The interrelationship of investment performance to estate, financial, tax and business planning is really a given, but it is not widely recognized as such. Even more important, the new tax laws make understanding this vital interrelationship compelling, if investment gains are to be preserved for those who have experienced them and not confiscated by state and federal governments through income and transfer taxation.
If you believe the estate tax and its cousins, the gift tax and the generation-skipping tax, have been repealed, let's dispose of that myth immediately. The current laws remain in full force and effect through the balance of 2001. This means if a person dies before next year, the top tax rate is 55% (kicking in when the estate assets hit $3 million plus), and the Applicable Exclusion Amount (what will not be taxed) is $675,000. In 2002, the exemption rises to $1 million, and the top rate is 50%. Thereafter, until 2009, the rate of tax gradually drops to 45%, and the exemption gradually increases to $3.5 million per individual.
In 2010, the estate tax and the generation-skipping tax are scheduled to end. If Congress does not act affirmatively in 2011, then the governing law, at today's current rate, springs back to life. In the event there is repeal in 2010, the gift tax remains at a proposed rate of 35%, with a $1 million exemption.
We may have reintroduced "carryover basis," which means that people who inherit (directly or indirectly through trusts) will receive for income tax purposes the basis of the person from whom they inherit. Basis can be adjusted from whatever it is to $3 million for gifts to a spouse and from whatever it is to $1.3 million for gifts to others.
Advisors enhance the wealth of cooperative clients by providing able investment advice. But because of the dramatic uncertainty of repeal and the long waiting period for changes to occur, your clients will see their wealth vanish-without proper tax planning-from being taxed upon their deaths or in the hands of their heirs, or both. This situation holds, whether or not we have repeal. The scenario is a sad tale because so many have believed so much and have been so wrong. Your clients may think that they still can keep all that they have and that transfer taxes have disappeared. You now know the rules and the result-taxes are alive, well and a barrier to wealth enhancement and preservation.
Few commentators have mentioned another relevant wild card. States currently share federal revenues from the estate tax. That will cease during the phase-out period. This will cost California alone almost $1 billion annually. (More lights are going out!) Several states, including California and Florida, are prohibited by their own laws from enacting inheritance taxes, but most are not. Do you think there is a modest chance that states will step in when the Feds stop the flow of money to them from the death tax? And if they do, they can set their own rates, their own exemptions and their own definition of what is taxed, with certain constitutional exceptions, or there could be other state taxes enacted.
Now just how do we avoid all of this? Fortunately, taxpayers have an ample arsenal of weapons available-if their estates are properly planned by professionals who are familiar with the options. This applies to any estate of any size, if the taxpayer gives the estate planner enough time (lives long enough), and investment results consistently outperform Treasury obligations. There is virtually no limit to the amount of wealth that can be passed tax-free or at significantly reduced tax rates if the taxpayer combines outstanding investment performance with the correct estate-planning device. But neither works without the other.
Let me illustrate the premise with one poignant example, called the "Walton GRAT," after a family name with which you surely are familiar. There are many, many techniques to illustrate investment-driven estate planning, but this technique is an excellent, single example. It was approved fairly recently by the Tax Court for GRATs and created by certain Walton family members to combine investment results (over Treasury obligation returns) with a proper estate-planning idea (the GRAT).
A GRAT (Grantor Retained Annuity Trust) is an irrevocable trust that uses the government against itself, so to speak. The Treasury requires the estate planner to make two assumptions about investments: (1) principal will not grow, and (2) principal will earn the rate of Treasury obligations in the month the trust is made irrevocable and funded, and that rate does not change throughout the term of the trust.
Here is how it works:
Your client transfers $100,000 (it can be any amount and any type of property) to a trustee. The terms of the trust require the trustee to pay your client (the grantor) a fixed sum annually (the annuity) for 20 years. (Your client picks the number of years based on his or her health and projected investment results). The amounts can be paid quarterly, semi-annually or annually.
The government, let us say, has established an interest rate by using Treasury obligations, which when multiplied by an additional factor, let us assume, results in a rate of 5% in the month your client creates the trust. The government requires you to assume that 5%-and only 5%-will be earned on the $100,000 of principal (which will not grow) for the 20 years your client has selected to receive the annuity.
Your client makes a gift to the trust beneficiaries of anything left in the trust after the annuity has been paid to your client for 20 years. Say the annuity picked by your client is $10,000. If the trust makes only $5,000 annually on the $100,000 and pays out $10,000 annually for 20 years, nothing will be left in the trust for your client's beneficiaries (children or others), so the gift is zero. Why? The trust earns $5,000; the trustee pays out $10,000; the extra $5,000 each year comes from principal. Do this for 20 years (20 years times $5,000 equals $100,000): Poof! No principal is left at the end of 20 years.
But, suppose the trustee selected an investment advisor who made $10,000 annually-not $5,000 annually-for 20 years (the government ignores the actual results). At the end of 20 years, $100,000 is left in the trust for the beneficiaries because your client's investments (for gift tax purposes) made $10,000-not $5,000-annually. Although $100,000 is left for the beneficiaries, your client (for gift-tax purposes) is required to assume nothing is there. So, $100,000 of "nothing" passes to your client's beneficiaries.
Counterintuitive? Yes, but correct! The Walton GRATs (there were two) each contained, I believe, $100 million, and all of that would pass tax free to the trust beneficiaries if the investment returns exceeded the Treasury obligation rates set when the trust became irrevocable and was funded.
There is a wrinkle here, however. If your client dies during the 20 years (or any other term the client may have selected), the value of the property (whatever it actually is) is included in your client's estate in the view of the Internal Revenue Service. We have a way around that called the "Guaranteed GRAT," but this is not the occasion to explain the variation. Take on faith that by the additional methodology of the Guaranteed GRAT, at your client's death there would be no taxes on whatever is left in the trust for the beneficiaries.
There is a famous saying that, "There are two things you do not want to see made: sausage or the law." Surely you see the intimate and necessary connection between investment performance and the ability to give away whatever you want transfer-tax-free. Without both the right investment advisor and the right estate-planning technique, the Walton result is unobtainable. Point made?
Here's another famous saying, quoted in the Old Farmer's Almanac: "If Patrick Henry thought that taxation without representation was bad, he should see how bad it is with representation." Your knowledge that investment results combined with proper estate planning can permit your clients to retain virtually all of the growth they have experienced through your counsel over many years should bring great comfort to you, as it certainly will to them.
It is truly ironic that the government's investment assumptions are unrealistic; the IRS even will issue a private-letter ruling confirming these assumptions-which will give your client complete assurance of the statements made in this column. It is this inconsistency that is at the heart of virtually all of these investment-driven estate-planning techniques, namely, possibly erroneous assumptions. (You must beat the federal Treasury obligation rates.) The heart of these techniques then will be for your performance to exceed these assumptions, and the results will be for your client to preserve and enhance his or her wealth without confiscatory taxes diminishing what you and they together have worked so hard to achieve.
As one wag put it: "The difference between tax avoidance and tax evasion is the thickness of a prison wall." Nothing talked about in this column should represent to your clients a device they would eschew because of IRS positions. These devices all fall within a category of what most of your clients and their professional advisors will assume represent reasonable reporting positions and absolutely reasonable risk assumption (witness the Walton victory).
As Judge Learned Hand said in a judicial opinion that I now paraphrase: Taxes are not voluntary contributions; they are involuntary confiscations. Every taxpayer has a right to use the laws in his or her favor to preserve his or her property.
Attorney Roy M. Adams is a partner and worldwide head of the trust and estate practice at Kirkland & Ellis in New York.