out $383,400 per year to cover the interest on the note. At the end of the 20-year term, the trust will repay Clint his $9 million. After repaying the note, the trust will hold nearly $32 million, which will be available to Clint's children and grandchildren without having paid any gift or estate tax. Because IDGTs are grantor trusts, Clint won't owe any income tax on the gains he realizes by selling his limited partnership interest to the trust, nor will he have to pay income tax on the interest payments he receives. As far as the IRS is concerned, it's as if Clint sold the asset to himself. Clint will, however, owe income tax on the partnership's earnings. In this example, though, the interest paid to Clint will more than offset his tax liability so long as the effective tax rate (earned through a combination of dividends, capital gains, and other income) is less than 22% or so. There are plenty of caveats. Neither the tax code nor case law specifically addresses IDGTs, and the IRS has been known to challenge them on occasion. Perhaps the biggest risk is that of the trust going bust. If its assets decline in value, the IDGT will have to come up with the cash to pay Client. It can always use the money Client gave it—the $1 million. If that happens, Client won't be able to reclaim his $1 million gift tax exemption. It will have been wasted. Specifics. I. Structure of the IDGT. The key to the success of an IDGT transaction is the creation by senior family members of an irrevocable trust that (i) successfully avoids estate tax inclusion under Sections 2036 through 2038 of the Code; but (ii) which will be treated as a grantor trust for income tax purposes under Sections 671 through 677 of the Code. The so-called "string statutes" (statutes that cause trusts to be ignored if the grantor retains too many "strings") are similar in the income and transfer tax areas, but they are not the same. There are a number of "strings" on the list for grantor trusts in the income tax code that have no counterpart when it comes to estate and gift taxes. As a result, clients can create an IDGT, which is ignored for income tax purposes, but which will be given full effect for gift and estate tax reasons. When the senior family members sell limited partnership interests or other appreciating assets to the IDGT (typically for an interest-only promissory note with a balloon payment), the sale is ignored for federal income tax purposes. See Rev. Rul. 85-13, 1985-1 CB 184. 2. Seeding of Trust. The IRS has offered no official guidance, but most practitioners recommend that the trust have "equity" of about 10% of the purchase price. In most cases, clients provide this "seed" money by making a taxable gift of cash or assets to the trust, typically sheltering the gift from tax by using some of their unified credit. A gift tax return is filed, reporting both the seed gift and the sale, thereby starting the gift tax statute of limitations running on the values used in the sale. Some clients can use an existing grantor trust which already has sufficient assets to provide the seed money. Sometimes it may be impractical for a trust to be seeded with the appropriate level of assets (i.e., the senior family member is unwilling to incur a sizable taxable gift). Instead of (or in addition to partially) seeding the IDGT, the beneficiaries could personally guarantee the promissory note. However, the beneficiaries should independently have sufficient net worth to cover the amount of the guarantee. There is an element of risk with the guarantee approach because the IRS might take the position that the guarantee constitutes a gift from the beneficiary to the grantor trust. One way to reduce this risk is to have the trust pay the guarantor(s) a reasonable fee for the guarantee. See Hatcher & -7- EFTA01103630 Manigault, "Using Beneficiary Guarantees in Defective Grantor Trusts," 92 J. TAX'N 152 (Mar. 2000). 3. Impact of Interest Rates. When interest rates are low, sales to IDGTs become very attractive, since any income or growth in the asset "sold" is more likely to outperform the relatively low hurdle rate set by the IRS for the note. 4. Servicing the Debt. With regard to servicing the interest payments on the promissory note, the sale to the IDGT works especially well when rental real estate or other high cash-flow investments are sold. If these assets are contributed to a family limited partnership prior to being sold to the IDGT, a distributions of partnership rental or investment income to the IDGT can be used to service the note payments. 5. Grantor Trust Implications. Senior family members must thoroughly understand the notion of a grantor trust. They should understand their obligation to pay tax on the IDGTs income, even if the IDGT does not have cash flow to make interest payments (or if the interest payments are insufficient to service the debt or pay these taxes). 