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    Advanced Estate Planning: Split-Interest Gifts and Trusts

    by Ellen J. Boling

    There are a number of tax-planning strategies that use trusts to reduce or eliminate potential estate tax liability. Some of these trusts offer income tax savings as well, but our focus is on the estate and gift tax benefits available.

    We discussed basic trusts in our June Estate Planning column (“The Tools of the Trade: Basic Estate-Planning Trusts”). The focus this month is on advanced ‘split-interest’ gifts and trusts, which are equally important tools. This type of trust includes grantor retained annuity trusts, qualified personal residence trusts, and charitable lead or charitable remainder trusts. Each of these trusts shares the characteristic that there are concurrent ownership interests in the assets that are transferred to the trust. The trust holds legal title to the assets, but one beneficiary of the trust has a current right to income derived from or beneficial enjoyment of the assets, while another beneficiary will have that right in the future. Therefore, it is important to consider not only the type of asset being transferred to the trust, but also how the value of that asset will change over time.

    Grantor Retained Annuity Trust

    The grantor retained annuity trust (GRAT) is an excellent trust option to shift future income and appreciation to another person for either a small amount of gift tax, or perhaps none at all, on the transfer. As a split-interest trust, a GRAT fractionalizes the ownership of an interest in property across time. The grantor, who is the person with original ownership of the assets, transfers the assets to the trust, but retains the right to current distributions in the form of an annuity payment for life or a term of years. At the end of this period, the grantor’s interest in the trust ends and the beneficial interest in the trust assets, called the remainder interest, either passes outright or in further trust to the future beneficiaries. A GRAT is sometimes called an estate tax “freeze” mechanism, because the grantor is able to “freeze” the value in his estate and transfer future appreciation to beneficiaries.

    It is essential that the assets transferred to the GRAT appreciate in value over the term of the grantor’s annuity in order for this type of trust to be successful in transferring value to future beneficiaries. The value of the gift to the future beneficiaries is determined by taking the total current value of the property transferred to the GRAT and subtracting from it the actuarial value of the future annuity payments that the grantor has retained. The actuarial value of the reserved annuity is a function of several variables, including:

    • The applicable interest rate (under Internal Revenue Code Section 7520) that prevails for the month during which the property is transferred to the GRAT,
    • The dollar amount of the annuity,
    • The term of the trust, and
    • The age of the grantor.
    If the assets appreciate at a rate in excess of the applicable interest rate, then that appreciation passes to the future beneficiaries for minimal gift tax cost, if any. Currently, with interest rates at historic lows, a GRAT is more likely to be successful at passing excess growth to beneficiaries, because there is a lower performance hurdle for the assets transferred to the trust.

    If the grantor retains an annuity interest equal to the value of the assets transferred to the trust, then actuarially the grantor has not made a gift. This is commonly referred to as a “zeroed-out” GRAT, because the value of the remainder interest is actuarially zero. This technique may involve making the annuity payments payable to the grantor or the grantor’s estate if the grantor dies prematurely. An example of the gift and estate tax savings that can be achieved in establishing a GRAT with these terms is included in Table 1.

    Besides market risk, another risk of a GRAT is that the grantor will die during the annuity term, which causes the full value of the property in the trust to be subject to federal estate tax. For this reason, it is generally not advisable for spouses to split gifts during the year the GRAT is funded. If the grantor and spouse elect gift-splitting and the grantor dies during the GRAT term, then there is no adjusted taxable gift relief or unified credit restoration for the surviving spouse, even though the property is subject to tax in the grantor’s estate. Also, it is generally not advisable for the grantor to allocate her generation-skipping transfer tax exemption toward a gift that is at risk for being pulled back into her estate.

    To minimize the risk of estate inclusion, GRATs with short terms of only a few years are quite common. If the asset continues to perform well, then another consecutive short-term GRAT could be established. This is often called a “cascading” GRAT structure in which the annuity payment from a previous year’s GRAT is used to fund a new GRAT in a subsequent year.

    The terms of a GRAT cannot be changed once the trust is funded. However, in setting the initial terms, two variables can be manipulated in setting the annuity—the length of time over which it is paid and the dollar amount, which is usually a percentage of the fair market value of the assets on the date that they are transferred to the trust. The annuity must be specifically fixed, but that does not require that the amount be the same for each year. It is quite common to have smaller payments in the earlier years of a GRAT in order to let the assets remain in the trust longer and maximize the growth within the trust. However, the annuity amount may not increase by more than 20% over the prior year. The trust terms must also prohibit both the commutation of the annuity interest and any additional contributions to the trust.

