• The Best of Times or the Worst of Times?
  • January 9, 2009
  • Law Firm: Bingham McCutchen LLP - Boston Office
  • Introduction

    Low asset values. Low interest rates. Tremendous volatility in stock prices. Increasing exemptions. Increasing tax rates. Whether these are the best of times or the worst of times for our estate planning clients will depend in part on steps that are taken over the coming months. Possible legislative changes may outlaw some techniques that are currently available. The following articles highlight some of the areas that will be important to consider over the coming months.


    This is an ideal time to consider short-term GRATs.

    A grantor retained annuity trust (GRAT) allows future appreciation in an asset to be transferred to family members, or a trust for the benefit of family members, free of gift tax and estate tax. The substantial decline in asset values over the past few months means that some assets could have significant appreciation potential over the coming months and years. If this appreciation occurs, it may be transferred tax-free through the use of a “zeroed-out” GRAT, thereby reducing the transferor’s ultimate gift tax or estate tax liability. If the hoped-for appreciation does not occur, there is no tax penalty associated with the use of the GRAT. The asset transferred to the GRAT would merely be returned to the grantor, and there would be no gift tax or estate tax drawback associated with the GRAT attempt.

    Because there is no tax penalty connected to an unsuccessful GRAT, but there could be a significant tax benefit from a successful GRAT, it often makes sense for a grantor to create several GRATs simultaneously, each one holding an individual stock or sector of a diversified portfolio. For example, if two GRATs were created, one holding oil and gas stocks and the other holding stocks in manufacturing companies, it is possible that the oil and gas sector would decline in value over the next two years but that the manufacturing sector might rebound. If two separate GRATs were used, one for each sector, a tax benefit would result from the increased values of the manufacturing sector stocks. On the other hand, if a single GRAT had been used for both sectors, the decline in the energy sector portfolio could offset the increase in the manufacturing sector portfolio, with the result that no tax benefit would be realized. For the same reason, a large concentrated stock position is an ideal candidate for GRAT funding.

    Although low interest rates are certainly helpful to the success of a GRAT, given the short terms of the GRATs we typically recommend (two years is most common), appreciation in asset values is a much greater factor in determining the success or failure of a GRAT.

    Some of our clients have experienced such a large decline in asset values that they may be reluctant to employ a GRAT now because they would like to reap some of the benefit from future asset appreciation for themselves. This is possible through the use of a GRAT that includes a formula to determine how asset appreciation is divided between the grantor and the ultimate trust beneficiaries (the remaindermen). For example, upon the termination of a GRAT, if there was $1,000,000 of value that potentially could be distributed tax-free, this amount could be divided by a formula so that a portion of it was returned to the grantor and the balance distributed to children. The formula might provide that this value is to be divided evenly between the grantor and the children. The grantor's spouse could also be included as a potential beneficiary of the portion that will be passed along to the children so that distributions can be made to the spouse if appropriate.


    Qualified personal residence trusts (QPRTs) are another asset transfer device that can benefit greatly from low asset values, in this case, low residential real estate values. These trusts permit residential real estate to be transferred at a discounted value for gift tax purposes. If the value of the residential real estate increases over the term of the trust, the benefits of the QPRT technique are compounded.

    A Review of Trust Funding Formulas May be Advisable

    The estate tax exemption is scheduled to increase from $2 million to $3.5 million in the case of persons dying on or after January 1, 2009. This increase, together with the unprecedented market volatility of the last few months, suggest that this would be an opportune time to review the funding formulas that may be contained in revocable trusts. These trusts typically use a formula to determine the funding of a marital trust and a credit shelter (or exemption) trust upon the trust grantor’s death. Under a “pecuniary” marital deduction formula, the marital trust is funded with a set dollar amount. If asset values increase during the period of estate administration, the credit shelter or exemption trust could end up being funded with values greater than the amount of the estate tax exemption. This sort of leverage works extremely well when asset values are increasing, but it can be harmful if asset values decline during the period of estate administration. In these uncertain times, it may be preferable for the marital trust to be funded based on a “fractional” formula, or to use a pecuniary credit shelter formula. Clients are advised to consult with their estate planning attorneys to review the appropriateness of the funding formulas used in their estate planning documents.

    Gifting and Selling Assets

    Individuals with investment portfolios, commercial properties, or operating businesses may seriously want to consider gifting and/or selling interests in these assets at this time for three important reasons.

    Low Values

    First, as noted above, with the economy in a recession, values are depressed, making it easier to justify a low valuation of the assets to be transferred (of course, marketable securities are based on established values, which are on the average down about 40% from the beginning of the year). Likewise, the cost of selling such assets to “freeze” their value is based on the current depressed market values.

