Wilsey Estate Planning Blawg

FLP-GRAT: An Awesome Combination

Last post, I described the way a Grantor Retained Annuity Trust (“GRAT”) works. Today, I want to explain how a client can leverage their $1,000,000.00 lifetime gift tax exemption with a Family Limited Partnership (“FLP”) and a GRAT. The combination works like this.

The client will place a significant amount of assets into a FLP (please review my November 3, 2006 article on FLPs if you have any questions on their use). These partnership interests will be subject to a significant discount because of the lack of marketability and other discounts. The client will then gift between 95% and 99% of those assets to a GRAT. When the assets are valued in the GRAT, the annuity paid back to the grantor will be based on the discounted value, not the value of the underlying assets.

Let’s put some numbers to this. Client forms a FLP and places $1,000,000 of assets into such entity. The client receives an appraisal and values the assets at a 35% discount, or $650,000. These discounted assets are then placed into a GRAT for a period of 20 years. The GRAT is deemed to have received assets totaling $650,000, and therefore must pay an annuity of at least $35,815.00. The client will need to file a gift tax return on a gift of just $225,524.20, the value of the remainder. However, if this GRAT lasts the 20-year term, then the actual remainder going to the children, assuming a 12% return, will be $7,065,734.00! All for less than a quarter of the client’s gift tax exemption!

What the client has done is leveraged the use of their $1,000,000 exemption as much as possible to move assets outside of their estate and lower their estate tax burden. Using the above numbers, the use of the client’s entire $1,000,000 gift tax exemption could move up to $31,330,269.00 out of their estate, without incurring a dime of gift tax.

This strategy is very powerful, and should be considered with any wealthy client who is interested in reducing their estate tax burden as much as possible.

GRATs- Low Risk, High Return

For client with significant net worth, the Grantor Retained Annuity Trust, or GRAT, is one of the best techniques for passing assets to loved ones free from gift and estate tax. The best part is that for all the benefits, there is a very low amount of risk associated with the GRAT.

In a GRAT, the Grantor (the owner of the assets) transfers the property into the trust, and receives an annuity back from the trust each year for the duration of the trust term. The annuity must be set using an interest rate that is at least equal to or greater than the “hurdle rate” set by Section 7520 of the Internal Revenue Code. Then the Grantor has made a gift of the present value of the remainder value, and must file a gift tax return. However, the amount that actually passes to the Grantor’s loved ones will be much larger than the amount declared on the gift tax return.

Lets use some numbers. Say Joe Client has $1,000,000 that he wants to gift to his kids using a GRAT. He places the money into a GRAT, and uses the December 2006 7520 rate of 5.7% at his basis for the annuity. Joe will receive a yearly annuity payment of $57,000. Joe will be deemed to have made a  gift of $576,472.90, and will have to file a gift tax return to that effect. However, assuming the principal grows at an interest rate of 12%, the ACTUAL remainder at the end of the term will be $2,105,570.31 for his loved ones.

Since the 2000 tax court case of Walton v. Commissioner, a new use for GRATS has emerged that is even more low risk, and allows ALL of an asset’s appreciation to pass without ANY estate or gift tax. This is through the process of a “Zeroed Out Remainder”, and works as follows.

Joe Client takes the same $1,000,000, but now instead sets such a high annuity rate that the remainder is technically nothing. The rate chosen will be determined by the 7520 rate. In this case, the annuity will pay out 13.54% per year back to Joe. There will be no gift tax return filed because the present value of the remainder is 0. However, by the glory of compound interest, at the end of the trust term, there will be $744,069.24 left in the trust, despite the lack of taxable gift.

BUT BEWARE!!! In either example, if Joe were to die prior to the completion of the GRAT term, the whole value of the GRAT is pulled back into his estate. This is not really a penalty, it is just what would have happened had he never done the GRAT in the first place. In long term GRATs, the client should always purchase a term life insurance policy as insurance against dying during the term of the GRAT.

If your client wishes to get creative, they can avoid the much of the prospect of the GRAT contents being brought back into their estate by the use of successive 2-year “Rolling GRATs”. Here’s how it works

Joe Client puts his money into a 2-year Rolling GRAT. The GRAT pays Joe 543,921.50 each year. There is no gift because the GRAT is “Zeroed-Out”. However, at 12% interest, there will be a remainder of $101,286.42 at the end of the term. Joe does this again at the end of two years, and so on and son on. The advantage is that even if Joe dies during one of the GRATs, only the assets contained in that GRAT will be brought back into his estate, the previous GRATs will pass outside his estate. The second advantage is that if the stock market goes flat over a long period of time, Rolling GRATs will capture upswings outside of the Grantor’s estate. For example, from 1965 to 1973, the S&P 500 averaged a paltry 3.30% return. If the Grantor were to put $1,000,000 in an 8 year GRAT, the amount left to the Grantor's loved ones would be 0. However, using four successive 2-year GRATs, the Grantor would have caught the upswings in 1967 and 1971, and would be able to leave a remainder of $300,000.

