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3 Estate Planning Strategies That May Die Soon

Posted by Michael Kitces on Wednesday, July 4th, 11:10 am, 2012 in Estate Planning

As Congress and the White House continue to search for revenue to close the gap on the US fiscal deficit, numerous estate planning strategies - especially for high net worth clients - are coming under attack. Recent legislative or budget proposals have threatened the use of both Grantor Retained Annuity Trusts (GRATs) and Intentionally Defective Grantor Trusts (IDGTs), both popular strategies to "freeze" the value of hopefully-rapidly-appreciating assets for transfer to the next generation. In addition, the new rules on portability - currently temporary, but likely to become permanent at some point in the future - threaten the even more popular and common estate planning strategy, the bypass trust. While the exact timing for when these new rules become permanent law, the reality is that change appears to be coming. As a result, some clients may wish to accelerate the implementation of strategies before the laws change... while others may prefer a wait-and-see approach before deciding what estate planning strategies to implement at all!

The inspiration for today's blog post is a recent discussion I had with a reporter regarding coming trends and changes in the tax law, with a focus on what might be changing over the next few years, given both perceived abuses of the tax laws by the wealthy and a general push from Congress for more revenue. While the focus of the discussion was on income tax laws, the reality is that changes are also coming to the estate planning world as well.

Don't Take GRATs For Granted

The first strategy likely to bite the dust in the coming years is the Granted Retained Annuity Trust (or "GRAT" for short). The basic approach is as follows:

Jeremy transfers $5,000,000 of closely held stock to a GRAT that will distribute its assets to his children in 3 years, in exchange for payments of approximately $1.7 million per year for the next 3 years. At today's interest rates of less than 1%, the present value of $1.7 million per year for three years is almost the same as the $5,000,000 of stock transferred; as a result, Jeremy will report only a gift of a few thousand dollars (the difference between the $5 million transferred to the trust and the slightly-less-than-$5 million received back from the trust in annual payments for the next 3 years). If the assets in the trust merely grow at approximately 1%, the entire transaction is a wash. However, if the company is sold within the next three years and the shares turn out to be worth $8,000,000, then even after paying out the $1.7 million per year for 3 years, there will be nearly $3,000,000 left over in the trust, that flows to the children as beneficiaries - entirely free from gift (or estate) taxes! More generally, as long as the property was fairly valued in the first place, any appreciation in excess of the required discount rate will flow gift and estate tax free to the beneficiaries; except in today's environment with ultra-low tax rates, it's remarkably easy to beat the discount rate and accrue benefits to the next generation! At worst, the property will fail to appreciate enough - and in that scenario, the grantor simply repeats the strategy again in three years once the property has been paid back in annuity payments!

The GRAT strategy is currently entirely permissible under the tax law, but legislators view the strategy of repeatedly establishing rolling GRATs that generate little or no current gift tax liability (because the retained annuity almost perfectly offsets the stock transferred) as being abusive; the situation essentially becomes "heads, the client wins, and tails, the client doesn't lose and just tries to flip heads again" as it is repeated over time.

The "solution" that has been proposed several times, most recently discussed in the so-called Treasury Green Book (which provides a detailed explanation of the President's budget proposals for the upcoming year), would apply a minimum term of 10 years to a GRAT. Technically speaking, this would not eliminate GRATs - in fact, it would further support their use, albeit with a 10-year minimum term. The caveat is that from a practical planning perspective, a 10-year term is often unappealing, in a world where most GRATs are designed to run for only 2-3 years. The longer term is problematic because if the grantor dies during the term, the entire value of the trust is still included in his/her estate, making the strategy a moot point. Furthermore, with a 10-year term, the property itself is tied up for a much longer period of time, and the ongoing cash flows coming back from the trust are much smaller, making the strategy far less appealing.

Ultimately, GRATs may still be used even with a minimum 10-year term implemented. But they will likely be used far less frequently than they are today with such a long minimum time horizon.

IDGT Strategies Rendered Useless

The next estate planning strategy that may be struck down by legislative changes in the coming years is the use of Intentionally Defective Grantor Trusts (also known by their acronym as "IDGTs"). The basic approach of the IDGT strategy is as follows:

A grantor might gift $2,000,000 to an IDGT (using a portion of the individuals' lifetime gift tax exemption amount), and then use the money to finance the installment note payments (or sometimes a self-cancelling installment note, or "SCIN") to purchase a $10,000,000 share of closely held business (by the time the $2,000,000 of cash is used up making installment note payments, the business should have distributed enough income itself to sustain the payments further). Since the sale is between a grantor and the grantor's own trust, the sale would not be taxable. The installment note pays interest back to the grantor at the Applicable Federal Rates (AFRs) - which are quite low in today's interest rate environment - while the business generates a return between dividends and appreciation that hopefully exceeds the interest rate. To the extent the business grows faster than the installment note's interest rate, the grantor has effectively traded a rapidly-appreciating asset outside the estate for a slow-growing asset - the installment note payments - that come back into the estate; at the grantor's eventual death, the IDGT is excluded from the grantor's estate, and the entire assets of the trust will distribute estate-and-gift-tax-free to the trust beneficiaries, and only the value of the note payments (either already paid and held in the estate, or those still due) are included in the grantor's estate (which may be none in the case of a SCIN). With a rapidly appreciating business (or some other similar high-appreciation asset), the amount of money removed from the estate can be very significant over the span of many years of growth (especially since the assets inside the trust effectively grow "tax free" because the taxes are being paid from the grantor's assets, further reducing his/her estate, not the trust's assets). And all it cost the grantor to get all the "excess" future growth of a $10,000,000 highly-appreciating asset out of the estate was a $2,000,000 "seed money" gift (which would have applied against the estate tax exemption in the future anyway)!