6. Death of Note Holder. As with an inter-family loan, if the lender dies during the term of the loan, any unpaid balance will generally be included in the taxable estate of the lender. Again, however, the value of the note is generally limited to the value of the collateral and the net worth of the borrower, without regard to any amount the borrower might inherit. See Est. of Elizabeth v. Harper., 11 TC 717 (1948); TAM 9240003. If the grantor dies before the note is paid in full, or if grantor trust treatment is otherwise terminated before the note is paid off, there may be adverse income tax consequences, including recognition of gain on the sale, and future recognition of interest income on the note payments. See Madorin v. Comm'r, 84 TC 667 (1985); Treas. Reg. § 1.1001-2(c), Example 5; Rev. Rul. 77-402, 1977-2 CB 222; Cf. Estate of Frame v. Comm'r, 93-2 USTC 1 50,386 (8h Cir. 1993) (gain on SCIN recognized by estate of payee upon death of note holder); Peebles, "Death of an IDIT Noteholder," TRUSTS & ESTATES (August, 2005), p. 28. 7. Benefit to Heirs. The property in the IDGT in excess of the note obligation passes to the ultimate beneficiaries (typically junior family members, either outright or in further trust) with no gift tax liability. This is the goal of a sale to an IDGT. If the contributed assets grow faster than the interest rate on the IDGT's note, the excess growth passes to the IDGT beneficiaries with no additional gift or estate tax. With a sale to an IDGT, the IRS requires that the gift tax consequences be evaluated when the assets are sold in exchange for the note—not when the note is paid off. 8. GST Issues. Unlike a GRAT (discussed below), the senior family member can allocate MT exemption to the seed money contributed to the IDGT. As a result of that allocation, the IDGT has a GST inclusion ratio of zero, which means that all of the assets in the IDGT (both the seed money and the growth) can pass on to grandchildren or more remote generations with no additional estate or gift tax. This multi-generational feature can make a sale to an IDGT a much more powerful transfer tax tool than other similar wealth-shifting techniques. 9. Selling Discounted Assets. Appreciating or leveraged assets are an ideal candidate for sale. As noted in the example above, use of lack-of-marketability and minority interest discounts -8- EFTA01103631 can provide more bang for the buck. The trust pays interest at favorable rates on the discounted value, while the underlying assets grow at full market rates. C. Grantor Retained Annuity Trusts. With a grantor retained annuity trust, or GRAT, heirs typically won't receive quite as much as they would with an IDGT. But GRATs, are also less risky, in part because they can be setup to completely avoid any gift tax consequences. Moreover, because the Code sanctions them, there is very little risk of running afoul of the IRS. In fact, GRATs have been so successful that the IRS has asked Congress to impose some restrictions on their use, for example, requiring them to have a term of at least ten years. See U.S. Treasury, "General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals," p. 123 (May 11, 2009) (commonly called the "Greenbook"), which can be found at hap://www.treas.gov/offices/tax-policyflibrary/gmbk09.pdf. So far, Congress has not acted on this request. The Technique. In many ways, GRATs resemble loans. As with a loan, they mature within a specified number of years. As a result, any money (or assets) that the client puts into the GRAT will be returned by the time the trust expires. So, what's in it for the client's heirs? Assuming all goes well, a big chunk of the earnings will go to them, free of gift and estate taxes. Because a successful GRAT is one that appreciates a lot, it's best to select an asset that the client thinks is on the verge of a rapid run-up. The classic example: shares in a privately held company that is likely to go public. These days, beaten-down shares are also good candidates. In reality, any asset that the client expects to rise in value more rapidly than the IRS interest rate works—the higher the appreciation, the better. Example: Greta owns all of the stock in her closely held business. Although there is no deal on the table, some potential buyers have expressed an interest in buying the company for $15 million. Nevertheless, a business appraiser valued a one-third interest in the company at $3 million (applying traditional lack-of-marketability and minority interest discounts). Greta decided to transfer a third of her stock to a GRAT, retaining the right to get back the $3 million of value she put into the trust in equal annual installments. Greta will also receive a little extra— an annual interest payment designed to make sure she takes back what the IRS assumes the stock will be worth in 10 years, when the trust expires. To estimate the rate at which investments in these trusts will grow, the IRS uses the so-called "7520 rate," which is based upon 120% of the monthly mid-term Applicable Federal Rate. When Greta set up her GRAT in June, 2009, the 7520 rate was 2.8%. (In August and September of 2009, the rate was 3.4%) If Greta's stock appreciates by more than the 2.8% annual hurdle rate, the excess profits will remain in the trust and eventually go to her two children. In fact, if the sale eventually goes through, the trust will hold $5 million (remember that Greta only gave away one-third of her stock). If that happens, nearly $2 million in value will pass to the kids