Top 10 estate planning strategies.

Every estate planner has an arsenal of favorite techniques to offer clients. Part I of this two-part article presents five methods: use of lifetime gifts, insurance trusts, dynasty trusts, qualified personal residence trusts and grantor retained annuity trusts. The article discusses how each works, the types of clients for which each is suitable and technical and planning considerations.

When meeting with clients to discuss estate planning, tax advisers generally have an assortment of ideas they consider, discuss and present. This article discusses 10 estate planning techniques. It is not intended to be an in-depth analysis of each topic; rather, it merely provides an overview of each concept, presents some of the more pressing (or troubling) technical considerations, discusses the type of client suitable for the concept and addresses some of the planning considerations involved.

One: Lifetime Gifts

Most taxpayers can accomplish significant estate planning objectives simply by taking advantage of lifetime giving. This includes making (1) maximum use of the annual exclusion, (2) lifetime use of the applicable exclusion amount and (3) lifetime taxable gifts.

How They Work

Annual Exclusion Gifts

Under Sec. 2503(b), every taxpayer can transfer up to $10,000 each year to any donee, free of estate, gift and generation-skipping transfer (GST) taxes.(1) There is no limit on the number of permissible donees. Annual exclusion gifts can be made to minors by using a Uniform Transfers to Minors Act account under applicable state law or a minor's trust that meets the requirements of Sec. 2503(c). If a client has a large family, significant wealth can be transferred and escape estate taxes, by making annual exclusion gifts.

Example 1: X, an individual, has three married children and five grandchildren. Giving $10,000 to each of these 11 donees, for a total of $110,000, saves X $60,500 in estate taxes if he is in the 55% estate tax bracket. If annual exclusion gifts are made in each of two calendar years, X can transfer $220,000, for a $121,000 tax savings.

The growth in value of the asset after the transfer date also comes out of the estate. If both X and his spouse are U.S. citizens or residents, X can double the gifts (to $440,000 over two years); his spouse can elect on a timely filed gift tax return to treat the gifts as made one-half by her (Sec. 2513), thereby doubling the benefit.

If other large gifts have been made or are contemplated for the same year, the gift-splitting election forces the spouses to consent to split all gifts made by both during the year to third parties. The spouses may not pick and choose which gifts to split; thus, they cannot decide to split only the annual exclusion gifts and no others.

Planning Considerations

Valuation discounts: If the annual exclusion is used to make gifts of property other than cash (such as real estate, an interest in a closely held business or units in a family limited partnership (FLP)), minority interest and lack of marketability discounts could be available. A client would be able to transfer a greater interest as a result.(2) If, for example, there were a 30% combined lack of marketability and minority interest discount,(3) in one year a client and spouse would be able to transfer $314,286 in value of a business, using the same $220,000 annual exclusions. Over five years, the client could transfer over $1.5 million in business interests, using just the annual exclusions.

One drawback, however, is that if the valuation used for gift tax purposes is found to be incorrect, the gift would use part of (and reduce) the applicable exclusion amount (or would be taxable). Given the change in the gift tax statute of limitations(4) (SOL), however, there may now be greater certainty as to valuations. However, for the SOL to begin to run, the transaction must be adequately disclosed on a gift tax return. Adequate disclosure may require substantial information under Regs. Sec. 301.6501(c)-1 (f).

Annual revaluations: A revaluation, with the attendant expense, would be required annually. However, if a taxpayer is making other gifts of these interests during the year, he would already have obtained a valuation. If the valuation is close to year-end, presumably the client would incur minimal additional expense to obtain valuations for both the year-end gifts and those at the beginning of the following year.

Medical and Tuition Payments

A client can also make unlimited tuition and medical payments to an unlimited number of beneficiaries under Sec. 2503(e). To qualify for this exemption, the transfers must be made directly to the educational institution or the medical care provider. If the client has grandchildren attending private school or beneficiaries with large medical expenses, transfers using this technique can add up quickly. At a 55% maximum estate tax rate, such transfers can also produce significant estate and gift tax savings.

Applicable Exclusion Amount

Similarly, a client can achieve a substantial benefit from using the applicable exclusion amount to make gifts during life. Under Sec. 2010(c), each U.S. citizen or resident can transfer up to $675,000 of property in 2001 without the imposition of estate or gift tax. The applicable exclusion amount (formerly the unified credit equivalent amount) increases incrementally from the original $600,000 for decedents dying in 1997 and earlier, to $1 million by 2006.

Outright Taxable Gifts

There are significant estate tax savings to be achieved from making lifetime taxable gifts.(5) If a donor survives the gift date by three years, the gift tax paid will not be included in his estate under Sec. 2035. Under that provision, the gift tax paid is included in the estate for estate tax purposes only if the donor dies within three years of the gift date. The result is to treat gifts made within three years of death the same as bequests for transfer tax purposes.

