An Integrated Estate Planning Program for Wealthy Older Clients

Estate planning involves the process of creating and implementing a program for the growth, protection, use and transfer of wealth. It involves making arrangements for the transfer of property, both during life and at death, which are legally secure and subject to the least possible tax burden. An estate planning program for a wealthy older client involves coordinating the client's objectives with the resulting tax consequences and changing economic times.

There are a number of techniques available that can be used to implement a client's estate planning objectives with the least possible estate, gift and inheritance tax being imposed, and the purpose of this article is to introduce some of those techniques to you. The techniques in question include the Revocable Living Trust, Qualified Personal Residence Trust ("QPRT") and Grantor Retained Annuity Trust ("GRAT").

Revocable Living Trust

An effective tool in the design and implementation of an estate plan for a wealthy older client is the Revocable Living Trust. A Revocable Living Trust is a document which holds a client's assets, and manages and distributes those assets according to the client's wishes, both during lifetime and at death. You might think that a Will does this, but you must keep in mind that a Will does not come into existence until death.

What are the advantages of a Revocable Living Trust? The reasons for establishing a Revocable Living Trust as a part of an estate plan include avoiding probate, keeping the nature and extent of a client's financial holdings private, providing a mechanism to handle a client's financial affairs in the case of a disability and avoiding the pitfalls of owning property by joint tenancy.

Probate is a court supervised process pursuant to which an executor or a personal representative is appointed and an estate is settled at death. In many cases, Probate fees and attorneys fees are quite sizeable, and the probate process can result in significant delays in transferring property upon death to a client's intended beneficiaries. In addition, probate requires the filing of an inventory, which makes a client's entire portfolio of assets subject to public scrutiny. The Revocable Living Trust also provides a mechanism by which to manage a client's affairs in the event a disability occurs. The trust document will specifically state what is to occur with regard to the client's financial affairs in such an event. By having this mechanism in place, expensive court guardianship proceedings can be avoided.

The Revocable Living Trust will also provide the proper tax clauses necessary for an older wealthy client who has a joint estate, with his or her spouse, in excess of $1.25 million dollars. For such clients, unified credit and marital deduction trusts will be required for proper estate tax planning. For example, each individual is entitled to a $625,000 threshold amount which is not subject to estate or gift taxes. This is the unified credit exemption amount. In order for a client to take full advantage of the $625,000 exemption, the client must generally have $625,000 worth of property in his or her own individual name. Property titled jointly with one's spouse does not qualify for the $625,000 exemption, and for this reason a couple whose joint estate exceeds $625,000 must not own all of their property jointly. A worst case scenario is one where a couple owns $1.25 million dollars of property, and all of the property is owned jointly. In such a case, upon the first death there will be no estate tax due because of the unlimited marital deduction for transfers of property between spouses, either during life or at death. This will result in additional estate tax of $235,000 being paid at the surviving spouse's death, whereas if the couple had each owned $625,000 in his or her own name (or in his or her revocable Living Trust), no estate tax would be paid on the $1.25 million dollar estate.

Qualified Personal Residence Trust

For wealthy older clients, a Qualified Personal Residence Trust, or a QPRT, is a must. A QPRT simply is a trust which holds a primary or secondary residence of a client for the benefit of the client, and then after a period of time, for the benefit of the client's children or other family members, The objective of the QPRT is to remove the value of residence from the estate of the client, so that at death the residence remains in the family and no estate tax is paid on the value of the residence.

Let's assume that a client purchases a vacation home for $300,000, and the home is now worth $600,000. The client's taxable estate is $4.0 million dollars. It is expected that the home will be kept in the family and used by the client's children and grandchildren. If the client keeps the home in his or her name, estate tax will have to be paid on the $600,000 value of the home, resulting in approximately $300,000 of estate tax. By establishing a QPRT for the vacation home, the client can save approximately $187,500 in estate tax.

In this example, the QPRT has a term of ten (10) years. During this term, the client and his or her spouse have the right to live in the vacation property rent-free, just as the client has always done. At the end of the ten-year term, the property is then owned by the client's children, either outright or in trust. The client and the QPRT will agree, at the beginning of the QPRT, that at the end of the ten-year term, a fair market value lease will be entered into whereby the QPRT and the children will lease the vacation property back to the client and his or her spouse. This will assure that client has full use of the property after the ten-year QPRT term. The tax consequences to this example include the following:

• Upon creation of the QPRT, the client has made a gift to his or her children equal in value to the interest in the residence that the children will receive at the end of the ten-year term, With a value of $600,000, IRS actuarial tables equate that gift to $225,000. The client "pays" for that gift by using $225,000 of the client's $625,000 exemption from tax, which can be used for both federal estate (at death) and gift (during life) tax purposes.
• If the client had done no planning and the residence stayed in the estate until death, estate tax would be due on the property's $600,000 value, which would result in approximately $300,000 of tax being paid.
•  With the QPRT, gift tax on the $225,000 gift would be $112,500. The savings produced by the QPRT results from the difference between the $300,000 estate tax that would have been paid, and the $112,500 gift tax that was created by the QPRT, for a total saving of $187,500.