    A business interest can be an excellent asset to fund a GRAT if the business earns sufficient income to pay the annuity. For example, profitable S corporations [qualified small corporations taxed as partnerships] often produce larger annual dividends than regular corporations because S corporations are not subject to double taxation. By funding a GRAT with profitable S corporation stock, the annuity payment can often be made from dividends on the S stock. This allows the full value of the transferred stock, plus the balance of any income in excess of the annuity payment, to remain in the GRAT and pass to the next generation at little or no gift tax cost. In addition, the grantor pays the income taxes on the S corporation income during the term of the GRAT. If the grantor elects not to have the GRAT reimburse him or her for the payment of income taxes on the annuity income, then that payment is an additional transfer of wealth without any gift tax ramifications. Non-voting and minority interest S stock is especially attractive because the value of the stock can be discounted for lack of marketability and minority interest status. These discounts reduce the overall value transferred to the GRAT, and will thus reduce the value of the remainder interest subject to gift tax.

    Qualified Personal Residence Trust

    A qualified personal residence trust (QPRT) is a variation of a split-interest trust. It is a trust to which a grantor transfers a personal residence, while retaining an interest in the possession and beneficial enjoyment of the residence for a term of years, at which point the house transfers to the remainder beneficiaries. This strategy is often used to retain vacation homes within families. By retaining such an interest, the value of the residence in trust is discounted for gift tax purposes, hence providing a potential for significant tax savings. One of the motivating factors to fund a QPRT is that the grantor can remain in the home rent-free during the retained term, but then also may lease the home after the retained term ends. The fair market value rental payments then become a way of transferring additional monies to the future beneficiaries with no gift tax consequence.

    Similar to a GRAT, the amount of the gift to the trust is computed under the terms of Internal Revenue Code Section 7520. The value of the residence transferred to the QPRT is reduced by the actuarial value of the retained right to possession of the residence. Also similar to a GRAT, the primary risk of a QPRT is that if the grantor dies during the term, the full value of the property is included in the grantor’s taxable estate. Contrary to a GRAT, which is more desirable to establish when interest rates are low, QPRTs become more desirable from a gift tax perspective when interest rates are higher.

    The potential tax savings available through the use of a QPRT can be significant. For example, assume a 60-year-old grantor has taxable assets that place him in the 50% gift and estate tax bracket. The grantor owns a residence worth $500,000, which he transfers to a 15-year QPRT with a reversionary interest, naming his children as beneficiaries. Assuming an applicable federal rate of 4.4%, the present value of the remainder interest passing on to the children subject to current gift tax would be $185,225. The grantor would owe $92,613 in gift tax. By placing the residence in a QPRT, the grantor has effectively reduced the value for gift tax by approximately two-thirds. Alternatively, assume that the grantor retained ownership without the trust for 15 years and then died. Assuming the residence appreciates annually at a 3% rate, the value of the residence upon his death would be $778,984. At a 50% estate tax bracket, the resulting tax liability is $389,492, as opposed to a current gift tax liability of $92,613 through use of the QPRT, resulting in tax savings of $296,879.

    A QPRT may only hold the grantor’s personal residence or one other residence (if both are desired, then each residence must be in a separate trust). It may also include appurtenant structures used for residential purposes and adjacent land not in excess of that which is “reasonably appropriate” for residential purposes, taking into account the residence’s size and location. It may hold cash for limited purposes such as expenses that will be incurred within the next six months. If the house is sold by the trust, then the qualified cash proceeds must be reinvested in another personal residence within two years from the date the proceeds are received. If not reinvested, then the QPRT will essentially become a GRAT, the terms of which should be set out in the trust document.

    Similar to a GRAT, a QPRT is a “grantor trust” by virtue of Internal Revenue Code Section 677, which means that although there is a completed gift of the remainder interest (subject to a contingent reversion to the grantor’s estate), the grantor continues to be treated as the owner of the house for income tax purposes. Thus, the grantor can pay all income and expenses associated with the use of the house directly and any mortgage interest and property taxes paid by the grantor can be deducted on his income tax return. However, it is best if a residence is not encumbered by a mortgage when transferred to a QPRT. If the grantor makes a principal payment on a mortgage, the payment would be deemed an additional contribution to the QPRT. Similarly, if there are cash expenditures for substantial improvements to the residence, each mortgage principal payment or cash infusion constitutes a gift. Therefore, the grantor would owe additional gift tax on these payments, recomputed each time such a payment is made based upon the remaining life of the QPRT and the applicable federal interest rate at the time of the new gift.

    Charitable Lead Trusts/Charitable Remainder Trusts

    If an individual has charitable intentions, then he or she may consider special types of split-interest charitable trusts called charitable lead trusts and charitable remainder trusts. Either trust may be established during the life of the grantor or as a testamentary trust that becomes effective at death. A charitable lead trust (CLT) provides that the income (or lead) interest is paid to one or more charitable beneficiaries and the remainder interest either reverts to the grantor or is paid to one or more non-charitable beneficiaries at the termination of the trust. There is no minimum or maximum percentage that must be transferred to the charity. In contrast, a charitable remainder trust (CRT) provides that a non-charitable beneficiary receives the income interest and the charitable beneficiary receives the remainder interest. The income interest cannot be less than 5% or more than 50% of the initial fair market value of the trust. Additionally, the value of the charitable remainder interest must be at least 10% of the fair market value of the property on the date of the transfer. The determination of which type of trust to fund depends on such factors as whether the grantor depends on a current income stream from the assets transferred to the trust and how the value of the assets is expected to change over the term of the trust.