with no gift or estate tax. If the sale doesn't happen and the stock doesn't increase in value, the trust will simply give Greta her stock back over the term of the trust. In that event, Greta may have wasted some money on professional fees (the attorney, accountant and appraiser fees she spent to set up the trust, report the gift and value the stock). But the GRAT will simply pay her back what's left of her investment by the time it expires—no one is required to make up for a shortfall. -9- EFTA01103632 Clients with diversified investment portfolios might want to use a separate trust for each class of investments they own. For example, a client might set up three $1 million GRATs—one composed of U.S. small-cap stocks, another of commodities, and a third of emerging-markets stocks. If any of these three asset classes outperform the 7520 rate, the client will have effectively shifted wealth. Those assets that underperform will simply be returned to the client, perhaps to be "re-GRATed". Had the client instead combined these three volatile investments into a single GRAT, he or she would run a risk that losses on one might offset gains on another. Many advisers favor limiting GRAT terms to as few as two years. That way, if a particular investment soars, the client will be able to get the gains out of the GRAT before the market cycles back down again. As with IDGTs, GRATS are grantor trusts. As such, they allow the grantor to pay capital-gains and income taxes on the investments in the GRAT on behalf of his or her heirs. Because the IRS doesn't consider such tax payments a gift, they are another way to transfer wealth to the next generation free of gift and estate taxes. As with any estate planning technique, there are drawbacks. Because GRATs have to pay higher interest rates than short-term and medium-term family loans, they pass along slightly less to heirs. In addition, GRATs must make fixed annual payments. Unlike a sale to an IDGT, the grantor can't defer the bulk of the payments for years into the future by using a balloon note. The biggest risk with a GRAT is that the client might die before the trust ends. In that situation, it's as if the GRAT never existed: Its entire value—including returns—is generally included in the client's estate and subject to estate tax. Specifics. 1. Structure. In the typical GRAT, a senior family member transfers assets to a trust, which provides that he or she will receive an annual annuity payment for a fixed number of years. The annuity amount can be a fixed dollar amount, but most estate planners draft the GRAT to provide for the payment of a stated percentage of the initial fair market value of the trust. That way, if the IRS challenges the initial valuation, the payment automatically adjusts. As discussed below, most GRATs are "zeroed out"—that is, payments are usually set so that the actuarial value of the interest passing to the heirs is very close to zero. Once property is contributed to the GRAT (i) no additional assets can be contributed; and (ii) the GRAT cannot be "commuted" or shortened by accelerating payments. 2. Setting the Annuity. The annuity can be a level amount, or an amount that increases each year, although the IRS regulations limit the amount of each annual increase to not more than 20% per year. By providing for an increasing annuity payment each year, payments can be minimized in early years leaving more principal to grow in the GRAT for a longer period of time. If the asset consistently grows in value at a rate that exceeds the GRAT interest rate, retaining these extra funds will allow the principal to generate additional appreciation. 3. Gift on Formation. Upon the creation of the GRAT, the grantor is treated as making a gift to the ultimate beneficiaries equal to the initial value of the trust assets, reduced by the present value of the annuity payments retained by the senior family member. Since a GRAT results in a gift of a future interest, no annual exclusion can be used to shelter the gift tax. As a result, taxpayers who set up GRATs must file gift tax returns to report the transfer. The present -10- EFTA01103633 value computation of the retained annuity is based upon the term of the GRAT and the Section 7520 rate in the month that the GRAT is created. Fortunately, the IRS is bound by the actuarial computation performed in the month the GRAT is created. They can't come back and the end of the GRAT term and re-assess how the GRAT actually did to measure the gift tax. 4. Impact of Interest Rates. The common wisdom is that GRATs work best in times of low interest rates and depressed markets. This notion is based upon the fact that the lower the Section 7520 rate, the lower the annuity payments need to be to zero out the GRAT. As a result, at the end of the annuity term, more assets will be available to pass to the ultimate beneficiaries gift tax free. Surprisingly, studies have shown that for short-term GRATs, current interest rates have very little impact on the success rate of the GRAT. Instead, GRATs work best when the value of the assets contributed to the GRAT are depressed and rebound in the short term to far exceed their value at the time of contribution. In fact, one study showed that the success of short-term GRATs are impacted only about 1% by the Section 7520 rate, 66% by first-year growth, and 33% by second-year growth. See Zeydel, "Planning in a Low Interest Rate Environment: How Do Interest Rates Affect the Calculations in Commonly Used Estate Planning Strategies?" 