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Your Bank > Education and Advice > CNB University

Lifetime Planning Strategies - Estate Freeze Strategies

James Lieb, CTFA
James Lieb, CTFA is Senior Vice President - Group Manager, Trust Administration Services and can be reached at JLieb@CNBank.com or (585) 419-0670 x50665.

With today's low interest rates and slumping stock and real estate markets, it is challenging to find something positive to talk to clients about. But, behind all the negative news, there are some positive estate planning strategies for people who have taxable estates.

There are many types of so called "estate freeze" strategies and we will review three of the more common types: the Grantor Retained Annuity Trust (GRAT), Qualified Personal Residence Trust (QPRT) and Charitable Lead Annuity Trust (CLAT). These three strategies are designed to "freeze" the value of the gift asset and move any future appreciation outside the individual's taxable estate.

An important factor to these strategies, is whether the asset will appreciate more than the published Applicable Federal Interest Rate (7520 rate) also known as the "hurdle rate". For April '08 this rate is near a historic low of 3.4%. This is the IRS's estimate of how much the asset will appreciate and is the basis for determining any gift tax implications by creating these strategies. If the asset is depressed due to current market conditions, this could increase the chance it will beat the hurdle rate.

GRATs are typically funded with equities or cash used to purchase equities. Asset selection is important since it will need to outperform the hurdle rate during the term of the GRAT. During the trust term the grantor (donor) receives a fixed annual annuity with the remaining assets passing to the next generation, assuming the donor survives the trust term.

For example, assume a transfer of $1 million to 10 year GRAT with a payout of 6% at the hurdle rate of 3.4%. The present value of the grantor's 10 year annuity payments totals $518,572, thus passing a future interest of $481,427 to family members at the end of the 10 years. The $481,427 would be considered a taxable gift; however, the grantor may apply a portion of his/her lifetime gift exclusion so that no gift taxes are due.

If during the 10 year period the investments realize a 9% annual total return (not 3.4%), the estimated value of the trust passing to the next generation would be $1,523,052. In summary, the grantor contributed $1 million to the GRAT and transferred $1,523,052 to the next generation thereby shifting $523,052 of appreciation out of his/her taxable estate.

A QPRT is a variation of a GRAT, except it is funded exclusively with a personal residence, a second home or vacation property. During the term of the trust one is entitled to use the property held in the trust and will continue to be responsible for the property taxes, insurance and repairs. When the property is transferred to the QPRT you are considered to have made a gift to the future beneficiaries who will receive title to the property at the end of the trust term. The value of the contributed property is afforded a discount; the exact amount depends of the age of the grantor (donor), the term of the trust and the current federal 7520 rate "hurdle rate". The discounted value is "frozen" and is the expected value of the property when it passes to the next generation.

Any appreciation of the property is removed from the donor's taxable estate, provided the donor lives beyond the term of the trust. QPRTs are commonly used with vacation (second) homes that have been in the family for many years.

With a CLAT, the annuity payments are made to charities (instead of the grantor) with the assets passing to the next generation at the end of the trust term. When the CLAT is funded, the value of the annuity payments is deducted from the value of the contributed property to arrive at the adjusted value that is "frozen".

The calculation is similar to the GRAT example. Assuming a donor contributes $500,000 to a 15 year CLAT; the donor would transfer $1,011,399 to the next generation and shift $511,399 of appreciation out of his/her estate. The present value of the annuity payments may be taken either as a deduction on the donor's personal tax return or as deduction against income during the life of the trust.

Today's environment offers a good opportunity to discuss these planning strategies with a trusted financial advisor. When used in conjunction with an individual's lifetime and estate planning, they are a powerful and effective means of transferring wealth tax efficiently to the next generation. To discuss these and other planning strategies, please contact one of the financial professionals in the Wealth Strategies Group at CNB.