Trust Planning Through Economic Turmoil

Summary:

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.

Securities
GRATs

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.

Conclusion

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.