As discussed previously on this blog, the use of IDGTs was also targeted in the latest Treasury Green Book. The key proposed change would cause the assets of the IDGT to be included in the grantor's estate simply because the trust is a grantor trust; however, if the IDGT is in the grantor's estate, the entire purpose of the strategy is moot, as there's no value to transferring property to the business that can appreciate more rapidly than the installment note interest rate, if the whole property will be included in the grantor's estate anyway! The IDGT would cease to be an "estate freezing" technique at all... unless the trust was not  a grantor trust; this would be problematic, though, as without grantor trust status, the sale of property to the IDGT in exchange for an installment note would itself be taxable, and the trust would also be responsible for its own tax liabilities, further slowing the trust's growth.

For the time being, the IDGT strategy is still available, and the proposed changes indicate that they would only apply prospectively (which means IDGTs established before the new law would be grandfathered). Nonetheless, given estimates that the IDGT proposal could generate $1 billion of tax revenue, and would only adversely impact the ultra-wealthy who use the strategy (who are being targeted by many other tax proposals as well), the days of the IDGT may be numbered.

Portability Bypasses The Bypass Trust

The last estate planning strategy that may become moot in the coming years is the Bypass Trust, thanks to current laws established under the Tax Relief Act of 2010 that have made the estate tax exemption "portable" between spouses, as shown in the example below:

Harry dies and leaves Harriet with $5 million of assets, which brings her total estate to $8 million when added to her own property. If Harriet subsequently passes away, her $8 million of assets will exceed the current $5.12 million estate tax exemption, resulting in an estate tax liability of $1,008,000 at a top 35% tax rate. Had Harry left his $5 million to a bypass trust that is excluded from Harriet's estate, then at her subsequent death, she would own only $3 million of her own assets, avoiding any estate tax liability and saving her heirs over $1 million!

With portability, however, when Harry dies and leaves his $5 million to Harriet, he also bequeaths his own $5.12 million estate tax exemption, bringing Harriet's total exemption up to $5.12 (Harry's) + $5.12 (Harriet's) = $10.24 million total. As a result, even if Harriet subsequent passes away with a combined estate of $8 million, her heirs face no estate tax liability given the total $10.24 million exemption, thanks to portability! 

Under current law, portability is scheduled to expire at the end of 2012, making it unreliable to count on its use in the future. However, there is a high probability that portability will ultimately become permanent; in fact, as discussed last week on this blog, the Treasury just released portability Proposed Regulations that would apply in 2012 and beyond, if/when/as Congress ultimately makes portability permanent.

Once portability is made permanent, bypass trusts will become the exception to the rule, not the standard for estate planning, and will generally be applicable only to very high net worth clients who still want to use a bypass trust to "freeze" the future growth of assets (to keep from going over the $10.24 million exemption limit at some point in the future), and/or to use a trust more generally to receive assets for beneficiaries for asset protection purposes. Nonetheless, given recent estimates from the Heckerling Institute that the estate tax may apply to as few as 4,000 estates per year across the nation, bypass trust planning will be unnecessary for the overwhelming majority of clients.

Timing Is Uncertain

While the timing for these strategy changes is uncertain - portability may be extended at the end of the year, but it's not clear when it will be made permanent, and it's even less clear when Congress may ultimately pass laws to increase the required time period on GRATs and change the estate tax treatment of IDGTs as grantor trusts - the fact remains that Congress has tipped its hand about the direction of estate tax law changes in the coming years. Thus, while it's not clear exactly when the puck will get there, it's pretty clear where the puck is heading.

So what do you think? Do you use any of these strategies with your clients? Are you considering any changes to your planning approach in light of these proposals? Are you trying to complete any GRATs or IDGTs sooner rather than later, before new rules get implemented? Is portability impacting your estate planning already?

  • Evan Guthrie

    We will find out soon enough if these three strategies will remain. Estate planning will be very interesting in the coming years. Thanks for highlighting and breaking down these strategies.

  • yousef

    how do you solve this

    Estate planning students have been studying the concept of estate planning in the context of highly appreciated assets (low cost basis) – and are exploring the tax ramifications of gifting, inheritance, or sale of the asset. In particular, a client, Harold Johnson is retiring from Homestead Industries in one month and 25 percent of his $2 million portfolio comes from performance shares he has received over time from Homestead Industries. Mr. Johnson is a highly risk-averse investor and is particularly concerned about diversification of his assets.
    Provide and describe the various strategies available for consideration for Mr. Johnson and the resulting potential outcomes from each strategy. In such, the three angles of investment planning, taxation and estate planning should be clearly demonstrated in the potential outcomes.”

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Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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