Example 2: H and W, a married couple, are in the 55% effective rate bracket for both gift and estate tax purposes. H's will leaves a $1 million interest in a business to D, his child. H needs $2,222,222 of assets to fund this bequest. The $2,222,222 will be included and taxed in H's estate, resulting in $1,222,222 of estate tax, leaving the desired $1 million for D. The estate tax is imposed on a "tax inclusive" basis (i.e., the amount used to pay the tax is included in the tax base).

If, instead, H gives D $1 million as a gift during life, he pays $550,000 in gift tax, for a total cost of $1,550,000 if H lives for three years from the gift date, a $672,222 savings. The gift tax is imposed on a "tax exclusive" basis (i.e., the amount used to pay the tax is excluded from the tax base). If the gift is a direct skip for GST tax purposes, the GST tax is not added back to the gross estate for estate tax purposes, effectively removing it from the gross estate.

Suitable Clients

General Application

Lifetime giving techniques work for all taxpayers, but work best for those with smaller estates. These taxpayers are less likely to be willing to incur the costs associated with some of the more sophisticated planning. They can have significant benefits for high-net-worth clients as well, particularly if used in combination with other techniques. As with all gifts, lifetime transfer techniques work best for property with significant appreciation potential.

Three-Year Rule

Because of the risk of inclusion of the gift tax paid under Sec. 2035, outright taxable gifts work best for clients likely to outlive a transfer by at least three years. As a corollary, if the client lives for too long beyond the three-year period, the lost opportunity cost attributable to the gift tax paid must be considered.

Planning Considerations

Carryover Basis

Because the income tax basis of the property transferred will carry over from the grantor, the income tax cost must be weighed, particularly if the gift is made outright to family members, rather than transferred to a grantor trust of which the client is the grantor for income tax purposes.

Two: Insurance Trusts

The creation of a life insurance trust is viewed by many as one of the main building blocks of an estate plan.

How They Work

Either the insured (i.e., the person on whose life the policy is held) or another party creates an irrevocable trust; the trust then purchases insurance on the insured's life. Occasionally, an existing policy is transferred to a trust. When the insured dies, the trust owns the policy; the policy proceeds are generally not included in the insured's estate for estate tax purposes.

Technical Considerations

Estate Tax

Under Secs. 2042, 2035 and Regs. Sec. 20.2042-1(b)(1), insurance proceeds payable on the life of the insured are included in his estate if (1) the insured retains "incidents of ownership" in the policy at death or relinquishes such rights within three years of death; (2) the insurance is payable to the insured's estate; or (3) the insurance is available for the payment of the taxes, debts or other expenses or charges of the insured's estate.

"Incidents of ownership" are defined by Regs. Sec. 20.2042-1(c) to include the right to designate the policy beneficiary; the power to cancel, surrender, pledge or borrow against the policy; the right to the cash surrender, value; a reversionary interest in the policy worth more than 5%; or any other right that gives the insured or his estate the economic benefits of a policy.

Thus, the insured must not have (either directly or indirectly) any policy rights or interests. In addition, if the insured relinquishes such rights (e.g., transfers policy ownership to a trust) within three years of death, the policy proceeds are included in his estate under Sec. 2035(a). It is thus preferable for the insurance trust to purchase the policy directly. If this is not possible and the insured transfers the policy to the trust, he must survive the transfer by three years to avoid policy inclusion.

Gift Tax

The initial transfer of an insurance policy to a trust, as well as future payment of premiums by the insured, is a gift for Federal gift tax purposes. To avoid payment of gift tax, either (1) beneficiaries must have Crummey(6) withdrawal powers qualifying the gifts for annual exclusions or (2) the applicable exclusion amount must be used to cover the gift. Giving such withdrawal powers to numerous trust beneficiaries can absorb a large amount of the gift tax cost of a premium payment.

The use of Crummey powers provides benefits only for gift tax purposes. For GST tax purposes, the transfer is considered a transfer to the trust; either GST exemption must be allocated under Sec. 2632, or the trust will have an inclusion ratio of greater than zero, so that distributions to skip persons will be subject to GST tax.

Suitable Clients

General Application

A life insurance trust is suitable for a broad spectrum of clients (both corporate and individual), of modest or substantial means. As to individual clients, if the combined estates of the insured and his spouse (including insurance) could exceed their combined applicable exclusion amounts ($1.35 million in 2001, $2 million by 2006), the creation of an insurance trust could be worthwhile.