33 ESTATES, GIFTS & TRUSTS J. 223, 226 (2008). 5. Zeroed-Out GRATs. The most popular form of GRAT involves a short-term, "zeroed out" GRAT, in which the term of the GRAT is limited to no less than two years, and the present value of the retained annuity amount is structured to nearly equal the amount transferred to the GRAT. This approach produces a very small (near zero) taxable gift. As noted earlier, the IRS would like to see Congress require longer term GRATs, and limit the payments so that the value of the remainder interest is at least 10% of the value of the initial contribution. If the senior member survives the annuity term, none of the GRAT assets will be includible in his or her gross estate for estate tax purposes. 6. Death During GRAT Term. If the senior family member dies during the annuity period, the senior family member's estate will include the lesser of (i) the GRAT assets at the date of death; or (ii) the amount necessary to yield the remaining annuity. See Treas. Reg. §§ 20.2036-1(c), 20.2039-1(e); T.D. 9414 (7/14/08). In many cases, the amount necessary to yield the remaining annuity is very close to the entire value of the GRAT, so virtually the entire GRAT value gets included in the estate of the deceased senior family member. 7. Payments in Kind. The annuity does not have to be paid in cash. Instead, it can be paid "in kind" (i.e., with a portion of the assets initially contributed to the GRAT). However, if the GRAT assets are rapidly appreciating, a return of these assets creates a "leak" in the freeze potential of the GRAT. One partial solution to this "leak" is to have the grantor contribute the distributed assets into a new GRAT. The GRAT must expressly prohibit the use of a promissory note to make the GRAT payments. 8. Benefit to Heirs. At the end of the annuity period, the property remaining in the GRAT (after paying the senior family member the annuity) passes to the ultimate beneficiaries (typically junior family members, either outright or in further trust) with no further gift tax liability. This is the goal of a GRAT, and why highly appreciating assets work best. If the contributed assets grow faster than then GRAT interest rate, the excess growth passes to the GRAT beneficiaries. Remember, the IRS requires that the gift tax consequences be evaluated when the GRAT is created—not when the GRAT term comes to an end. -11- EFTA01103634  9. GST Issues. Unfortunately, the senior family member cannot allocate GSTT exemption to the GRAT until the end of the GRAT term (i.e., the end of the estate tax inclusion period or "ETIP"). See IRC § 2642(f). Therefore, the senior family member cannot leverage the GSTT exemption by allocating it to the GRAT property before it appreciates in value. (To circumvent the ETIP rules, some practitioners have suggested that the remainder beneficiaries of the GRAT could sell their remainder interest to a GMT exempt dynasty trust, from which distributions can be made to future generations free of transfer taxes; however, there are no cases or rulings approving this sort of transaction). The ETIP rules mean that GRATs do not allow for efficient allocation of GSTT exemption. Therefore, GRATs are typically drafted to avoid the imposition of GSTT. For example, children can be given a "conditional" or standard general power of appointment. Naturally, if the GRAT assets are expected to continue to appreciate after the GRAT term ends, GSTT exemption can be allocated to the trust, based upon the fair market value of the assets retained by the trust at the end of the GRAT term. 10. Short-term v. Long-term GRATs. As indicated above, the use of short-term (i.e., 2- year) GRATs have typically been more popular than using longer term GRATs. The reasoning behind the preference for short-term GRATs is twofold. First, using a short-term GRAT reduces exposure to the risk that the senior family member will die during the term, which, as stated above, would cause all or a portion of the value of the GRAT assets to be included in the senior family member's gross estate. Second, a short-term GRAT minimizes the possibility that a year or two of poor performance of the GRAT assets will adversely impact the overall effectiveness of the GRAT. When funding a GRAT with volatile securities, a series of short-term GRATs typically perform better than a single long-term GRAT. Notwithstanding the benefits of short- term GRATs illustrated above, in times of low interest rates, a longer term GRAT may be more desirable because it allows the senior family member to lock in a low 7520 rate for the duration of the GRAT term. See Melcher, "Are Short-Term GRATs Really Better Than Long-Term GRATs?" 22 ESTATE PLANNING 23 (2009). II. Insuring the GRAT. As mentioned above, if the senior family member dies during the annuity term, all or a portion of the GRAT assets will be included in his or her gross estate. In that event, the G