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).

Refinancing Family Loans
The intrafamily loan is another popular estate planning strategy that could become even more popular as the IRS' applicable federal rate drops to record-low levels. When the loan is set up correctly, a client is allowed to lend his or her children money at lower rates than those available commercially without the IRS looking on it as a gift. Can your client refinance a family loan in the same way he can refinance a mortgage?

First, it may not be necessary. Depending on the type of loan, the rate may automatically reset annually. With a term loan, the rate is fixed for the life of the loan. Meanwhile, a demand loan's interest rate changes annually, usually based on a benchmark stated in the loan document.

With the term loan, it may be possible to reset the interest rate and to even prepay the loan with the additional appreciation that the lower loan rate creates. But refinancing the loan in this case is not the same as refinancing a mortgage, because the parents now pay gift taxes. One way to work around this is for the children to obtain a short-term commercial loan to pay back the parents. Then the parents and children can renegotiate a new loan with a lower rate and use the family loan proceeds to pay back the bank. Alternatively, the children could renegotiate the loan either by paying a larger "down payment" or choosing a shorter term. Both solutions can put the parents in the same economic position they were in under the terms of the original loan (and help them avoid gift tax).

Restructuring Installment Sales
In the current market climate, clients with estates should also re-evaluate the strategy of making an installment sale to an intentionally defective grantor trust (IDGT). This is a popular way to fund a life insurance trust while avoiding the creation of a gift. Although there are several formats, the grantor usually sells income-producing property to the trust in return for a promissory note.

As a "grantor trust," the IDGT is an alter ego of the grantor and doesn't incur income taxes. Under these arrangements, the trustee has the means to pay the life insurance premiums without relying on the grantor to make annual gifts to the trust. The note can be paid back through cash flow or expected asset appreciation.

Previously, GRATs were used in conjunction with installment sales to IDGTs. At the end of the GRAT term, whatever was left in the trust was transferred to the remainder beneficiary-that is, the IDGT. The trustee of the IDGT could then pay off the installment note and exit the arrangement without having to touch the cash values of the life insurance.

In today's market, however, the "exit strategy" may be at risk. This transaction can only work if the growth rate of the trust assets is greater than the costs of the loan-or if the GRAT can be relied on to pump money into the trust.
Here again is an opportunity to renegotiate the promissory note. The installment note could be restructured as an interest-only note, giving the trustee time for the trust's principal to recover. Note that the renegotiation must be based on an "arm's length" standard to be accepted by the IRS.

If the trust document allows, the grantor may be able to exchange assets held in the IDGT for ones that might either outperform the loan's interest rate or possibly generate more reliable cash flow.

Fulfilling Promises
The charitable remainder trust (CRT) is another estate planning vehicle at risk in today's market. CRTs allow the grantor to transfer assets out of his or her estate, retain an income interest and provide for a future transfer to charity. They come in two forms: the charitable remainder annuity trust (CRAT) and the charitable remainder unit trust (CRUT).

The CRAT pays a fixed annuity to the grantor or the grantor's family while the CRUT pays a percentage of the trust's value annually. Unfortunately, too many CRTs were designed with overly optimistic assumptions of future growth and income. Today's reality is that either the CRAT's annuity payment is eating into the principal or the CRUT's payments are woefully short of the grantor's expectations. In a bear market, there is a real possibility that both the income beneficiary and the CRAT's charity can end up with nothing. Payout rates are irrevocable and cannot be adjusted for market conditions. Besides adjusting the portfolio's asset allocation, what else can a trustee do?

If the client still has a strong desire to give, he could consider terminating the trust and donating his income interest, along with the charity's remainder interest, to the charity. This is often a good solution when trust administration expenses are greater than the income earned on trust assets. If your client is considering the termination of the charitable trust, he or she may have to get permission from the state's attorney general.

If the CRT's income stream is still desired, it may be possible to exchange the vehicle for a charitable gift annuity. The latter is a contract between the charity and donor in which the charity promises to pay an income to the donor for a number of years or for life. This will likely result in reduced income payments to the client, but the charity will have immediate access to the former CRT's assets. It is important to understand that the donor will no longer benefit from any future appreciation of the assets. The payments from the charitable gift annuity are fixed. In light of the market's impact on the charity's own endowment funds, it's important for the client to consider the health of the charity when choosing this option.

Always Consult Your Client's Legal And Tax Advisors
These are just a few ways to clean up existing estate plans that are at high risk of failing in their purpose, but none should be taken without the involvement of the client's legal counsel or tax advisors. All of the strategies have consequences and disadvantages that must be considered carefully.

Tere D'Amato is the vice president of advanced planning at Commonwealth Financial Network in Waltham, Mass. She can be reached at [email protected]. Commonwealth Financial Network does not offer tax or legal advice.