    A CLT or a CRT must either be a guaranteed annuity trust or a unitrust. A guaranteed annuity interest (a CLAT or CRAT) grants the initial beneficiary an irrevocable right to receive a sum certain payable not less often than annually for either a term of years, not longer than 20 years for a CRAT, or for the life of one or more individuals. The annuity is defined as a fixed percentage of the initial fair market value of the trust assets. In comparison, a unitrust interest (a CLUT or CRUT) grants the beneficiary an irrevocable right to receive payment, at least annually, of a fixed percentage of the net fair market value, determined annually, of the assets of the trust. The annual payment from an annuity trust remains constant, whereas the amount paid by a unitrust fluctuates with the fair market value of the trust assets. If the grantor wishes to share in the appreciation of the transferred assets, a charitable remainder unitrust would be the preferable vehicle. In addition, a unitrust may provide for the payment of the lesser of the fixed percentage or trust accounting income (a “net income only” unitrust, or “net income with makeup” CRUT, also called a “NIMCRUT”). In the case of a NIMCRUT, the unitrust may, but need not, provide that any amount by which the trust income falls short of the fixed percentage is to be paid out in subsequent years to the extent the trust’s income exceeds the fixed percentage in such later years, which is called a “make-up” provision.

    A CLT provides an excellent opportunity to transfer property to future beneficiaries at a reduced transfer tax cost. The present value of the income interest of the charity qualifies for the gift tax charitable deduction if the trust is funded during the grantor’s life or for the estate tax charitable deduction if it is funded at the grantor’s death. In determining the present value, the lowest interest rate under Section 7520 for the current month or either of the two preceding months may be selected and will produce the lowest gift tax value. For example, in October 2003, if a 65-year-old grantor funds a $500,000 lifetime CLUT with a 7% annual payout to charity, the gift tax value of the remainder interest is only $174,805. This is calculated using the applicable interest rate of 3.2% for August 2003, instead of 4.4% for October 2003. Note that the remainder interest gift does not qualify for the gift tax annual exclusion for either a CLAT or a CLUT. If the CLT is structured as a grantor trust for income tax purposes, then the grantor receives an income tax deduction for the present value of the charity’s income interest. In this example, the grantor would have made a charitable contribution of $325,195. However, the grantor must then report all of the income of the trust until the expiration of the charity’s income interest. Alternatively, the grantor could forgo the upfront charitable deduction in favor of not having to pay income tax during that time period. Once a CLT is established, the grantor or anyone else may make additional future contributions. However, no income, estate or gift tax charitable deductions are available for future contributions to a CLAT, but they are available for a CLUT.

    A CRT provides an excellent opportunity to transfer assets to a charity, while also maintaining an income stream for life. This is an ideal trust for someone with low basis stock who wishes to diversify his or her investments but defer the income tax on the gain over the time period of the retained income stream. Additionally, if funded during lifetime, the grantor receives an income tax charitable contribution for the present value of the charity’s remainder interest.

    For example, in October 2003, if a 65-year-old grantor transfers $500,000 of securities to a CRUT with a lifetime 7% annual payout, then the grantor will have a $174,805 charitable contribution. There is again the option of choosing the applicable interest rate for the current month or either of the two preceding months. If funded at death, the grantor does not receive an income tax charitable deduction. Furthermore, if the retained income stream is given to someone other than the grantor or the grantor’s spouse, then the grantor will have made a completed gift for gift tax purposes of the present value of the income stream. This gift does qualify for the annual gift tax exclusion.

    For a trust funded at death, if someone other than the grantor’s surviving spouse receives the income interest, then the present value of that interest is subject to estate tax, but there is also an estate tax charitable deduction for the charity’s remainder interest. In either case, a spouse’s income interest qualifies for the marital deduction. Additional contributions may be made to a CRUT once it has been established, but not to a CRAT.

    Conclusion

    For those who have put a basic estate plan in place and are looking for more advanced ways to transfer wealth to family members or charitable beneficiaries, the split-interest trusts described here are excellent strategies. While more complicated, the benefits can be considerable. However, due to the complexity, we encourage you to work with your financial planner and estate attorney to determine what may be best for you to consider.


    Ellen J. Boling, CFP, is director of Private Client Advisors for Deloitte & Touche, LLP, in Cincinnati, Ohio. Tracy Tinnemeyer, JD, is a senior manager in Private Client Advisors for Deloitte & Touche, LLP, in Pittsburgh, Pennsylvania.


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