Save the Estate--Tax or No Tax

Wealthy families are taking no chances. A wide range of trusts remain popular

The wealthy have always paid advisers fat sums to help them move assets from one generation to the next while minimizing Uncle Sam's cut. With the estate tax winding down over the next seven years, though, you might think these maneuvers had become passé.

Yet the alphabet soup of trusts that help the wealthy avoid inheritance taxes are hotter than ever. Why? Because of the way the estate tax phaseout was written, the tax will return in 2011 unless Congress acts to make the repeal permanent. Many Washington pols insist the tax is dead, but plenty of well-to-do families are taking no chances.

Ultralow interest rates are also making these trusts attractive. That's because many of the tax-avoidance strategies that are popular today resemble loans between family members. Because low rates allow the next generation to borrow cheaply, your heirs will be able to pay you back and pocket gains on successful investments while keeping tax bills to a minimum -- if not zero.

The trust you choose depends in part on your age and health, the amount of risk and complexity you can handle, and whether you want a charity to have a cut. "I have clients doing these like there's no tomorrow," says Joanne Johnson, managing director at JPMorgan Private Bank in New York. "These are strategies that everyone should be doing."

You need a considerable amount to put into a trust -- at least $100,000 for a loan and $500,000 or more for something more complex -- before it makes sense to set one up, says Don Weigandt, managing director at JPMorgan Private Bank in Los Angeles. Of course, before taking that step, you and your spouse can give up to $11,000 each to a relative or friend every year before you'll owe a dime in gift tax. Plus, over your lifetime you can transfer an additional $1 million, tax-free. Give anything more than that, though, and you'll owe gift taxes of up to 49% this year.


One of the most attractive wealth-transfer strategies is also one of the simplest -- a family loan. The Internal Revenue Service permits relatives to lend money to one another at rates the federal government sets monthly that are significantly below those on bank loans. July's rates are between 1.23% and 4.17% -- the exact rate will depend on your loan's maturity. The trick is for the borrowers to invest the proceeds in something that earns enough to pay you back and leave them with a profit. Of course, if the money is invested poorly -- say, in a stock that falls by 20% -- your heirs will have to dig into their pockets to retire their debt.

To protect against this possibility, you can lend the money to a trust set up for your relatives. That way, your heirs can't be held liable for a shortfall, says JPMorgan's Weigandt. Still, to set up a trust you'll need to pay a lawyer $1,000 to $10,000, depending on the trust's complexity.

Moreover, to pass muster with the IRS, the trust must own other assets worth at least 10% of the loan's value. So you'll have to donate that much to the trust and pay gift taxes of up to 49% on that amount or use some of the $1 million you're allowed to exempt from the gift tax. That means that if you want to lend your heirs $500,000, you'll have to put at least $550,000 into a trust.

A big risk is that if your asset declines in value, the trust will have to use money you gave it to repay its debt. If that occurs, you won't be able to file for a refund of the gift taxes you paid.


A GRAT is a trust that acts like a loan. As with a loan, it matures at a predetermined time. Moreover, any money you put into a GRAT will be returned to you by the time the trust expires. So what's in it for your heirs? All of the trust's earnings -- minus a percentage reserved for you that's determined by a government interest rate -- go to them, free of gift and estate taxes.

Here's how it works. Consider someone who puts $1 million of stock, real estate, or other assets into a GRAT that earns 10% each year. So no gift taxes are due, the owner -- say, a father -- agrees to take the entire $1 million back, plus an interest rate. In July, that rate is 3%, its lowest ever. Then, if your GRAT earns 10%, the additional seven percentage points of annual appreciation goes to your heirs tax-free when the GRAT expires.

GRATs have another advantage: If the trust falls in value, neither you nor your heirs have to cover the loss.

But there are a few caveats. Because GRATs have to pay you higher rates than short-term family loans -- 3%, vs. 1.23%, if you lock in a rate in July -- they pass along slightly less to your heirs. The biggest risk is that if you die before your GRAT expires, your estate will owe tax on the trust's entire value, both the initial contribution and any earnings, says Douglas Moore, national director of estate and charitable planning for Citigroup (C ) Private Bank.


Similar to GRATs, these trusts can be structured to pass most of their appreciation to your heirs, free of gift and estate taxes. But whereas a GRAT returns both interest and principal to its owner, a CLAT gives everything away. Interest payments, for example, must be earmarked for charity. Principal can go to charity and heirs. Once you fund a CLAT, you can't get the money back. As a result, these trusts are most appropriate for those with a considerable net worth -- say, $10 million or more, says Kevin Flatley, a lawyer and adjunct faculty member at Suffolk University Law School in Boston.

Low interest rates make CLATs attractive. That's because when rates are low, the IRS assumes your trust won't grow much. That, in turn, minimizes the amount of gift tax you'll have to pay. Say you put $5 million of stock into a CLAT and direct it to make a 5% annual payment to charity over the next 20 years. Since whatever's left in the trust after 20 years of charitable contributions will go to your heirs, the IRS levies gift tax up front on an estimate of what's likely to remain.

The IRS gift tax formula takes several factors into account, including an estimate of the trust's annual growth rate based on a government interest rate. Because that rate is currently 3%, the IRS assumes your CLAT will have to dip into its principal to make annual contributions to charity that are greater than 3%. Of course, if the IRS assumes your trust is going to eat into its principal, its estimate of what will remain for your heirs will fall -- and so will your gift tax bill, says Evelyn Capassakis, a partner at PricewaterhouseCoopers. Even if your CLAT actually grows by 20%, you'll owe no additional taxes.

CLATs have one big advantage over GRATs: If you die before your CLAT expires, no estate taxes are due. That's a big allure -- especially if the estate tax returns.

By Anne Tergesen

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