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Protect Your Assets for Future Generations

Posted by Sean T. Perkins, CFP®

Asset Transfer Strategies that Safeguard Your Legacy

As your family grows with marriage and children, it can change the way you think about the future of your assets. It can also bring into sharp focus any concerns you may have about the flow of your assets and how you can best protect your legacy.

It’s important to understand what terms you can write into a trust regarding the transfer of your assets to future generations, and the potential consequences of the terms you choose to include or exclude in your documents

When it Comes to the Language in Trusts, Less is Sometimes More

Whether you’re conferring assets during your lifetime or leaving them as an inheritance, drafting trusts with well-thought-out terms can ensure your assets end up in the right hands. You can write any terms or restrictions you wish into a trust, but it’s important to weigh the options between including a strict requirement versus leaving some flexibility for the trustee to exercise discretion. This is particularly true as the world changes, as what makes sense today may not make any sense 5 or 10 years from now, either due to changing tax law or changes in your objectives or the lives of your beneficiaries.

To reduce the chance of regret, it is often recommended that a trust be drafted with provisions that bestow trustees with discretion on distribution of income or capital to the beneficiaries. Sometimes referred to as discretionary trusts, these trusts tend to restrict the extent to which a beneficiary can make demands upon the trustee. They provide trustees with the freedom to make decisions on their merit and without any interference from the beneficiaries (and hopefully reduce the exposure to creditors of the beneficiaries).

If leaving full discretion to a trustee causes concern, there are some important items that can help with this, such as providing guidance to your trustee in a non-binding manner and ensuring that the right trustee provisions are included (language regarding successor trustees as well as who has the right to remove and replace a trustee).

Regarding the non-binding guidance, grantors can outline their general wishes with respect to the trust assets and how/when trust distributions should be made. Since the letters are non-binding, the trustee can use the letter to have a better idea of the values and objectives of the grantor while maintaining the right to ignore the guidance if that is in the best interest of the beneficiary. These types of circumstances could include:

In our view, a properly-drafted trust with a non-binding letter not only provides the trustee with freedom to make decisions, but also some guidance on what decisions to make.

Here are 3 topics a grantor may want to discuss with their attorney that could be included in their trust via non-binding letters:

  1. Prenuptial Agreements

Marriage is a business relationship almost as much as a romantic one. This dual nature and purpose has led to the increased acceptance of prenuptial agreements (prenups, for short) as a tool to protect a spouse’s financial interests. If you’re concerned about your assets remaining within your family (i.e. passing to your relatives, such as children, grandchildren and great-grandchildren), then a prenup can help with any possible divorce or separation.

You may choose to hardwire language into your trust that specifies a prenuptial agreement is in place for your married children before any distributions are made, or other requirements about how trust assets can be used with respect to your children’s lives and choices. Spelling out certain parameters can eliminate any ambiguity down the road, but be sure you work closely with your estate attorney and wealth advisor to understand the potential impact of these types of decisions. It is ultimately your choice how specific to make the language in your trust and whether it is binding or not binding on the trustee, but it is recommended that this decision be made with your attorney since it could have significant consequences if done incorrectly, such as unintended family resentment or financial/creditor exposure.

  1. Age-Specific Distributions

Grantors may also choose to hardwire language into a trust that requires distributions to the beneficiaries once they reach a certain age. Alternately, grantors could leave distributions to the full discretion of the trustee and outline their distribution wishes in a side letter. Assets that are placed in a trust for another party’s benefit are typically not considered to be property of the trust beneficiaries and therefore have a higher level of creditor protection in the event of a divorce. However, once a distribution is made to the beneficiary (or made available to the beneficiary if hardwired into the document), the assets are no longer protected and become part of the beneficiary’s personal property rather than part of the trust property.

  1. Business Investments

If your children are entrepreneurial, it might make sense to consider how trust assets are best used to support business ventures. One option may be to require your child to establish a business plan and provide funding to a certain point–whether through their own investments or with the help of an outside investor–before they can tap into their trust. This prerequisite, along with a cap on trust distributions, allows you to ensure the trust assets aren’t being used for incomplete ideas that may not last. The trustee could also choose for the trust to make the investment directly, rather than making a distribution to the beneficiary to make the investment, which would keep the assets under the control of the trust and potentially with a higher level of asset protection.

