Anita Sarafa, a managing director for JPMorgan Chase & Co. (JPM) Private Bank, helped a client give more than $300,000 to his parents free of gift taxes, using an estate strategy the Obama administration is seeking to limit.
Grantor retained annuity trusts, or GRATs, allow wealthy children to pass investment gains to their parents or grandparents without dipping into their $5 million lifetime gift-tax exemptions.
“It’s sort of a heads-I-win, tails-I-win technique,” said Allen Laufer, managing director for New York-based Silvercrest Asset Management Group.
The strategy hasn’t escaped the attention of President Barack Obama’s administration, which is recommending imposing 10-year minimum terms on GRATs that would make them less appealing for children looking to pass money on to elderly parents, according to Joseph Falanga, president of the Cleveland-based National Association of Estate Planners & Councils.
“If they want to do something for their parents they may want to go ahead and do it now,” said Sarafa.
Individuals currently can give up to $5 million to others during their lifetimes without triggering gift taxes, which have a top federal tax rate of 35 percent. This amount will fall to $1 million and the maximum gift tax rate will rise to 55 percent in 2013, unless Congress acts.
“A lot of people don’t want to use their lifetime exemption to move money upstream to their parents, they would rather use it to move money downstream to their children,” said Chicago-based Sarafa, whose clients have $25 million or more in investable assets.
With a GRAT, a child sets up a trust with a term of at least two years and funds the trust with stock or other investments. The trust pays the principal plus interest back to the child over its term as if it were an annuity, based on an interest rate set by the Internal Revenue Service. Any appreciation of the underlying investments above this “hurdle” rate passes on to the GRAT’s beneficiary, in this case the parents, without being considered a gift for tax purposes. If the investments return less than the interest rate, which was 3 percent in March, the GRAT must pay all its assets back to the child, with no gain for the parents.
For example, a child could have created a two-year GRAT funded with $1 million of Apple Inc. (AAPL) shares in March 2009, when the IRS-set interest rate was 2.4 percent. The child would have received a payment of $471,476 in the GRAT’s first year and $565,771 in its second year, according to Laufer. By March 2011 the shares would have gained a total of 300 percent and the trust would pay the parent $2.6 million, Laufer said.
The Standard & Poor’s 500 Index has returned 5.5 percent this year, which means a GRAT set up in January and invested in the index’s stocks currently would be ahead of its 2.4 percent hurdle rate. The IRS sets rates every month for new GRATs.
“Now is a very opportune time to do something like this” because interest rates are low and it’s still possible to set up GRATs with terms of as little as two years, said Sisi Tran, director of trust and estate planning for Rockville, Maryland- based Convergent Wealth Advisors, which manages more than $14 billion and whose average client account is about $50 million.
A 10-year minimum term would make GRATs less useful in providing for the elderly, said Tran, who’s based in Los Angeles. “The parent has to wait until the end of the term to reap the benefits,” she said.
If a child dies before a GRAT has paid out its assets, the GRAT becomes part of the child’s taxable estate, so 10-year terms also increase this mortality risk, said Tran.
Help With Expenses
GRATs have been a popular tool for estate planners and are most commonly set up by parents to pass money to their children, according to Tran. Using GRATs for a parent is “not that much different from planning for your child,” she said.
For Sarafa’s client, who set up two GRATs with two-year terms in late 2008 and early 2009, the structures allowed him to assist with medical expenses related to his mother’s Alzheimer’s disease and to provide for the quality of life of his “very active” father, she said.
“That really is going to provide a good cushion,” said Sarafa. She declined to provide the client’s name for privacy reasons.
Beneficiaries generally pay capital gains taxes of up to 15 percent on the appreciation of assets they receive from a GRAT, based on those assets’ original cost basis. The Obama administration has proposed raising the maximum rate on capital gains to 20 percent. The highest rate on ordinary income is currently 35 percent, which may rise to 39.6 percent in 2013, unless Congress acts.
One step children can take to increase the benefit their parents receive is to substitute cash for any investments that have appreciated within the trust before the term ends, in order to minimize the parents’ taxes, said Sarafa.
Families may pay anywhere from $5,000 to “hundreds of thousands of dollars” in legal and other fees to set up one or more GRATs, said Deborah Korompilas, head of trust and estate services for Chicago-based Harris Private Bank, which manages $29 billion and is a subsidiary of the Bank of Montreal. (BMO) The cost depends on the number and complexity of the trusts and on the lawyer’s hourly rate, she said.
The gift-tax status of GRATs was established in 2000 when the U.S. tax court decided a lawsuit in favor of Audrey Walton, the ex-sister-in-law of Wal-Mart Stores Inc. (WMT) founder Sam Walton, according to Richard Covey, who represented Audrey Walton in the case. Walton had set up two GRATs each funded with about $100 million in Wal-Mart shares and designed the GRATs to ‘zero out,’ or to fully liquidate their principal, so that only investment gains would pass through to her two daughters, said Covey, senior counsel for New York-based Carter Ledyard & Milburn LLP.
Beating Hurdle Rate
The biggest risk for financially needy parents is that a GRAT’s underlying investments won’t beat the IRS hurdle rate, said Laufer. “The GRAT only works where you have that appreciation,” he said.
Those unwilling to bet on the market’s return may consider giving money to their parents outright. For 2011, gifts of up to $13,000 are not taxed and will not count against an individual’s lifetime gift-tax exemption. A married couple may give married parents up to $52,000.
Children can also pay their parents’ medical expenses without dipping into their gift-tax options, as long as they pay the service provider directly rather than reimbursing their parents, according to Coventry Edwards-Pitt, a managing director of Ballentine Partners, a registered investment adviser, based in Waltham, Massachusetts.
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