Some additional features of the QPRT are that the client can sell the residence during the term of the QPRT and replace it with a new vacation home, improvements can be made to the residence, and the $500,000 exclusion of gain rule for the sale of a principal residence is still available to the client with respect to the residence.

While there are many benefits to the QPRT, there are cautions to be aware of. First, the client must survive the initial term of the QPRT (in my example above, the term was 10 years) in order to achieve the tax benefits of the technique. As a result, the selection of the QPRT term is an important point to consider when establishing a QPRT, With a shorter QPRT term, the risk is somewhat reduced, but the value of the gift to the children will be increased. Second, the client will lose a "step-up" in basis for the property upon his or her death. In other words, the client's children will not take the date-of-death value of the residence for purposes of computing gain on the property for income tax purposes when the property is eventually sold. They will use the client's cost as their own for purposes of computing gain for income tax purposes.

Grantor Retained Annuity Trust

A Grantor Retained Annuity Trust, or GRAT, is a companion to the QPRT, with the exception being that instead of using a residence, the GRAT uses other assets such as marketable securities. While with the QPRT the client receives the right to live in the residence rent-free for the term of the QPRT, with the GRAT the client receives an annuity payment during each year of the GRAT, usually from the income the GRAT assets produce, For example, the client might fund the GRAT with $600,000 worth of securities, and receive a 7% annual annuity payment back from the GRAT of $42,000.

The tax savings to be achieved are also similar to those created by the QPRT. A lower, discounted gift occurs upon creation of the GRAT, which gift is "paid" for by using the client's $625,000 exemption from gift and estate tax. Estate tax is avoided by the fact that at the client's death, the assets comprising the GRAT are not owned by him or her, but are already owned by the children, either outright or in trust.

As with the QPRT, the cautions with regard to the fact that the client must survive the term of the GRAT and the loss of a step-up in basis also apply. In most cases, however, the tax benefits to be achieved outweigh the risks associated with both the QPRT and GRAT.

Two final notes with regard to a GRAT deal with the concept of using a closely held business to fund a GRAT and a , "zero" GRAT. A GRAT can be an attractive technique to hold the stock of a client's closely held business. The tax savings to be gained can be quite substantial. In essence, the client removes the value of the business from his or her estate at a lower, discounted gift tax value, and shifts all future growth in the business to his or her children, all of which reduce the client's exposure to estate tax. In addition, the client would still receive a flow of income from the profits of the business. After the term of the GRAT ends, the children might own the stock in trust, with the client's advisors serving as trustees. The client could then be retained as a consultant by the business to maintain the client's income stream, if necessary.

A wealthy older client who has a significant degree of financial expertise should consider the concept of a "zero" GRAT. With the "zero" GRAT, the client actually establishes a series of one or two-year GRAT's with the annuity payment that the client receives from each GRAT being set at such a high rate that no gift tax is deemed to be due according to IRS tables. If the after-tax rate of return on assets that the client funds each GRAT with outperforms the federal rate (which is used by the IRS when determining the gift tax portion of the GRAT transaction), the excess of the actual rate of return over the federal rate represents a transfer of wealth from the client to his or her children at no tax cost whatsoever. For example, a client would set up a I-year GRAT with $1.0 million dollars of selected securities which the client believes will have a rate of return of 15% or greater. At the end of the first year, the GRAT would be worth $1,150,000. The GRAT would then pay the client his or her annuity payment, which would be set at such a high rate such that no gift tax, according to IRS tables, would be due. After the client receives his or her annuity payment, since the 15% rate of return was higher than the federal rate, the GRAT will still have assets remaining. These assets would now be owned by the client's children, free of any estate or gift tax. The client would then, at the beginning of each following year, establish another I or 2-year GRAT with a "zero" gift. After ten or so years of throwing off the excess earnings to the children, free of any estate or gift tax, substantial wealth can be transferred at no tax cost through this technique.

Conclusion

The Revocable Living Trust, Qualified Personal Residence Trust and Grantor Retained Annuity Trust are proven estate planning techniques which must be considered when planning an estate for a wealthy older client. All of these techniques assist in producing an effective and workable estate plan which meets the client's objectives and produces significant estate and gift tax savings.