Liquidity

One frequently touted use of insurance (and insurance trusts) is to provide liquidity to an estate with unmarketable assets. Although the decision to purchase insurance is often an investment decision (i.e., whether the internal rate of return of the insurance policy can outpace the after-tax earnings outside the policy), there are certain circumstances in which insurance is purchased to protect against the risk that the insured will die before sufficient funds will be available to pay estate taxes. As a result, the insured may wish to avoid the (perhaps catastrophic) event of a forced sale of assets to pay estate taxes.

For example, if an insured has valuable assets (e.g., a family farm or vacation home) that he desires to keep in the family, it may not be desirable to risk having insufficient funds to pay taxes. Accordingly, if insurance is to be purchased as a hedge against such risk, it should be purchased through an insurance trust. If the premium payments can be covered by using the available annual exclusions, no gift tax or estate tax cost will be incurred. The insurance trust can make loans to the estate or can purchase the family assets from it, thereby infusing the estate with cash to pay taxes and other expenses.

A related use for insurance and an insurance trust is to fund a cross-purchase agreement for purchase by the surviving shareholders of a deceased shareholder's closely held stock. If a shareholder purchases the insurance through an insurance trust, the proceeds and the stock purchased with them (indirectly through a loan to the surviving shareholder) are removed from the purchasing shareholder's estate.

Wealth Replacement

Finally, an insurance trust can also be used as a wealth replacement vehicle for the value passing to charity at the termination of a charitable remainder trust. If the noncharitable lead interest is measured by a life, insurance could be purchased on that life (through an insurance trust) to make up the value to the family of the assets "lost" to charity.

Planning Considerations

Escape Hatch

It is generally worthwhile to draft an "escape hatch" into an insurance trust. In other words, if it becomes undesirable to continue a policy within the trust, there should be some mechanism in place to extract it from the trust with minimum cost. For example, a grantor's spouse and children could be named permissible current beneficiaries of the trust principal (i.e., the insurance policy), in the trustee's discretion. If necessary, the trustee can then direct that the policy be distributed to the grantor's spouse or adult children. Adding the grantor's spouse as a discretionary beneficiary, however, may serve to disallow gift-splitting for all transfers to the trust.

Even without such an escape provision in a trust agreement, it may be possible to remove the policy from the trust. For example, it may be purchased by someone to whom the Sec. 101 transfer-for-value rules do not apply, such as a partnership in which the insured is a partner or a trust that is a grantor trust as to the insured.

Lapsed Crummey Powers

There are numerous issues with respect to lapsed Crummey powers in an insurance trust. For example, a lapsed withdrawal power may have an effect on a trust's grantor trust status. Also, lapsed Crummey powers may be important in determining who the transferor is for GST exemption allocation purposes.

Dynasty-Type Trust

Finally, in addition to providing benefits for a spouse and children, a grantor can provide for succeeding generations in combination with a dynasty-type trust. The grantor can use and leverage the GST exemption by allocating it to the premium payments. If the insured is in good health, a late allocation may be even more beneficial than a timely allocation of exemption to annual premium payments. The annual increase in trust value may be less than the annual insurance premiums, thereby requiring a smaller allocation of GST exemption cumulatively.

Three: Dynasty Trusts

Grantors with sufficient means to plan for more than one generation of heirs should consider creating a dynasty trust.

How They Work

A dynasty trust passes significant wealth through multiple generations without the imposition of additional estate, gift and GST taxes.

A grantor and spouse allocate part or all of their respective $1,030,000 GST exemptions ($2,060,000 combined) under Sec. 2631.(7) Once sufficient exemption is allocated to a trust to produce a zero inclusion, further GSTs from the trust are continuously exempt from the GST tax as long as there is no new transfer or addition to the trust (regardless of any increase in value of the property or trust due to appreciation or income earned). Thus, by allocating sufficient exemption to property transferred to a trust at the outset, the entire trust will be exempt, including any appreciation in the property's value or the income generated.

The trust is structured to give successive generations of beneficiaries interests in trust income and principal in the trustee's discretion, usually for the maximum term permitted by law (or, where permitted, in perpetuity). Generally, few distributions are anticipated until after the deaths of the grantor and spouse. Also, because distributions are left to the trustee's discretion, the assets may be insulated from divorce actions and creditor claims.

Suitable Clients

High-Net-Worth Clients

A dynasty trust works well for a client with sufficient wealth to set aside the amount of the GST exemption in a separate trust for future generations without impeding the overall estate plan. For example, clients may be good candidates for a dynasty trust if they feel that their children have been well taken care of during their lives, and question how much more to give them without removing the incentive to be productive members of society.

Family Heirloom Assets

An asset that a client seeks to maintain within the family for more than one generation (e.g., a vacation home that has been in the family for many years) may be appropriate for a dynasty trust.

