Most practitioners know about the estate tax planning “window of opportunity” that may be closing soon. We’ve only got the $5.12 million gift tax exemption until year-end and President Obama’s budget proposal has targeted “loopholes” like GRATs and valuation discounts.
You would think these urgencies would be enough to convince high net worth clients to move forward with advanced-level planning (like Dynasty Trusts, GRATs, LLCs, installment sales and completed gift DAPTs) — but it’s still difficult to get people to take action!
Having run into this client procrastination problem too many times, I realized that this has less to do with what we say to our clients than how we say it. We, as attorneys, are often guilty of making planning strategies sound too technical and complex for people to absorb them and feel comfortable committing to implement them.
So, after considerable arm-twisting, I persuaded renowned estate tax and asset protection attorney, Steven J. Oshins, to share with me exactly how he explains GRATs to his clients – – and gets so many of them to agree to move forward right at his initial meeting! Here are some excerpts from our interview…
Phil: How do you grab clients’ attention about the GRAT, in a way that they understand it and you get them to actually engage you and move forward with this planning?
Steve: I’ll role play this with you.
“Phil, it’s good to see you again. We’ve just signed your Living Trust and now we’re ready to talk about doing some advanced estate planning and try to move some of the wealth out of your estate for estate tax purposes. I noticed when looking at your list of assets that there are a couple of assets that I think would be perfect for something called a GRAT. The assets that I noticed which would be good include the $5 million portfolio of publicly traded stock. It would be nice to move that out of your estate. I also noticed that your existing business that you have down as a $10 million asset would be a nice GRAT candidate. Have you heard of a GRAT before or should I explain it to you?”
Phil: “No, I don’t know much about GRATs.”
Steve: “The way a GRAT works is you set up an irrevocable trust for the benefit of your family and you retain a stream of annuity payments for a term of years. At the end of that term of years, whatever is left, if anything, continues in trust without any further gift taxes for the benefit of your spouse and decedents or other beneficiaries. The benefit of a GRAT is that you can move a lot of wealth out of your estate for estate tax purposes at a very low gift tax value. Let me explain this in basic mathematical terms.
Let’s start with your publicly traded stock of $5 million. Let’s say we put that stock into a 2-year GRAT, for example. You put the stock into the Irrevocable Trust and for a 2-year period, you’ve received a stream of annuity payments, let’s say once a year. You get about half the stock at the end of the first year and you get approximately the other half at the end of the second year. If the stock grows faster than the IRS’ assumed rate of growth, then the excess of that assumed rate of growth will be moved out of your estate for estate tax purposes. So the hurdle that you have to beat is the IRS assumed rate of growth.
During the current month, the assumed rate of growth is only 1.4% (as of January 2012), which is one of the historical lowest rates that the IRS has ever issued. So, all we have to beat is 1.4% of growth and dividends per year in a 2-year period. If we don’t beat that rate, it all comes back into your estate and we did nothing and all you’re out is the set-up fees. If we beat that hurdle, then we might move $1-2 million out of your estate, for example, if the stock grows at 10-20% per year.
The way this works on an economic basis, not factoring in any time-value of money, is very basic. If you put $5 million into a GRAT that pays you $2.5 million per year for two years, what is the value of the gift? It’s simple subtraction.
Phil: “Not very much I guess.”
Phil: “Maybe a little interest or something, that’s it.”
Steve: “Great. Very perceptive. That is the IRS’s assumed rate of return, let’s say, 1.4%. If the stock grows at exactly 1.4% during both years, then we will have essentially moved zero out of the estate. So, the value of the gift for gift tax purposes is essentially zero. Now, I do aim for at least a $1 gift for gift tax purposes, just because I want to be able to report some element of a gift on a gift tax return so the IRS can’t fight it years later. But, if you gift $5 million and you retain two payments of $2.5 million, not factoring in time value, you’ve made a gift of zero.
This technique works really well because we’re not using any of your exemption for gift tax purposes. We can use the exemption for other gifts or save it to be used at your death against the estate tax. And the other reason this works well is there is almost no valuation risk. That doesn’t really matter when it’s publicly traded stock, but it could matter with hard-to-value assets like your business, where there’d be some element of valuation risk with any other technique but a GRAT.”
Phil: “So, how could this GRAT work with my business?”
Steve: “Your business looks like it is an S-Corporation. Let’s recapitalize your S-Corp into 1% voting and 99% non-voting and gift the 99% non-voting into a GRAT that has a longer term of years. We won’t use a 2-year term because how will we make a payment back each year if we have to pay about half the value of the business back?”
Phil: “Right, that was easy to do with stock, but not so easy with a business because it’s not liquid.”
