Certain junctures in life call for a shift in focus from accumulating wealth to retaining it for the sake of current and future generations. For insight on some of the strategies to retain the value of as many assets as possible, we tapped the knowledge of four wealth preservation experts: Robert C. Lawrence III and Jane Tse of Cadwalader, Wickersham & Taft, and Diane Lederman and Heidi L. Steiger of Neuberger Berman. We presented them with composite profiles of individuals at four stages of an affluent life: transferring assets to children and grandchildren, establishing an estate plan, selling a business, and restructuring a trust. Although it is tempting to summarize the experts’ advice with the adage of a fool and his money being soon parted, this paints the issue of wealth preservation with too broad a stroke. As has been demonstrated during the past three years, even the wisest individuals can part with large sums. Still, it would indeed be foolish not to seek and use information that would preserve your wealth—for yourself and future generations.
Structuring an estate plan that will minimize tax liability.
John Carey, a 75-year-old widower with a net worth of $70 million, wants to leave the majority of his wealth to his three children and his five grandchildren, who range in age from 3 months to 12 years old. Already, he makes the largest tax-free annual gift ($11,000) allowed by law to each child and grandchild.
Carey’s wealth comprises ranching properties and other investment real estate ($30 million), oil and gas interests in developed and undeveloped properties ($25 million), cash and marketable securities ($10 million), and personal residences ($5 million). In 1997, Carey and his wife, Maryann, established an irrevocable life insurance trust. An $8 million joint and survivor life insurance policy was purchased by the trust, and both of the Careys used $600,000 of their applicable exemption amounts and $600,000 of their generation-skipping tax (GST) exclusion amounts to fund the trust.
Carey is also the beneficiary of two trusts created by Maryann’s will. The first, a marital deduction trust (the assets of the deceased are put in trust for the benefit of the survivor), has a current fair market value of $32 million, which is reflected in Carey’s net worth. The children and grandchildren become beneficiaries of the second trust at his death. The current fair market value of this trust is $500,000, and it has a GST inclusion ratio of zero. Carey has no powers over this trust; therefore, it is not included in his gross estate.
Jane Tse: John Carey has not used his full applicable exemption amount, which is $1 million. He’s only used $600,000. That means he can still give away $400,000 without gift or generation-skipping transfer tax consequences. In making these gifts, he should plan to stuff as much as possible into this $400,000 so he can obtain a discount for gift-tax purposes. If he just gave $400,000 in cash, then he is really just giving away $400,000. Alternatively, he can give away interest that can have a lower value for gift tax purposes than its actual value.
Heidi L. Steiger: Carey could create an entity—a family-limited partnership or a family-limited liability company—and receive a 1 percent general partnership interest and a 99 percent limited partnership interest. Then he could gift the limited partnership interests to his children and grandchildren.
JT: If he gives away fractional interest in the limited partnerships, he could obtain a discount for lack of marketability and for minority interest. In valuing a gift, you look at what a willing buyer and a willing seller would pay. If you’re selling a limited partnership interest, or a small percentage interest, and there’s no market for it, obviously, the buyer would pay less. Your discount could go up to 35 percent—conservatively. You can really give away a lot more than $400,000 using this technique.
Robert C. Lawrence III: Let’s assume he takes some of the oil and gas interests and puts them into a family-limited partnership. If John Carey were to give oil and gas interests, then it would presumably be just worth $600,000. But if he takes those interests, puts them in a limited-family partnership, and then gives only a minority percentage of that partnership, the value is lower because you’re getting the discount. The real value, though, is higher.
JT: Suppose he gifts a 5 percent interest to the trust for his children and grandchildren. He can gift an actual value of $400,000. Or, he can give away an interest that’s really worth $600,000 if he takes a 30 percent discount. That comes to about $400,000. There’s already some leeway in valuing the underlying oil and gas interests to begin with, then on top of that, you get a discount.
HS: The one caveat is that the IRS has recently increased scrutiny on these partnerships.
RR: Can you elaborate on receiving the most benefit through valuation?
JT: When you make gifts, it’s best to make gifts that have a high cost basis versus a low cost basis because the beneficiary receives the property with certain adjustments. Suppose you have IBM stock that’s worth $100, but you purchased it for $10. When the beneficiary receives it, you made a gift of $100. When the beneficiary sells it, he has a gain of $90, so the beneficiary really isn’t receiving $100.