Regarding trustee powers, the key items to be mindful of include:

These considerations are particularly true with discretionary trusts, since you’re leaving control to the trustee to use their judgment on how best to manage the assets and when to make distributions. A few items to consider are:

  1. Successors

It’s all too common for a grantor to select a close friend or attorney to serve as successor trustee, but that friend or attorney is often the same age (or older) than the donor, so what happens when both the grantor and the successor age? Who should replace them on a trust that could last multiple generations? It may make sense for the beneficiaries to serve as co-trustees so they’re involved in the management of the assets. It may also be wise for a professional to serve with them to make sure the trust is being managed properly from a tax, legal and investment standpoint.

  1. Removal Power

Without removal power, a donor or beneficiary may be forced to work with an unreasonable trustee and may have no leverage to negotiate fees, asset management or distributions.

  1. Appointment Power

It’s typical for the donor to be able to appoint a trustee in the event of a vacancy or to plan for succession, but it is as important to consider who has this right after the donor. Keep in mind that the trust may last for multiple generations, so having some governance structure that works with an evolving world is important.

Optimizing Your Trust Performance

A trust is a vehicle by which your assets can be transferred to future generations, and it ultimately controls how your legacy is protected. Executing a trust should be a collaborative effort between your estate attorney and wealth advisor to ensure the distribution parameters are optimal for your goals, and reflect your intentions with respect to your heirs.

Your financial legacy is the culmination of your hard work, and represents a gift to your beneficiaries that will last long after you. Considering these different approaches to your asset distributions and trustee provisions will help ensure your legacy will be protected for future generations, and leave you with the peace of mind that your assets will be used the way you intended.

Minimizing Gift Taxes on Your Estate Through a GRAT

Posted by Sean T. Perkins, CFP®

How the Grantor Retained Annuity Trust (GRAT) Helps High Net Worth Investors Transfer Assets

Gifting wealth to the next generation is a wonderful way to leave your legacy and know you’re helping secure the futures of those you love. But even better is transferring that wealth in such a way that it helps minimize the impact of estate and or gift taxes of high net worth individuals and families.


What is a GRAT?

To understand how a GRAT can benefit you, it’s important to first understand some key points. A grantor is the person who creates and funds a trust. Trusts can be revocable, which means the trusts provisions may be changed during the life of the grantor, or irrevocable, which generally means the provisions may not be changed. If the grantor retains the power to control or direct the trust’s income or assets, that trust is considered also to be a grantor trust. So, by definition, all revocable trusts are grantor trusts, but only some irrevocable trusts may be grantor trusts.

Why is this significant? Grantor trusts are treated the same as the grantor for income tax purposes, so transfers between the grantor and trust are not taxable events, and any income earned by a grantor trust is reported on the tax return of the grantor.

A GRAT is an irrevocable trust, but it is also a grantor trust. It allows a grantor to potentially pass a significant amount of wealth to beneficiaries with no gift tax consequences. At a high level, the way GRATs are generally structured is that the grantor transfers an asset to the GRAT and retains the right to an annuity stream over a set term. The annuity amount is determined by the initial funding value, an interest rate set by the IRS (IRS 7520 rate or “hurdle rate”) that is in place at the time of funding, and the term of the GRAT. The idea is that the grantor will transfer an asset to the GRAT, which has the potential to appreciate more than the interest rate such that after the annuity payments plus interest are paid back to the grantor, there is a remaining balance that is left to the beneficiaries (typically heirs of the grantor or a trust for the benefit of the heirs).

For gift tax purposes, the amount of the taxable gift to the grantor is the fair market value of the property transferred to the GRAT less the value of the grantor’s retained annuity interest, which includes the interest rate mentioned above. If the grantor dies during the GRAT term, the value of the trust assets is included in the grantor’s taxable estate.

A popular approach these days is the “zeroed-out” GRAT. In such a scenario, the grantor sets the retained annuity interest equal to the value of the assets contributed to the GRAT, reducing the taxable value of the grantor’s gift to $0. The appreciation shifts to the beneficiaries without eating into the grantor’s gift and estate tax exemption.


Betting on the Market

On its face, a GRAT may seem like a strange option for a trust, since you’d be setting it up for your heirs, but getting all your assets back as an annuity.

Heightened market volatility can be unsettling for investors, but it is times like these that can present the best estate planning opportunities. Coupled with low interest rates (with a low hurdle rate a grantor doesn’t need much appreciation to generate tax savings), undervalued or potentially highly appreciating assets are ideal for GRATs. Any appreciation during the term of the GRAT is not included in the grantor’s gross taxable estate and, in effect, passes to the beneficiaries free of estate tax (GST tax may apply if the beneficiaries are skip persons).

