What can be done when an estate plan turns into an empty shell?
The recent market meltdown has resulted in a substantial drop in value in virtually all trusts and charitable portfolios. Lifetime gift-tax exclusions may have been wasted in order to transfer assets that are now worth less in the hands of donees. Charitable trusts appear to contain empty promises for their charitable beneficiaries.
Given the turmoil, can existing vehicles in a client's estate plan be revived?
Actually, despite the worries, there has never been a better time for estate planning, as there are several factors at play. First, it is always better to transfer assets out of an estate when their values are low. In the current environment, your clients have an opportunity to gift their real estate and investments at today's depressed values-and many of these things may regain their value in the future. Second, some estate planning vehicles work best in a low-interest-rate environment: The Internal Revenue Service's published rates for determining the value of the gift in certain types of trusts are at historic lows. Third, there is investment opportunity. Some companies may close their doors, but there are also many sound companies that are now trading at a bargain because of investor skittishness, and these holdings could appreciate in value.
What About Estate Planning Vehicles Currently Under Water?
Let's look at the state of grantor-retained annuity trusts, a popular estate planning vehicle designed to transfer property to heirs with very little gift-tax impact. The current market meltdown has put existing trusts in jeopardy, since they are in a tougher position to both pay back money to their grantors as required and leave some money behind for beneficiaries in the way they are intended.
A GRAT is an irrevocable trust that pays a fixed annuity payment to the grantor for a set term of years. If the asset doesn't generate enough income to meet the annuity payments, the trustee can distribute principal to make up the difference. In fact, GRATs are sometimes designed to return nearly the entire principal to the grantor over two or three years. At the end of the term, the trust terminates and distributes its assets to the remainder beneficiaries (the grantor's heirs or another trust). On paper, it appears that very little will be transferred; therefore, the gift tax is minimized.
If, however, the trust is invested in property that could significantly appreciate, such as commercial real estate, closely held stock or shares in a hedge fund (all of which are subject to additional risk), and the trust does in fact increase in value, the actual return could outpace the interest rate assumption (the Section 7520 rate) used to calculate the initial annuity rate and the remaining gift. That excess appreciation, if any, is credited to the heirs.
But a GRAT only works if the total return (income and appreciation) of trust assets can outperform the federal rate used to calculate the annuity payment. Otherwise, the GRAT fails to accomplish its goal of transmitting wealth to the remainder beneficiaries. A GRAT can at the same time be "under water" if, after it pays the grantor his required annuity payments over the trust term, it has nothing left to pay the beneficiary.
One arrangement for estate planners is to create a rolling series of short-term GRATs, where each annuity payment received by the grantor is contributed to a new GRAT. In effect, you can use the same asset to fund several successive short-term GRATs, each time in an effort to recover principal and pass on any appreciation or potential appreciation to the heirs with very little gift-tax cost.
Taking advantage of today's low interest rate environment can be more of a challenge for existing, longer-term GRATs. If the trust's asset is underpriced in today's market, the grantor may be able to repurchase the asset from the trust or substitute it with an asset of equivalent value that may achieve the goal of the trust. The grantor could then donate the reacquired property to a newly formed GRAT using today's low 7520 rates. (The 7520 for February 2009 was 2%.)
If the grantor cannot exchange assets, the GRAT may allow him or her to instead purchase the trust assets with a promissory note based on today's low interest rates. If necessary, the trustee could use such a note (or a portion of the note) to satisfy the trust's required annuity payments. If the trust was not written to allow either a repurchase or a substitution, you may suggest that the client replenish the family's inheritance by using the GRAT's annuity payments to buy life insurance within an irrevocable life insurance trust (ILIT).