The markets are in turmoil. Daily Dow movements make Cedar Point roller coasters look tame. The remake of the movie "Fast and Furious" will star a number of leading bankers. Lending sources have dried up for many. Tax, business, economic, investment matters are increasingly uncertain. How does this affect your planning? The bottom line is that you need to reevaluate all aspects of your planning with consideration to the current environment, while at the same time continuing to maintain planning basics. This article will provide an overview of some of the points you might consider. Given that ugly news is coming at Warp Speed, some of the comments below may not even be relevant once this newsletter hits your desk. Beam me up Scottie!
Insurance and Insurance Trusts (ILIT)
Even in rosy financial environments it is advisable every couple of years to review the financial status of the insurance company, obtain an in-force illustration and so on. Whether you've done this in the last year or two, the current turmoil should motivate you to do a review now. Don't assume your insurance company is safe, AIG changed all that. Query how that changes the fiduciary responsibility of trustees? If the policy is a variable policy, how badly have the underlying mutual funds been hammered? What does that do to future plans and the viability of the policy? If the variable policy is held inside a trust, what about the impact on the need for future gifts? What if the grantor has made other plans for her annual gifts? Just because your brother in law asked you to be a trustee doesn't mean you can ignore your responsibilities as trustee! Action Steps: Review and document the current status of the insurance company. If new insurance is purchased diversify - use a different carrier. Reevaluate whether the lower rate from a less secure insurer is a bargain or a problem waiting to happen. Obtain an in-force illustration and review steps you might take to shore up the policy. If you're a trustee, meet with counsel and review the benefits or obligations to communicate these matters with trust beneficiaries.
Insurance may need to be evaluated from another perspective. If your other income sources have been reduced, can you reduce or even delay insurance premiums for a couple of years until your financial situation turns around? Recent market shockwaves may have altered the fundamental reasons you purchased the insurance (to pay estate tax on your now defunct mortgage lending business). Re-evaluate what your needs are. You may want to freeze what had been an aggressive gift plan so that your insurance needs may increase. Perhaps you are now convinced that economic developments will force Congress to strengthen the estate tax, not repeal it. Perhaps increasing insurance in spite of economic conditions is the right move for you. Action Steps: Reevaluate all insurance decisions.
Grantor Retained Annuity Trusts come in many flavors. A common flavor has been a short term, typically two year GRAT designed to capture upside (not downside!) market volatility. The annuity paid to the grantor would be set high enough so that the GRAT would have a nominal value for gift tax purposes (the so-called post-Walton zeroed out GRAT). The result of this approach is that a substantial portion of the assets of the GRAT (your principal plus the 7520 mandated return) would be paid back to you as the grantor setting up the GRAT. Any market returns (do you remember what that means?) above the mandated federal interest rate, would inure to the benefit of your heirs (or a trust for them under the GRAT). This would result in your having to re-GRAT the large distribution you receive in each year of the GRAT to a new GRAT. This is why the technique of using repetitive short term GRATs is referred to as "rolling" or "cascading" GRATs. Whoops, instead of earning more than the mandated interest rate, your GRAT is worth 20% less than what you initially transferred to it. Most likely your GRAT will bust. All the assets will be distributed to you with nothing left for the heirs. What do you do? When life hands you a lemon, make lemonade! When the final GRAT assets are repaid to you, the trustees should sign a short acknowledgement that the GRAT has been terminated with a final payment to you (so that there is a record in the files of what happened should a question arise in future years). Next, continue your plan. Set up a new GRAT and re-gift the assets to the new GRAT. This was your plan when you undertook the rolling GRAT plan, no need to change now. If in fact the markets have been sufficiently hammered, this may be the ideal time to contribute depressed assets to a new GRAT. Stick with the discipline. If the asset class contributed to the GRAT rises within two years, you'll have made GRAT lemonade.
Real Estate and Business Note Sale Transactions
A common estate planning technique is to sell assets to a trust. This type of transaction can take many forms. The sale can be to a irrevocable grantor (taxed to you as grantor) trust (IDIT) for a note, for a self-cancelling installment note (SCIN), for a private annuity, etc. Similarly, many clients gift interests in assets to GRATs. A key to these transactions achieving their goals is that the assets will generate sufficient cash flow for the trust to pay the note, or the GRAT to make its periodic annuity payment. If economic developments have cast doubt on the trust being able to make payments out of cash flow, don't miss any payments. Don't miss a payment as it may provide a basis for the IRS to challenge the validity of the entire transaction. Audits have focused more attention on compliance with the formalities of maintaining the transaction. Issuing a note back to you to meet a GRAT payment won't fly. While it might be feasible to secure third party lending by the trust, this is likely to be complex in normal times, and perhaps impossible under current market conditions. The result will be that you may have to distribute back part of the equity of the underlying real estate, business interests, etc. This will require an appraisal. Watch out for discount whipsaw! If you realized a 35% discount on the 45% LLC interest you sold to the IDIT, or gave to the GRAT, will a higher discount apply to the 2% LLC interest that is distributed back to you? Again, while it is a cost, it doesn't necessarily disrupt your plan. Most of these transactions contemplated re-distribution of equity interests anyhow. Action Step: Review cash flow and payment options now, not when they become due.
Discounts and Valuations
Discounts are a cornerstone of many estate planning leveraging techniques. A discount is simply illustrated as follows: 30% of a $100 business is worth less than $30 because the minority interests is hard to market and has no control. Has recent market turmoil legitimately increased the discounts on certain transactions?
What about valuations? While the decline in the value of marketable assets is pretty obvious, other assets have also taken big valuation hits. To understand the impact, consider an approach of building up a capitalization rate for valuing real estate assets in today's environment: [Corporate bond rate + Premium for lower liquidity of target asset as compared to bonds generally + Premium for greater management difficulty of real estate + Premium for unique difficulties of assets in question (location, difficulty to liquidate) + Premium for additional management burdens of residential real estate, vacancy and credit risks of tenants in the actual properties involved + Premium to reflect unique factors in 2008 = Total Capitalization Rate.] Credit risks may be far greater than they have been in years. Unique factors certainly exist in the current market. Action Step: Now may be an opportune time to structure gifts. Higher discounts might be justified. Asset values may be depressed. Interest rates remain low. Estate taxes are unlikely to be repealed. Stop hiding under the bed. Move your planning forward.
Market turmoil is never pleasant. Taking the ostrich approach could torpedo your planning. Instead of fretting about what you can't control, take charge of the planning that you can. This article has illustrated only a few of the myriad of ways recent developments may have impacted your trusts.
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