Realizing that a properly designed GRAT is a “win-win” for taxpayers, restrictions have been proposed to limit the usefulness of GRATs. These proposed restrictions include:
•GRATs must have a minimum 10-year term.
•The annuity payment may not be reduced from one year to the next during the first 10 years of the GRAT term.
•The GRAT remainder interest at the time of the transfer must have a value greater than zero.
In 2012, GRATs remain alive and well, and interest rates that determine the size of the annuity that must be paid to the grantor to “zero out” the GRAT (and hence the amount of leakage back into your estate) are at historic lows. As a result, many tax experts are hawking 2012 as the last great GRAT opportunity. While that may be true, as discussed in Chapter 5 and later chapters, for many taxpayers 2012 GRATs may not be the optimal strategy. Like every great tool, GRATs need to be used in the right circumstances only.
Valuation Discounts
Remember your first grade math? 1+1 equals 2. Well with valuation discounts, taxpayers have long been able to prove that the sum of the parts is less than the value of the whole, at least for gift and estate tax purposes. When a taxpayer gifts 30 percent of an interest in a limited liability company (LLC) owning a $1 million rental property, the value of that LLC interest is not $300,000 (30% x $1 million), but something less to reflect that a 30 percent minority owner generally cannot influence important business decisions, including cash distributions, and so on. While there is clearly merit to this concept when unrelated parties do business together, the economic reality becomes less certain when mommy, daddy, and a trust for Junior are the partners. As a result of the perceived abuses associated with intra-family transfers of hard-to-value assets, and the costs to the court system of litigating discounts, many proposals have been floated to restrict or eliminate certain valuation discounts. There is a good chance that discounts as they presently exist will have a short half-life.
The use of entities like family limited partnerships (FLPs) as a wealth-shifting tool may be curtailed. For example, the tax laws provide that, for valuation purposes, certain contractual restrictions (e.g., in a partnership agreement) that are more restrictive than applicable state law should be ignored when determining values. Certain states (e.g., Nevada) have laws that incorporate significant transfer restrictions, thus undermining the effectiveness of this federal provision. New legislation might mandate that even certain state law restrictions be ignored when valuing family business interests for federal gift and estate tax purposes. This could include certain categories of restrictions, such as the lack of an indefinite term in an agreement, the creation by transfer of a limited assignee interest, or an inability to withdraw capital (called a “lock-in feature”). For example, a lock-in provision might prevent any member of a limited liability company (LLC) from exiting the entity as an equity holder for a specified minimum period of time without some adverse consequence. This would significantly increase the valuation discount for lack of marketability since it would prevent realization of the value of the LLC interests for the lock-in period. Transfers of small FLP interests to non-family members (so that family members cannot unilaterally remove the restrictions used to justify discounts) might also be legislatively addressed. So if you want to take advantage of these favorable valuation discounts, act quickly. Whatever changes may occur in the discount arena, FLPs and LLCs will likely remain important planning tools because of the many non-estate tax benefits they provide, such as asset protection, centralized management, and income shifting.
For 2012 the “Discount Game” is alive and well. When combined with the generous $5.12 million gift tax exemption (or $10.24 million for a married couple), it creates truly amazing wealth shifting opportunities. But many taxpayers, and even many estate planners, remain obsessively focused on discounts, distracting them from more valuable planning benefits, such as the tax burn that can be achieved with grantor trust status (that is, that the trust will grow free of income tax because its income will be taxed to you, as the grantor). The obsession with large discounts can prove to be a mistake for some, especially in light of the heightened audit risk that comes with claiming aggressive discounts. This issue will be addressed in later chapters.
Grantor Trust Modifications
Grantor trusts, in very simple terms, are trusts that include certain provisions (or are administered in certain ways) to allow the income to be taxed to the grantor (typically, but not always, the person who established and funded the trust). Because of the disconnect between the gift/estate tax rules and the income tax rules, it is possible to walk the tightrope between the two tax worlds such that the grantor pays tax on the income and gains earned by a trust that is excluded from his or her estate. One advantage of grantor trust status is known as tax burn in that your estate is “burned,” or reduced, by the ongoing income tax liability caused by the attribution of the trust’s income to you as the grantor, and not to the trust or its beneficiaries, Moreover, your payment of income tax on income and gains retained inside an irrevocable trust is not deemed to be an additional gift by you to the trust. Thus, grantor trust status can shift the value of the income tax savings over many years to the irrevocable trust and provide in aggregate a significant wealth shift. President Obama’s 2012 Greenbook has proposed eliminating this benefit by ending the dichotomy between income and gift taxation of grantor trusts. It proposes to do this by making transfers to all grantor trusts incomplete gifts for gift and estate tax purposes. This would mean that all of the growth of the assets inside the trust free of income tax, as well as the trust’s underlying assets, would be includible in your estate and subject to estate tax at your death.
In spite of the incredible benefits grantor trust status affords under current law, many estate planners are using irrevocable non-grantor trusts as the receptacles for 2012 gifts. Other estate planners continue to emphasize aggressive audit-attracting valuation discounts while ignoring the benefits of tax burn. Even if you are reluctant to make any meaningful gifts in 2012, you might consider the “Standby BDIT” technique. The use and application of grantor trust status in these as well as other ways is discussed in Chapter 5.
PLANNING NOTE: In some cases, use of grantor trust status can increase income tax. First, you as the grantor might be in a higher federal income tax bracket than the trust or its beneficiaries. Second, you might be subject to a state (and perhaps local) income tax that the trust, if not a grantor trust, would not. It is appropriate to consider these factors in determining if the benefits of grantor trust status is greater than the detriments.
GST TAX CONSIDERATIONS FOR 2012
The generation-skipping transfer (GST) tax is one of the most complex of all tax laws. But in 2012 it may be one of the most important tax rules to use effectively for long-term family wealth accumulation. If you view your planning as simple 2012 gifts, you may be overlooking the incredible power that proper GST planning can provide. In short, the goal for many should be to allocate your GST exemption amount to leveraged lifetime gifts, made to long-term, multi-generational trusts such that these dynastic trusts are entirely exempt from the GST tax (as well as future gift and estate taxes) for as long as feasible. These concepts can be illustrated with the following example.
EXAMPLE: You plan to establish a “complex trust” (a trust that pays its own income tax, other than to the extent that distributions pass income to the beneficiaries). The trust is to be established in your home state for your child and grandchild. You intend to gift $2 million in cash to the trust. The trust ends when
