Enhancing the Planning Value of Grats

Robert Alexander
May 14, 2009 — 1,540 views  
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INTRODUCTION.    Grantor Retained Annuity Trusts ("GRATs") are one of the most important wealth transfer planning techniques available.  Standing alone GRATs can be used to accomplish substantial wealth transfers; however, when properly structured and coordinated together with other planning tools such as self-cancelling installment notes ("SCINs") and intentionally defective trusts ("IDITs") wealth transfers to donees and beneficiaries can explode exponentially.  This two part article will discuss a number of planning techniques which can increase substantially the planning value of GRATs both individually and in combination with other estate planning tools.

Because of the limited length of these articles the ideas presented will not be discussed in detail.  Rather, these articles will highlight the planning considerations for GRATs and suggest ideas which can enhance significantly the value of this important wealth transfer tool.  Part one of this article will present a framework for accomplishing significant wealth transfer and asset protection in light of contemporary sophisticated planning needs.  It will continue with a discussion of GRATs in general and suggestions for planning with GRATs.  Part two of this article will discuss advanced planning issues with respect to GRATs including "zeroed-out" GRATs, solving the GRAT/GSTT problem, and hedging GRAT mortality and economic risks.

II.        CONCEPTUAL OVERVIEW. [1] Forward thinking estate planners use a combination of techniques  to 1) transfer wealth on a leveraged basis, 2) freeze the size of the transferor's estate, 3) accomplish sophisticated family income tax planning, 4) asset protect wealth, and 5) incorporate multi-generational family wealth management and control into the overall family wealth plan. 

            Key advanced planning techniques involve lifetime annual and applicable exclusion amount gifts, multi-generational dynastic asset protection trusts, and the integration of GRATs, IDITs, and SCINs.  Basic gift and estate planning techniques will make full use of both annual exclusion gifts ($12,000 per year per donee) as well as the lifetime gift tax applicable exclusion amount (currently one million dollars per donor) and also will take advantage of leveraged transfers of highly appreciated assets to GRATs and IDITs by way of gifts, conventional installment notes and SCINs.    

Key planning strategies involve the creative integration of estate, income tax and dynastic asset protection strategies; financial planning techniques; selection of the best entities in which to own assets; the proper use of valuation discounts; leverage/freeze techniques; sophisticated trust planning and self-cancelling installment notes.  Typically, the best entities to use are "S" corporations, family limited partnerships, and family limited liability companies because 1) they provide the cash flow necessary to drive the techniques discussed in this article, 2)  they are pass through entities for income tax purposes, 3) they can be used to enhance asset protection planning, 4) they can be used for valuation discount planning, 5) they can be used to plan entity management in combination with properly structured trusts, and 6) perhaps most importantly, they can be used to provide wealth management and control of assets which are the functional equivalent of outright ownership over multiple generations as well as the life of the original transferor.

With respect to each of these planning techniques it is critical to understand the importance of sophisticated mathematical modeling with respect to the donor/transferor's after- tax, inflation adjusted cash flow needs as well as the likelihood of accomplishing successful wealth transfers given projected estate and income tax rates, interest rates, inflation rates, life expectancies, economic assumptions, estimated asset financial performance and a myriad of other personal, financial and tax contingencies.  It is important for planners to develop a comprehensive analysis of these estate, tax and retirement planning techniques in order to determine whether the plan in fact will cash flow and protect the needs of the donor/transferor throughout his/her lifetime which could easily extend to ninety or one hundred years.  Planners need to develop sophisticated mathematical proofs and spreadsheets in order to compare all possibilities and probabilities relative to the client's risk tolerance.  This will involve sophisticated "monte carlo" modeling, developing "what if" strategies, and learning to hedge financial, economic and mortality risks.  In the final analysis, planning will involve layering and modeling a number of different documents and planning techniques in order to successfully accomplish our client's financial, tax and family planning needs.  