Of course, investors understand the market can be risky. Relying on market outperformance over the full term of a GRAT may seem like too much risk. However, because a GRAT is a grantor trust that allows for the substitution of assets, there are options that allow you to preserve or lock-in the benefits of investment gains, or call it quits on a GRAT that has failed.

One tactic is to swap the shares in the GRAT with something that is less volatile such as bonds or cash (if the grantor has them to swap). In cases where bonds or cash may not be available, there has recently been some discussion by estate practitioners that a grantor could swap the interest for a promissory note from the grantor with a face amount equal to the fair market value of the substituted shares, earning a fair market rate of interest (this should be discussed with the estate attorney as it is more complex than using cash or bonds and may have different tax considerations if the remainder beneficiary is not a grantor trust of the grantor). In effect, the swap (whether for bonds, cash or promissory note) will “freeze” the value of the GRAT shares based on the price (fmv) of the stock at that time of the swap. The GRAT then becomes the owner of the cash, bonds or promissory note.

In the case of a successful GRAT, swapping provides a great opportunity to hedge against any future market declines by locking in gains now. The possible downside to locking-in early is that the shares may continue to appreciate to some degree, but if the grantor believes that will be the case, he/she can always transfer them to a new GRAT.

You may be wondering what happens if the market does poorly and the value of the assets in the GRAT declines more than the remaining annuity payments due to the grantor. GRATs do fail from time to time, but the important thing to remember is that the grantor will receive the original assets back regardless. If the grantor had held them personally during that time, they would still have gone down in value, so they are no worse off other than the legal and accounting fees they paid to draft and execute the GRAT document. Further, swapping assets with a GRAT that has failed also can be helpful. In the case of a failed GRAT, swapping can be a way of pulling back the volatile assets, which will allow the grantor to contribute them to a new GRAT and start over. Doing so allows the annuity payments to be reset at a lower value given the decline in value of the assets, and hopefully means that there is plenty of room for appreciation in the new GRAT.


Is a GRAT right for you when it comes to planning your estate?

If your estate attorney or tax advisor recommends a GRAT for transferring assets, the grantor should take several items into consideration.

  1. Asset type.
    1. Assets that have the potential for greatest gain should be considered. Collaboration among estate attorneys, accountants, wealth advisors and investment managers is critical when making a decision. The move should be highly considerate of market performance and volatility. Marketable securities are ideal due to their liquidity and the flexibility they provide relative to annuity payments, but grantors can also consider placing non-marketable assets, such as a family business or private stock, which can result in a valuation discount at funding due to lack of marketability (this can be optimized if the business produces cash flow, which can then be used to make the annuity payments with no discount or subsequent valuation requirement).
    2. Depending on which asset is selected, it will also be important to consider the basis of the asset and whether further planning should be done (such as swapping prior to the end of the term to retain low basis assets within the estate for a potential basis step-up).
  1. GRAT term and personal health. If the grantor does not live to the end of the term of the GRAT, the assets will be transferred back into his/her taxable estate. To reduce this mortality risk, consider shorter-term GRATs for elderly individuals or those families who have health concerns.
  2. Personal needs. Grantors should be certain their wealth planning is such that they can afford to live without the appreciation of the specific asset they contribute and don’t need it to offset personal spending now or down the road. They should also consider the impact on their overall portfolio allocation and that of the beneficiaries to understand how contributing the selected asset to a GRAT will impact the risk/return of the portfolio.
  3. Tax exclusions. Under the recently-passed Tax Cut and Jobs Act, there is a lifetime exclusion for estate and gift taxes of $11.18 million per individual as of 2018. In light of such a high exclusion amount, GRATs may seem unnecessary to all but the wealthiest of clients. However, historically low interest rates make GRATs compelling. That said, GRATs are typically not the best strategy to use when the grantor wants to make the most out of their Generation Skipping Exemption since you cannot allocate GST exemption at time of funding, but rather only on the backend when the remainder interest value is determined (at full value).
  4. Political climate. Another item to consider is tax policy. Although the current administration recently made sweeping changes to our tax laws, there is no guarantee Congress will not revise or repeal some of the laws if a new administration takes office in 2020. Nothing is static; any long-term planning should take potential changes into consideration especially as the rules for GRATs have been up for discussion over the last few years. It’s possible they may be subject to changes or limitations in the future.

If you think a GRAT is a sensible idea for transferring your wealth, your estate attorney, accountant and financial advisor will be able to help you decide whether it’s the right move. Working together, they can develop a plan to efficiently transfer wealth to your heirs, grow your assets, and minimize taxes.