Planning Considerations

Duration

A trust's duration is one of the first points to consider. To obtain maximum advantage, it might be desirable to have the trust created in a jurisdiction with no rule against perpetuities, so that the trust can last indefinitely.

Several jurisdictions have abolished the rule against perpetuities, such as Delaware, South Dakota, Illinois, Alaska, Wisconsin and New Jersey. Florida has now changed its rule against perpetuities period to 360 years, which is viewed by some as equivalent to having no rule. To create a trust in one of these or any other jurisdiction, the trust generally must have some connection with the state. Having a trustee in the jurisdiction, with trust assets held and administered there, should suffice. Each jurisdiction's statute should be carefully examined, however, because there may be specific requirements as to a fiduciary's residence or duties, the trust language or the type of trust corpus needed to qualify for the abolition of the rule against perpetuities.

Trustee

Who will be the trustee? A bank or trust company, given the perpetual nature of such an entity, is an obvious choice. Most of the major institutions have branches in one or more of the above jurisdictions for the express purpose of acting as a trustee. In addition to a bank (particularly if there will be broad discretion as to distributions among beneficiaries), it might be advisable to name an individual without an interest in the trust to act as an independent co-trustee. Trustee succession then becomes an important issue. A mechanism for succession of independent trustees (such as by vote of a committee of the oldest generation of beneficiaries) is advisable.

Carryover Basis

From an income tax perspective, the trust will inherit a grantor's basis in the assets transferred. Thus, either high-basis assets should be chosen or the trust should have grantor trust status during the grantor's life. Any gains at the trust level will be minimal or taxed to the grantor, thereby maximizing the remaining trust assets.

Structure of Distributions

Finally, the decision of how trust distributions will be structured is an important consideration. One possibility is to retain the trust as one "pot" for all descendants during the life of the grantor and spouse, with a possible division along stirpital lines at the survivor's death. The trustee would have the power to "sprinkle" income and principal as needed among descendants. In addition, the trust might contain a provision directing the trustee to consider other assets the children may have before distributing trust assets to them, favoring distributions to grandchildren or more remote descendants, thereby maximizing the GST benefit.

Appreciation Potential

The benefit of the GST exemption can be maximized by using the exemption as early as possible and allocating it to property with significant appreciation potential. For example, allocating the GST exemption to a life insurance trust might be a good way to leverage it, because it requires relatively small, current transfers, yet can develop into a substantial asset on the client's death.

ETIP Rules

A grantor retained annuity trust (GRAT), qualified personal residence trust (QPRT) or any other trust in which a grantor retains an interest that will trigger estate inclusion if the grantor dies during the trust term may be a poor vehicle for a dynasty trust. The grantor's retained term would be an estate tax inclusion period (ETIP). Any allocation of GST exemption to the trust during the grantor's retained term would be ineffective until ETIP termination, under Regs. Sec. 26.2632-1(c). At ETIP termination, the trust's value may have appreciated significantly. Thus, the grantor's GST exemption may be insufficient to fully exempt the trust at that time, thereby causing it to have an inclusion ratio between zero and one, such that distributions from the trust to skip persons will incur GST tax.

If it is nevertheless desirable to use a QPRT or GRAT for a dynasty trust, the GST exemption would be allocated at ETIP termination. The trustee should be given the power at that time to divide the terminating trust into two further trusts, one with a zero inclusion ratio and another with an inclusion ratio of one. Thereafter, the trustees could make distributions from the nonexempt trust to nonskip persons, with the exempt trust reserved for distributions to skip persons.

Four: QPRTs

Under Sec. 2702(a)(3)(A)(ii), a QPRT allows a grantor to transfer a persona] residence to heirs at a reduced transfer tax cost, while continuing to use the property for a specified term. It is an exception to the normal rules of Chapter 14, which would not permit a grantor's retained interest to be deducted when computing the value for gift tax purposes of a property interest transferred in trust (or otherwise) for the benefit of family members.

How They Work

A homeowner transfers a personal residence (either a principal residence or a vacation home) to a trust, retaining the right to use it until the earlier of the expiration of a term of years or death. At the end of the term, the residence passes to the beneficiaries (usually members of the grantor's family or a trust for their benefit).

For gift tax purposes, the value of the gift to heirs at the end of the term is reduced by the grantor's retained right to use the property, thereby minimizing the transfer tax cost. The longer the term, the greater the retained interest and the lower the gift. The value of the retained interest is determined under Sec. 7520. The discount rate used is 120% of the applicable Federal midterm rate for the transfer month.