Steve: “Exactly. I see from your business financials that you have about a $1 million cash flow per year after expenses. We are going to probably end up doing a 6- to 9-year GRAT. It will be depend on the cash flow we expect and the valuation discount that is applied to a gift of a non-voting interest.
Assuming your business is valued at $10 million, we’ll hire a business valuation appraiser to both value the business itself and value a 99% non-voting interest in the business. That 99% non-voting interest will get a discount. The discount will reflect that it is a non-voting interest in a closely-held entity with no ready market. Assuming about a 40% valuation discount, you will make the gift of what we thought was $10 million, but gift it at a value of about $6 million after discounts. When you retain the annuity stream from the GRAT, we will have to retain an annuity with a fair market value of approximately $6 million on a present value basis, plus an interest element, of course.
So, if you have about a $1 million annual cash flow, then with appreciation and with factoring in the IRS’ assumed rate of return, we should be able to make this one work in about 7 years because we have essentially $6 million coming back in 6 years. But with only 6 years, we’re taking a risk that if we have a little bit of a down cash flow year, we’re stuck. Let’s go with either a 7- or 8-year GRAT because we want to make sure it works from a cash flow standpoint. Of course, we’re going to plan for you to keep enough other assets outside the GRAT so you won’t fall short of the cash flow you need to live on.
We are going to get the value down to about 0 for gift tax purposes and at the end of the 8-year period, you will have moved 99% of the business out of your estate at a taxable gift of approximately $1. That’s pretty good leverage.”
Phil: “Why don’t I just gift the business directly to my kids or to a ‘Dynasty Trust’ for them, like you’ve told me about before?”
Steve: “The Dynasty Trust is certainly better when we want to pass assets down to multiple generations without estate tax. But, I find the GRAT works the best when we have a valuation issue such as with your business, and especially for you since you have been my client for years and I remember you telling me that no matter what we do, you don’t want to take any gift tax risk. One appraiser might say it’s a $10 million business and another appraiser might say it’s a $20 million business. Certainly it’s very subjective. If we do a different type of technique, like a Dynasty Trust, there is more of a gift tax risk. But a GRAT has nearly a zero gift tax risk because if there is any change in value on an audit then there are just adjustments made by the GRAT and it doesn’t materially affect the gift tax element of it. If we did a different technique with a hard-to-value asset and the IRS later says it was worth $20 million and not $10 million, then you might owe a gift tax plus interest on the additional $10 million that you transferred and you wouldn’t be very happy.
That’s the reason why it’s sometimes better to use a GRAT for a transfer of a business or other hard to value asset. However, certainly the Dynasty Trust option should also be considered.”
Phil: “I see. Let’s stick with the GRAT. You’re right that I would rather give up the Dynasty Trust benefits to know that I won’t owe any gift tax.”
Steve: “Using the GRAT for your stock or business will help you save millions for your family that the IRS would otherwise get. Sound good?”
Phil: “Yes. Let’s do it!”
Steve: “Great! Here’s how we work…”
This is just a portion of our GRAT interview. Of course, in the process of advising clients about a GRAT, Steve also addresses the issue of what happens if the grantor fails to survive the term of years. As a benefit to fellow WealthCounsel members and WealthCounsel newsletter readers, The Ultimate Estate Planner, Inc. is making available the following items as a complimentary benefit. First is the full audio recording (including how to handle common client objections). The second bonus is a sample letter to be sent to clients with larger estates to help get them to act and come in and meet with you to discuss this advanced-level estate tax planning available to them this year. To access these bonus items, plus information on other audio recordings with Steve Oshins on how to successfully “close” more clients on various other advanced-level estate tax planning, click here.
Hope this helps you help more clients actually do the planning they need!
ABOUT THE AUTHORS
Attorney Philip J. Kavesh is the principal of one of the largest estate planning firms in California – – Kavesh, Minor and Otis – – now in its 34th year of business. He is also the President of The Ultimate Estate Planner, Inc., which provides a variety of training, marketing and practice-building products and services for estate planning professionals.
If you would like more information or have a question for him, he can be reached at [email protected] or by phone at 1-866-754-6477.
Steven J. Oshins, Esq., AEP (Distinguished) is an attorney at the Law Offices of Oshins & Associates, LLC in Las Vegas, Nevada, with clients throughout the United States. He is listed in The Best Lawyers in America®. He was inducted into the NAEPC Estate Planning Hall of Fame® in 2011 and was named one of the 24 Elite Estate Planning Attorneys in America by the Trust Advisor. He has authored many of the most valuable estate planning and asset protection laws that have been enacted in Nevada. He can be reached at 702-341-6000, ext. 2, at [email protected] or at his firm’s website, www.oshins.com.
This article was featured in the April 2012 WealthCounsel Quarterly Newsletter. To download the full newsletter, click here.