    Low Interest Rate Environment

    Second, where assets are sold to family members or trusts in exchange for a note, the interest rate required in the month of December on a note to avoid the imputed interest rules (where interest is payable annually) is only 1.36% for a short term loan (no more than 3 years), 2.85% for a mid term loan (more than 3 years and no more than 9 years) and 4.45% for a long term loan (more than 9 years). (These rates change every month.) In other words, family members, or trusts for their benefit, can borrow at rates much lower than commercial rates.


    Third, in the next session of Congress it is possible that significant restrictions will be placed on discounts used in valuing assets that are gifted or sold. Traditional discounts used in valuing assets are those for lack of marketability (e.g., closely held stock, member interests in limited liability companies or interests in family limited partnerships), lack of control (e.g., nonvoting interests or minority voting interests) or for transferring undivided fractional interests in property (e.g., family residences or commercial properties). Such discounts have ranged from 15% to 45%, or more, significantly increasing leverage in transferring assets to family members or other loved ones.

    Intra-Family Loans

    Another idea popular in a low interest rate environment is the intrafamily loan of liquid assets (e.g., cash, marketable securities, bonds). The reason is that the current interest rates required on such loans, known as the applicable federal rates (AFR), are low. (See the above discussion for the rates applicable in December.) Therefore, if an individual with a portfolio of cash or cash equivalents worth $10M that is invested to generate a return of 4.5% were to lend it to his or her children for 3 years, then the spread between the interest and/or dividends earned on the investments (4.5%) and the interest on the loan (1.36%) would pass gift tax free to the children. Over three years, this would amount to over $94,000. There is a risk, however, that the investments will decrease in value over the three-year period which could reduce if not eliminate the amount of the tax-free gift.

    “Reverse” Estate Planning

    In times like these, a client who is considering use of the tax-advantaged transfer techniques described above may feel concern that he or she is giving away “too much,” potentially leaving the client with too little, at least if current market trends continue. Here are a few techniques that we can use to address this concern.

    The irrevocable trust that receives gifts from a grantor, or that receives the GRAT remainder at the end of the term, can include the grantor’s spouse as a potential beneficiary. While the primary intention is to benefit children, grandchildren or other intended beneficiaries, the trustee can make distributions to the spouse if such distributions are advisable. Also, if a client creates a “grantor trust,” which requires the grantor to pay the income taxes attributable to the trust’s income, the grantor or the trustee can typically release certain powers over the trust so that going forward the grantor will no longer be responsible for the trust’s income taxes.

    Clients may want us to review their current estate plans in order to ascertain whether similar options are available under their existing irrevocable trusts.

    In some instances, whether for financial or other reasons, a client may want to find other ways to get back some assets that have already been transferred. Many irrevocable trusts give the grantor a power of substitution, allowing the grantor to take assets back in exchange for assets of an equivalent value. In addition, many of the estate planning techniques described above can be applied in reverse in order to send assets back to the grantor.

    While we generally facilitate the flow of family wealth in the direction of younger generations, clients should feel free to consult with us about the possibilities for moving assets in the reverse direction.

    Direct IRA Charitable Rollovers are Revived for 2008 and 2009

    The Emergency Economic Stabilization Act of 2008 has revived a valuable opportunity for individuals who are at least 70 and 1/2 to transfer funds directly from their regular IRAs to charities. In the right circumstance, using this vehicle to make a charitable gift can save significant income taxes and benefit charity at the same time.

    The direct charitable IRA rollover may be used in the following circumstances:

    • Where the IRA owner has reached age 70 and 1/2.
    • Where the intended charitable recipient is a public charity other than a supporting organization or donor advised fund. Private foundations are not permissible recipients of direct charitable IRA rollovers.
    • Where the gift to charity is made directly by the IRA custodian to the charity.
    • Where nothing is received by the donor in exchange for the charitable donation.
    • For charitable donations that when combined do not exceed $100,000 per year.

    This method of making charitable gifts from IRAs may eliminate state income taxes that might otherwise be payable when IRA distributions are made to the IRA owner and then are donated to charity. It can also preserve other tax benefits for the IRA owner, such as medical deductions or miscellaneous itemized deductions that might otherwise be lost if the IRA owner were to receive an IRA distribution directly and then contribute the distributed funds to charity. The direct charitable IRA rollover can be used to satisfy the annual required minimum distribution requirement for the IRA owner up to the $100,000 annual limit.

    IRA owners who are at least 70 1/2 years old should consult their legal and tax advisers to explore this possibility in more detail.


    If you are intrigued by some of the ideas discussed in this Alert — even if you are fearful over the current state of the economy and your own retirement planning — we strongly recommend that you discuss your concerns with your estate planning attorney and other advisors. The preceding discussions are, of necessity, general. Many adaptations may be possible to deal with your specific facts and concerns.