Technical Considerations

There are a myriad of technical requirements in Regs. Sec. 25.2702-5 that must be met to qualify a trust as a QPRT under Sec. 2702(a)(3)(A)(ii). Many of the requirements must be contained in the governing instrument itself. The rules deal with the type of property that may be contained in the trust, how many QPRTs may be created, when QPRT status will be deemed to have ended, how the property must be disposed of if the residence is sold, prohibition against the grantor's repurchase of the residence and similar technical provisions.(8)

Suitable Clients

Appreciation Potential

The technique works best if the property transferred to the trust either increases in value (or at least does not significantly decrease in value).

Keeping a Residence within Family

It would be preferable if a grantor does not expect to sell the residence during the term (e.g., a family vacation home).

Planning Considerations

Carryover Basis

Because a grantor's basis in property will carry over to beneficiaries, the transfer tax savings must be compared to the capital gain cost to the beneficiaries.

Term Length

If a grantor dies during the trust term, the entire trust property is included in the grantor's gross estate under Sec. 2036. Therefore, the term chosen should be one that the grantor is likely to outlive. If the grantor is not in good health, perhaps his spouse may be a more appropriate transferor for these purposes. If the spouse is a U.S. citizen, the property could be transferred to the spouse gift tax-free. The spouse could then create the QPRT.

GST Planning

If a trust is intended to benefit grandchildren or other skip beneficiaries, the grantor's retained interest would be subject to the ETIP rules. Thus, any allocation of GST exemption to the trust during the grantor's retained term would be ineffective until ETIP termination, under Regs. Sec. 26.2632-1(c).

Interest Rates

Rising interest rates are beneficial for a QPRT. Because the IRS values a gift by deducting the value of the grantor's retained interest and calculates the retained value by using the Sec. 7520 rate, the higher the rate, the larger the retained value and the smaller the gift.

Mortgaged Property

If property is subject to a mortgage, the transfer may be handled in one of two ways.

If the grantor continues to be personally liable on the mortgage after the property is transferred to a trust, and the trustee can enforce the debt against the grantor and is subrogated to the mortgagee's rights, an argument exists that the gift should be the house's full fair market value, not just the equity.(9) This is arguably the better approach, because the grantor can maximize the amount of the initial transfer, thereby reducing the gift by the retained interest in the property transferred and the overall gift tax cost. Any future mortgage payments will then have no effect for gift tax purposes.

In the alternative, the grantor can transfer the property into the trust subject to the mortgage. The trust will be liable for any unpaid amounts. Thus, the grantor effectively makes a transfer net of the mortgage. Each time the grantor makes a payment on the mortgage, however, it is considered to be an addition to the trust, subject to gift tax. The interest portion of the mortgage payment should not be a gift to the trust. Only the portion representing principal should be a gift. In addition, for gift tax purposes, the transfer is valued as of the date of payment, which would necessitate a discount for the grantor's retained interest in the trust, recomputed as of the time of the new transfer. This may be cumbersome from a compliance perspective, because mortgage payments are typically made monthly, requiring a monthly valuation of the transfers for gift tax purposes.

Renting Residence After Expiration

The grantor can continue to live in a residence after the term expires by paying fair market rent to the then owners (i.e., the heirs or a mast for their benefit). It might be easier for the grantor to rent the residence if it is owned by a trust, although there should be no retained right to do so or implied understanding to that effect. This could be interpreted as a retained interest, such that the property would be included in the grantor's estate. Also, the rental payment would constitute income to the recipient, unless the recipient is a grantor trust as to the grantor (payer) after the termination of the grantor's term.

Grantor Trust Status

It may be advisable to structure a mast as a grantor trust (as to both principal and income), both during and after the term of the donor's retained interest. Grantor trust status is beneficial; it enables the grantor to take advantage of deductions such as real estate taxes and (if the house is sold), the Sec. 121 exclusion of gain on the sale of a principal residence (if available and desirable).

Partial Interests

If a spouse transfers an undivided one-half interest in a home to a QPRT, a fractional interest discount may be available to lower the property's value for transfer tax purposes. If the property is owned jointly with right of survivorship (or as a tenancy by the entirety), as is traditionally the case, the joint tenancy could be converted to a tenancy in common to facilitate the transfer of a partial interest to a QPRT.

Example 3: Y is 55 years old; his wife, Z, is 57. Their house is worth $1 million. Y and Z own the property as tenants in common. If each spouse's undivided one-half interest were valued at half of the whole, it would be worth $500,000. If their respective interests were discounted by 20% for the fractional interests, the value of each interest would be $400,000.

If both interests are transferred to separate 10-year QPRTs in a month when the Sec. 7520 rate is 9.6%, the grantor's taxable gift will be $141,852 and the spouse's taxable gift will be $138,756.(10) The transfer tax value of the transfer of the $1 million residence to the separate QPRTs is $280,608, versus $399,848 if the entire property is transferred to one QPRT without the benefit of discounting. The grantor's age, the term of the QPRT and the IRS discount rate will all affect the amount of the taxable gift.

