Anita Sarafa, a managing director at JPMorgan Chase & Co. 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 allow wealthy children to pass investment gains on 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 of Silvercrest Asset Management Group of New York. The strategy has not escaped the attention of the Obama 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, the president of the National Association of Estate Planners and Councils in Cleveland.
"If they want to do something for their parents, they may want to go ahead and do it now," said Sarafa, who is based in Chicago.
Individuals can give up to $5 million to others during their lifetimes without triggering gift taxes, which have a top federal tax rate of 35%.
That will fall to $1 million and the maximum gift tax rate will rise to 55% 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 Sarafa, whose clients have $25 million or more of investable assets.
With a GRAT, a child sets up a trust with a term of at least two years and funds it 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% 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. shares in March 2009, when the IRS-set interest rate was 2.4%. 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% and the trust would pay the parent $2.6 million, Laufer said.
The Standard & Poor's 500 index had returned about 5% percent this year at Wednesday's close, which means a GRAT set up in January and invested in the index's stocks would have been ahead of its 2.4% 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 Convergent Wealth Advisors of Rockville, Md., 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 is 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, Tran said.
GRATs have been a popular tool for estate planners and are most commonly set up by parents to pass money on 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," Sarafa said. She declined to provide the client's name for privacy reasons.
Beneficiaries generally pay capital gains taxes of up to 15% 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%. The highest rate on ordinary income is 35%, which may rise to 39.6% 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, Sarafa said.
Families may pay anywhere from $5,000 to "hundreds of thousands of dollars" in legal and other fees to set up one or more GRAT, said Deborah Korompilas, head of trust and estate services for Harris Private Bank in Chicago, which manages $29 billion and is a subsidiary of Bank of Montreal.
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. 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 Carter Ledyard & Milburn LLP in New York.
The biggest risk for financially needy parents is that a GRAT's underlying investments won't beat the IRS hurdle rate, Laufer said.
"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 in Waltham, Mass.