When a person dies, all of his assets get an adjustment basis to date-of-death value. If John’s assets are of a lower cost basis, it might be preferable for the marital trust so that he will have high cost basis assets with which to make gifts.
RL: Let’s assume that John and his wife bought the oil and gas interests together; say they each put in $100. When she died, her interest was then worth $1,000. John’s interest would be worth $1,000, too, on the day of her death, but her part would receive a stepped-up basis to $1,000; John’s remains at $100. If John is your dad and he gives you his interest, you take it at $100. When you go to sell it at $1,200, you’re going to have a gain of $1,100. If the amount is to be taken out of this marital trust and given to your father, and he uses that to give to you, then you would get a high basis. Since it had been stepped up, it would be $1,000, and you would only have a $200 gain.
RR: What are the tax consequences?
RL: There’s no harm done because to get the marital deduction in the wife’s estate, it will have to be taxable in the husband’s estate. But it gets stepped up in the process, so there is an income tax benefit. There will be no tax at the time of death when the first spouse dies.
JT: We’d have to look at Maryann’s will to make sure that the trustees are permitted to distribute principal for any reason. If not, the trustees would not be allowed to distribute this high-basis asset to John for the purpose of making another gift. We generally like to draft trusts in the most flexible manner, but sometimes trusts permit distributions of principal only for health and maintenance.
John also should review his assets and try to give away the assets that would appreciate the most. For instance, if he’s making a gift of $400,000, and if at his death it is worth $1 million, he’s really giving away $600,000 without any gift tax consequences.
RR: What about the tax burden in this case?
JT: The trust can be structured as a defective grantor trust [a trust used to decrease the value of an estate, which results in a reduction of taxable assets]. Any future growth of those assets will escape gift and estate tax altogether. For gift tax purposes, John has made a gift of the property, but he is not deemed to be making additional gifts when he pays the income tax liability. By paying the income tax liability, John is, in effect, adding assets to the trust without any gift tax liability.
RL: Let’s say I have $10 million, and I put it into a defective grantor trust. I make a completed gift for gift tax purposes, so I’m going to have to pay gift tax. If I live three years, I’ve taken $10 million out of my estate, I’ve taken $5 million in gift tax out of my estate, and I get all of the appreciation on the investment of the $10 million—assuming it goes up—out of my estate. I also have the ongoing obligation to pay the income taxes on the $10 million, which is also out of my estate. If I die within three years, though, the gift tax, by law, is brought back into the estate.
This is another technique that really is in competition with family-limited partnerships, and I think, quite frankly, it offers more economic benefit for passing wealth down. The problem? Assume this is a very successful trust, and pretty soon it’s worth $50 million—I’ve got the income tax liability. Or maybe the trustee does things that are taxable when it’s not convenient for me. I’ve got the ongoing responsibility, and it could bankrupt me. There needs to be some kind of exit strategy.
RR: What about loans?
HS: With interest rates being low, it would be a good time to do it.
Diane Lederman: If a father were to loan his children money and charge the rate that is required—it depends on whether it is a short-term, mid-term, or long-term loan—and then the trust of the children invests these assets and exceeds that rate, all of that increase in value stays with the children—or the trust—without being subject to gift tax or estate tax. All the father gets back is his loan amount plus this low interest rate. So it’s really a freezing technique in that you’re freezing the estate at today’s value and allowing all the appreciation to take place out of the estate.
RL: Wealthy people used to be able to lend money to their children without paying any interest. Then the law changed because it was felt that this was abusive. For a three-year loan, that rate is 1.46 percent, which is very low. The income that is payable—the 1.46 percent—he has to take as income and pay tax. But he would have had income tax on that anyway.
RR: We haven’t talked about philanthropy.
RL: We don’t know John’s charitable desires. But he has a fair amount of wealth, and it may well be that he will want to avail himself of some charitable deductions and make some variable gifts.
HS: Another thing to consider is a family foundation. There are reasons beyond just money and taxes to do a foundation. Obviously there are philanthropic reasons, as well. You get an income tax deduction, and money is going to pass to the foundation.
RL: There’s another thought. He may want to make taxable gifts because he’s quite elderly. If he makes a taxable gift, whatever he gives will be out of his estate. Any appreciation that occurs after he’s made the gift will be out of his estate. If he lives three years, he also has the gift tax out of the estate.