Split Gifts

Gift-splitting might not be desirable in the year a QPRT is created. If the grantor spouse dies during the QPRT term, the portion of the surviving spouse's applicable exclusion amount used for the transfer may not be restored. If gift-splitting is not elected, none of the gifts made by the spouses (including annual exclusion gifts) would be capable of being split. One way to elect gift-splitting for all but the QPRT might be to have the QPRT property continue after the grantor's term expires in a trust for a class of beneficiaries that includes the spouse. Because gift-splitting is not available for transfers that might benefit the spouse, the QPRT could not be split, although other gifts could.(11)

Mortality Risk

If a grantor dies during the trust term, trust principal is included in the grantor's estate, negating the benefit of creating the trust. When it is foreseeable that the grantor may die during the term, the grantor might consider purchasing the remainder interest from the remainder interest holder for its then actuarial present value. If a grantor has a contingent reversion or a power to appoint the remainder, and death is so imminent that the actuarial tables may not be used to value this interest, the value of the remainder may be so small as to cause the technique to be moot. In this case, the grantor removes the purchase price from the estate for estate tax purposes, even though the trust itself may ultimately be included. Alternatively, the grantor's spouse may consider purchasing the grantor's interest to avoid including the property in the grantor's estate (if the grantor survives the purchase by three years, to avoid Sec. 2035).

Law Changes

The President's Budget for fiscal years ending 2000 and 2001 have included proposals to repeal this provision.

Five: GRATs

A favorite technique for transferring appreciation in assets to heirs continues to be a GRAT.

How They Work

A GRAT is a trust to which a grantor transfers assets and retains the right to a specified annuity from the trust for a set term. At the end of the term, the assets pass to (or in trust for) the grantor's specified heirs. If the grantor survives the term, none of the assets are included in the grantor's estate. If the grantor does not survive the term, part or all of the trust assets may be so included.

If the technical requirements are met, the value of the portion of the GRAT projected to pass to heirs at termination will be subject to gift tax to the grantor on creation. The gift portion (governed by Sec. 2702) is the actuarial present value of the right to receive the property at the end of the grantor's retained term. This value is based on actuarial tables using the Sec. 7520 rate, which fluctuates and is published monthly by the IRS. If the technical requirements to qualify as a GRAT are not met, the entire value of the property transferred to the trust is subject to gift tax.

Technical Requirements

Numerous technical requirements are contained in final and proposed regulations. In addition, IRS letter rulings in this area should be considered, because they indicate IRS thinking and have tended to be precursors to regulations. Some of the technical requirements, which must be contained in the governing instrument, provide that the annuity interest cannot be prepaid, no additions may be made after trust creation and the annuity itself may not be paid via borrowing from (or a note to) the grantor.(12)

The trust must satisfy these requirements from creation, according to Regs. Sec. 25.2702-3(d). It is not clear, however, what the result would be if any of the trust requirements were not in fact followed after mast creation. For example, although under Regs. Sec. 25.2702-3(d)(4), a trust must contain a provision prohibiting commutation, local law may nevertheless allow a grantor and all beneficiaries to join together to terminate the mast.(13)

Suitable Clients

Appreciation Potential

If a grantor has assets expected to grow significantly, so that earnings and growth combined will exceed the Sec. 7520 rate, the valuation used to calculate the gift (i.e., the property passing to the heirs at mast termination) will have been understated, leaving potentially significant value to pass to heirs free of estate or gift tax.

The owner of an interest in a closely held company that is about to be sold (either publicly or privately) should consider transferring a minority interest in the company to a GRAT. Prior to sale, it should be possible to value the company using minority interest and lack of marketability discounts. Once the company is sold, the interest appreciates significantly. The appreciation then inures to the beneficiaries' benefit. Care must be taken, however, to make sure that the transfer is not too close in time to the sale or initial public offering, to avoid the IRS argument that the appreciation has already taken place. Otherwise, the income is taxable to the grantor under the assignment-of-income doctrine.(14)

Other assets that have significant appreciation potential (e.g., real estate or interests in a FLP or other entity that may be entitled to a minority interest or lack of marketability discount for gift tax valuation purposes) would also be good GRAT candidates.

In the recent favorable economic environment, many grantors have also transferred marketable securities to a GRAT, and have been able to earn more than the IRS-assumed rate in combined income and appreciation.

Conservative Clients

Because the requirements for and consequences of a GRAT are largely specified by statute and regulation, it is an appropriate technique for a conservative client not prepared to engage in more aggressive estate planning.