For wealthy clients who are looking to get future appreciation out of their estates, a zeroed out GRAT just cannot be beat. It is both low risk, and high reward, and will likely become a huge part of estate planning, especially in this era of uncertainty with regard to the estate tax

The Latest on Family Limited Partnerships

            The latest victory by the IRS against heavily discounted family limited partnerships, Estate of Rosen v. Commissioner T.C.M. 2006-115, gives further insight into the proper structure of Family Limited Partnerships (or “FLPs”). Far from rendering FLPs illegal or dangerous, this ruling simply gives us further instruction on the proper use of FLPs, and how to make them less susceptible to IRS attack.

            A FLP operates as a vehicle to use a parent’s annual gifting exclusion (currently $12,000) and lifetime gift tax credit (currently $1,000,000) to make gifts to family members. However, these exemptions are leveraged by the fact that the gifts are discounted to reflect minority and lack of marketability discounts. For instance, if the underlying assets of a FLP are $1,000,000, and gifts made of partnership interests in the FLP are appraised to have a discount of 25%, then a 10% gift would be worth $75,000 rather than $100,000. The gifts act as a powerful tool to move assets out of a client’s estate and into the hands of their loved ones, free from estate tax.

            In Rosen, the decedent’s daughter, operating under a power of attorney, executed a FLP on behalf of her mother, who was suffering from dementia. The daughter transferred over 95% of her mother’s assets to the FLP. The daughter, acting under the durable power of attorney, began making significant gifts on behalf of her mother of Limited Partnership interest in the FLP to family members. The idea was to get much of the FLP interests out of the mother’s estate and into the hands of family members on a discounted basis.

After the transfer of the assets to the FLP, the mother still needed money to (1) pay living expenses and (2) provide annual gifts to her children and grandchildren. The family attorney recommended that the family get around this problem by having the FLP loan the mother the money.

            The court ruled that the entire FLP was includible in the decedent mother’s estate, because she retained the right to income, possession or enjoyment of the property in the FLP. This ruling is based on the premise that because the decedent put all of her assets in the FLP, and as such needed such loans to pay basic living expenses, there was a prearranged agreement to give the decedent assets as needed. The court focused on the fact that the decedent and her daughter were not really involved in the planning process, and that the family attorney basically drafted the FLP paperwork without their input. The court also ruled that the FLP had no legitimate business purpose other than the avoidance of tax.

            This ruling should not discourage FLPs, and should encourage clients that, if properly done, FLPs are still a legitimate choice for moving assets outside of estates. Here are some guidelines for making sure FLPs are respected:

1.      The FLP should have a legitimate business purpose. Examples include centralized management and asset protection. Neither element was present in the Rosen case.

2.      Family members should be involved with the drafting attorney in determining the terms of the FLP.

3.      Parents should retain sufficient assets outside of the trust pay living expenses.

4.      Parents should not receive distributions from the FLP other than those determined by their interest in the FLP. For instance if mom owns 75% of a FLP and the kids own 25%, then mom should get 75% of any distributions and the kids should get 25%

5.      Have assets other than marketable securities and cash. Clients with significant real estate holdings continue to be perfect candidates for a FLP.

6.      Maintain the formalities of the FLP. Make sure meetings are held, minutes are kept, and personal expenses are not paid by the FLP.

The point is that FLPs are useful estate planning devices, when properly done. The controversy, and the negative court cases all involve poorly planned FLPs. I am not aware of any case where a properly planned FLP has been successfully attacked by the IRS. If you have any questions about this, or any other estate planning topic, please call me at (858) 546-4377 or email me at wardwilsey@wilseylaw.com.

WARNING- Private Annuity Trusts

The IRS has struck what appears to be a fatal blow in the increasingly popular “Private Annuity Trust”.

As you are probably aware, a Private Annuity Trust has been used where the Client owns a piece of appreciated property with lots of built in capital gains. The idea is that the Client sells the property to a Trust in exchange for a “private” annuity. The annuity is termed “private” because is it paid by the trust, as opposed to a “commercial” annuity being paid by a company in the annuity business. The trust would pay the client a yearly annuity payment as consideration for the property. The idea was that the capital gains would be deferred over the lifetime of the seller, rather than due upon the sale of the property. The trust would then sell the property to a third party in order to pay the annuity.

However, the Department of Treasury and IRS have just issued proposed regulations that would end tax deferral on such transaction. Now, these regulations are just “proposed”, but should be followed until further notice to avoid potential adverse tax consequences. According to the Regs, capital gains tax will be deemed due immediately upon the sale of the property to the private annuity trust, rather than being deferred over the course of the annuity payments. This puts the Seller in the same position as if they had sold the property for cash and purchased a commercial annuity.

The result appears to be that if a seller sells property to a private annuity trust, capital gains tax will be due immediately, even though the Seller will receive payments over the course of their lifetime, and will not have immediate access to the funds. As you can imagine, this apparently makes Private Annuity Trusts worthless, and even potentially disastrous, as a method to save capital gains. These rules also make perfectly legitimate estate planning transactions involving Private Annuities much more difficult.

The bottom line is that you should alert your clients that private annuity trusts are no longer a viable option effective today. Apparently, these rules do not apply to Private Annuity Trusts completed prior to today, however, your clients with Private Annuity Trusts completed prior to today should contact their tax advisor to be safe. Please call me at (858) 756-7297 or email me at wardwilsey@wilseylaw.com if you have any questions, about this post or estate planning in general.