JT: Assuming that the top estate and gift tax are 50 percent, people think that the estate and gift taxes are the same because they’re both 50 percent, but actually, that’s not true. Suppose you made a gift during your lifetime of $66 to your children. At the rate of 50 percent, you pay a tax of $33. And if you live three more years, the $33 would never be added back to your estate. Really, you only pay $33, and you transfer $66 to your children. But if you died with $100, the tax is 50 percent on $100, so your children get only $50.
RL: The tax is included in the estate if you die, whereas, in the gift situation, if you live three years, the tax is out of the estate. It’s a bit unfair.
HS: Another thing they could do is a charitable lead annuity trust (CLAT). With the CLAT, the charity receives payments for the term of the trust, and then the remainder goes to other beneficiaries. When you set up this annuity trust, there might be a gift tax on the value of the remainder beneficiaries’ interest, but the gift is discounted for tax purposes because the beneficiaries don’t receive the gift until the trust ends. So if the trust’s investments earn a higher rate of return than the rate assumed by the IRS, the excess can pass to the children invisibly, if you will, without incurring any estate or gift tax. It’s actually a really attractive thing to do right now. It’s not tax-exempt, so you can’t use it to avoid capital gains taxes. The trust income is going to be subject to those taxes.
JT: A GRAT, or a grantor retained annuity trust, is another way for John to make gifts to his children without any transfer taxes. He can set up this GRAT and transfer $10 million in transferable securities to it, and he can retain the right to receive an annuity for a term. I’d choose two years because he must survive the term. The IRS has special tables to determine how much he has retained for gift tax purposes. The IRS assumes that money appreciates, or earns income, at a rate of 3.8 percent. That rate changes monthly. You can set up the annuity in such a way that John has retained so much that the annuity is worth 100 percent of what he is transferring—that there’s nothing left at the end of the two-year term.
However, if the assets perform better than the IRS’ expected rate, all that excess would be transferred to the children tax-free at the end of the term. There’s no downside to the GRAT because if the assets didn’t go up in value, then he didn’t pay any gift tax and he would get property back and he could do it again the next year.
RL: Assume for a minute that he has an asset that is going to appreciate rapidly. Let’s say I put in $100, and all my hopes come true and it’s now worth $200. At the end of the day, the children get $100 tax-free—no gift tax—if I live out the term. So, I’ve transferred to my children substantial wealth that basically avoids the gift tax and the estate tax because that $100 isn’t going to be in my estate, either.
Finally, John Carey is not making any annual gifts to the spouses of his children. He can give $22,000 to the parents, and the grandchildren are each another $11,000. He has 11 people that he could give to and get $110,000 a year out of his estate.
There are some other things that are important. He could pay all of the educational expenses for his grandchildren, and that is not a taxable gift and not [considered part of] the annual exclusion. You have to pay it to the institution. There are also 529 plans for education. I’m not a great advocate because there are very restrictive rules with regard to the investment. But that’s another way to eliminate tax.
JT:I don’t like the 529 because it is counted as part of the $11,000. Give the $11,000 plus pay the tuition directly.
We would have to find out what John owns and what the marital trust owns because when John dies, it’s important that he and the trust don’t own a majority interest in any of the entities. Even though John’s assets are in the marital trust—they’re both included in his estate—they are considered different entities for valuation purposes.
RR: What do we need to know about the changes in the estate tax?
RL: In July 2001, Congress changed the estate and gift tax law. The gift tax exemption stays at $1 million, and the GST exemption goes up to $3.5 million in 2009. The top estate and gift tax rates are going down between now and 2009 to 45 percent. In 2010, the estate and GST tax will be repealed, but there will still be a gift tax. In 2011, we revert back to the rules of 2001, back to the rate of 55 percent and GST exemption of $1 million. We as practitioners and advisers find it difficult to know how to advise clients when we don’t know what the law will be, because it can’t stay the way it is.
Robert C. Lawrence III is a partner at Cadwalader, Wickersham & Taft in New York, where he serves as chairman of its Private Client Department, specializing in international and domestic tax, trust, and personal financial planning matters. Diane Lederman is a senior vice president and chief fiduciary counsel at the investment firm Neuberger Berman in New York. Heidi L. Steiger is executive vice president of Neuberger Berman and the editor of Wealthy & Wise: Secrets About Money (John Wiley & Sons, 2002). Jane Tse is special counsel in the Private Client Department of Cadwalader, Wickersham & Taft, where she specializes in estate planning.
Cadwalader, Wickersham & Taft, 212.504.6000, www.cwt.com;
Neuberger Berman, 800.877.9700, www.nb.com