Mortality Risk

Because a grantor must survive the trust term to avoid inclusion under Sec. 2036, this technique is not appropriate for a client in poor health.

GST Planning

If a trust is intended to benefit grandchildren or other skip beneficiaries, consideration should be given to the fact that a grantor's retained term would be subject to the ETIP rules. Any allocation of GST exemption to the trust during the grantor's retained term would thus be ineffective until ETIP termination under Regs. Sec. 26.2632-1(c).

Planning Considerations

Interest Rates

The lower the Sec. 7520 rate, the better the GRAT. It works best when its assets outperform the Sec. 7520 rate.

Regulations

Based on Regs. Sec. 25.2702-3(e), Example 5, a grantor's retained interest is valued as if it were the right to receive the annuity interest for the shorter of the specified term or the grantor's life, regardless of whether the trust document is so drafted. Numerous commentators have suggested that this provision in the regulation is incorrect and have urged Treasury to revoke it, without any success to date. For those interested in taking advantage of the possibility that the regulation will be invalidated by a court, it may be advisable to draft the trust to provide for the fixed term and no reversion. If the grantor desires to control disposition of the trust property in the event of death during the term (e.g., to facilitate qualifying the mast property for the marital deduction), the trust can provide for a contingent power of appointment.

Short-term, High-payout, Separate Trusts

Because the trust works best if its assets outperform the Sec. 7520 rate and a grantor outlives the term, placing separate assets into separate trusts and creating short-term trusts act as a hedge. In addition, by setting the retained annuity high and "zeroing out" the GRAT's gift component, the downside of inclusion is minimized.

Payment of Annuity

If assets in kind are used to make an annuity payment, there is less benefit to a trust. Also, there may be questions regarding the assets' valuation at payment. Because a loan by the grantor for purposes of making the annuity payment would not be permitted, it might be possible to have someone other than the grantor (such as a spouse) make the loan. In that case, however, the trust risks the possibility that the loan might be viewed as a constructive addition, possibly invalidating the GRAT. In addition, the Service has argued that loam outstanding at the termination of the grantor's term trigger income at that time equal to the amount unpaid under the note.(15)

Income Tax Issues

In addition to the need to outperform the Sec. 7520 rate for a GRAT to be successful, a trust (and thus the remainder beneficiaries) will have a carryover basis from the grantor in the trust assets. To hedge against this concern, it might be advisable to continue the property in a grantor trust for income tax purposes after the termination of the grantor's term. Care should be taken to include provisions that will make the trust a grantor trust as to both income and principal. It might be advisable for the trust to contain such provisions during the term of the grantor's retained interest as well, because the retained annuity itself may not be sufficient to tax all income and gains to the grantor.

The power under Sec. 675(4) to reacquire trust property by substituting property of an equivalent value, which appears to confer grantor trust status, has been argued by the Service not to confer such status unless, based on a factual determination, it is in fact "exercisable in a non-fiduciary capacity."(16)

Percentage Payout

If difficult-to-value assets are transferred to a GRAT, to hedge against the risk that the IRS may challenge the value (thereby increasing the gift and diluting trust benefits), it would be preferable to use a percentage payout (rather than a specified dollar amount).

Split Gifts

Gift-splitting might not be desirable in the year that a GRAT is created. If the grantor spouse dies during the GRAT term, the portion of the surviving spouse's applicable exclusion amount used for the transfer may not be restored. If gift-splitting is not elected, none of the gifts made by the spouses (including annual exclusion gifts) would be capable of being split. One way to elect gift-splitting for all but the GRAT might be to have the GRAT property continue in trust for a class of beneficiaries that includes the spouse. Because gift-splitting is not available for transfers that might benefit the spouse, the GRAT could not be split, although other gifts could.(17)

Mortality Risk

As discussed above for a QPRT, if a grantor's death is anticipated during the GRAT term, the risk of estate inclusion may be minimized if the grantor's interest is purchased by the spouse or if the grantor purchases the remainder beneficiary's interest. This type of planning is facilitated if the grantor designates a separate trust as the remainder beneficiary, so that the trustee can act without having to get consent of numerous beneficiaries (including minors).

On the other hand, if grandchildren are the intended ultimate trust beneficiaries, it might be preferable to name children outright as remainder beneficiaries, so that they can transfer their trust interests to (or in trust for) their own children, with minimal transfer tax cost.

It has been suggested that the mortality risk associated with a GRAT may be eliminated by use of an innovative technique.(18) Using this technique, a grantor creates a GRAT, retaining a contingent reversion in the event of death during the term. Immediately after trust creation, the grantor sells the reversion to heirs (or a trust for their benefit) for the actuarial present value of the right to receive the trust property in the case of death during the term. If the grantor dies during the term, his estate includes the trust property, but it must pay an equivalent amount to the heirs, resulting in an offsetting debt deduction under Sec. 2053(a).

Although this technique has appeal, it is not without potential drawbacks. It seems fairly clear that, if faced with this transaction, the Service will challenge it. The heirs must actually fund the payment. If the funding is tied back to the grantor, the Service may argue that it is a gift rather than a sale. The Service may also argue that the debt is not bona fide and thus not eligible for a deduction in the grantor's estate. In addition, if the grantor survives the term, the heirs have effectively paid for nothing. Also, the grantor has paid gift tax on the value of the reversion, which is not deductible when calculating the gift. Nevertheless, the technique is interesting and merits consideration in appropriate circumstances.

Conclusion

Part II of this article, in the February 2001 issue, will discuss five more top estate planning strategies.

EXECUTIVE SUMMARY

* Creation of a life insurance trust is viewed by many as one of the main building blocks of an estate plan.

* A GRAT is an appropriate technique for a conservative client not prepared to engage in more aggressive estate planning.

* A dynasty trust works well for a client with sufficient wealth to set aside the amount of the GST exemption in a separate trust for future generations without impeding the overall estate plan.

For more information about this article, contact Ms. Capassakis at [e-mail].

[C] 2000 Evelyn M. Capassakis. All Rights Reserved.

Editor's note: Ms. Capassakis is the Chair of the AICPA Tax Division's Trust, Estate and Gift Tax Technical Resource Panel. This article is adapted from a presentation at the 23rd Annual AICPA Advanced Estate Planning Conference.

Author's note: The author expresses her thanks to Michael Josephs and Lisa Barbieri, of PricewaterhouseCoopers, LLP, for their invaluable assistance in the preparation of this article.

(1) The $10,000 amount is adjusted after 1998 for inflation under Sec. 2503(b)(2), but only in increments of $1,000; it did not change for 1999 and 2000.

(2) See Regs. Sec. 25.2512-3 and -2(f)(2); Rev. Ruls. 59-60, 1959-1 CB 237 and 93-12, 1993-1 CB 202.

(3) See, e.g., Est. of Maude G. Furman, TC Memo 1998-157, in which the Tax Court allowed a 40% combined lack of marketability and minority interest discount for transfers of interests in a closely held business.

(4) See Secs. 2504(c) and 2001(f).

(5) If the estate, gift and GST tax regimes are repealed (as was proposed by the last Congress), the benefit could actually become a detriment.

(6) D. Clifford Crummey, 397 F2d 82 (9th Cir. 1968).

(7) The GST exemption is indexed after 1998 for inflation under Sec. 2631(c) and was increased to $1,030,000 for 2000; see Rev. Proc. 99-42, IRB 1999-46, 568.

(8) See generally, McCaffrey and Schneider, "Planning for GRATs and QPRTs; Large Retirement Accounts; Sophisticated Estates," presented in Valuation, Taxation & Planning Techniques for Sophisticated Estates 2000, 287 PLI/Est 243 (2000).

(9) Compare Est. of D. Byrd Gwinn, 25 TC 31 (1955), acq., 1956-1 CB 4.

(10) Although it is possible to calculate actuarial factors manually, using the tables provided in Regs. Sec. 20.2031-7 and IRS Pubs. 1457, Actuarial Values, Book Aleph, 1458, Actuarial Values, Book Beth and 1459, Actuarial Values, Book Gimel, it is generally simpler to use a commercial software package for the calculations. The calculations in this article were prepared using either NumberCruncher '99, by Leimberg and LeClair, Planned Giving Manager, by PG Calc, or Factors, by U.S. Trust Company.

(11) See Sec. 2513(a)(1) and Regs. Sec. 25.2513-1(a) and (b)(4).

(12) See, e.g., Kegs. Sec. 25.2702-3 and note 8, supra.

(13) See, e.g., NYS Estates, Powers and Trusts Law [sections] 7-1.9.

(14) See, e.g., Michael Ferguson, 108 TC 244 (1997), aff'd, 164 F3d 997 (9th Cir. 1999).

(15) See IRS Letter Ruling (TAM) 200011005 (11/23/99).

(16) See, e.g., IRS Letter Rulings 9922007 (2/10/99), 9908002 (11/5/98), 9713017 (12/27/96), 9648045 (9/3/96), 9645013 (8/9/96) and 9642039 (7/18/96).

(17) See note 11, supra.

(18) See Handler and Dunn, "Guaranteed GRATs: GRATs Without Mortality Risk," 138 Trusts & Estates 30 (December 1999).

Evelyn M. Capassakis
Wealth Transfer Solutions Partner
PricewaterhouseCoopers, LLP
New York, NY