 

III.       LEVERAGED FREEZES USING GRATs. A Grantor Retaining Annuity Trust (GRAT) is the lifetime transfer of cash or property to an irrevocable trust in exchange for the Grantor's right to receive fixed payments that are payable at least annually for the remainder of the Grantor's life or a specified numbers of years.  When the trust terminates the remaining amount of the trust assets are distributed to the trust beneficiaries transfer tax free even if the assets have appreciated significantly.  For gift tax purposes the value the remainder interest is the total value of the principal transferred to the trust less the present value of the retained annuity interest discounted using the Sec. 7520 rate.  Because the GRAT payment is a fixed amount determined as of the date of the transfer to the trust, it is like a fixed annuity.  There is virtually no downside estate planning risk with a GRAT other than the time it takes to successfully complete the transfer of wealth.  The most significant risk is the possibility of the Grantor's death during the term of the GRAT in which case some or all of the trust assets are included in the Grantor's estate for estate tax purposes.  This unfortunate event can have two disastrous results: first, estate taxes will have to be paid, and second, without proper drafting GRAT assets are not actually returned to the Grantor; therefore the Grantor may lack sufficient assets to pay the estate tax due.

            Pursuant to IRC Sec. 2702 there are six general requirements for a GRAT:  (1) the transfer to the GRAT must be irrevocable, (2) the retained income interest must be a "qualified interest" or the entire value of the initial transfer is a taxable gift of a future interest,  (3) the annuity payments must be made to the Grantor at least annually, (4) the annuity payments can only be made in cash and/or property,  (5) the annuity payments may increase at a rate of no more than 20% per year, and  (6) no further transfers to the trust are allowed during the term of the GRAT.

  GRATs are an excellent planning technique when: 1) the family wishes to shift wealth to beneficiaries at a gift tax cost that is less than the actual economic value of the transfer, 2) the grantor wishes to "zero out" the transaction, which means that the term, length and size of the GRAT payouts are arranged so that there is little or no taxable gift upon creation of the GRAT; 3) the grantor needs a steady cash flow during the term of the GRAT; and 4) in situations where either the initial contribution of property to the GRAT or later return of assets to the Grantor are difficult to value.  (i.e., the GRAT's property, such as closely-held stock, only needs to be appraised once at the time the trust is created - assuming GRAT property is not returned to the Grantor).

Upon creation of the GRAT there is a taxable gift equal to the fair market value of the property transferred to the trust less the value of the retained annuity payments.  Because transfers to GRATs are gifts of future interests, no annual gift tax exclusions apply.  Rather, the Grantor will have to allocate a portion of his/her lifetime applicable exclusion amount to the transfer in an amount equal to the value of the remainder interest.    The value of the retained annuity interest is based on the IRC Sec. 7520 for the month of the transfer.  By using the gift tax applicable exclusion amount ($1.0 million) and the $2.0 million GSTT exemption (2008), the current gift tax or GSTT liability may be reduced to zero.  For planning purposes keep in mind that the Walton case supports "zeroed out" GRATs where the gift tax value of the transfer to the trust is close to zero.  Walton v. Commissioner, 115 T.C. 15 (2000). The qualified interest is valued on the assumption that the term will end on the earlier of the actual termination date or the earlier death of the grantor.  Unless the retained interest is in the form of a qualified interest in a GRAT, the gift tax value of the retained interests is zero and the full amount of the entire transfer is at taxable gift.  Sec. 2702.  Valuation discounts also can apply to the value of the assets initially transferred to the trust and can be planned both to significantly leverage the wealth transfer and also hedge the economic risks of GRAT performance.

GRATs often include a provision for a reversionary interest in the grantor whereby the grantor's estate receives the trust property back if the grantor dies during the term of the trust.  However, under current law, the actuarial value of the reversionary interest does not reduce the value of the taxable gift of the remainder interest.

When determining whether or not a GRAT is suitable for the client there are several facts to keep in mind: 1) the planner needs to know if the client has appreciating assets with significant transfer tax exposure;  2) the client needs to be motivated to make lifetime transfers and is financially able to do so; 3) the trust property must be expected to outperform the IRC Sec. 7520 rate during the term of the GRAT; and 4) the Grantor is expected to survive the term of the GRAT,  although planners should keep in mind that it is possible to hedge the mortality risk of a GRAT.  As an example, both the spouses can fund separate GRATs in order to hedge the mortality risks; however, this requires careful planning, and may require an up-front intra-spousal transfer of assets.

There are several planning advantages with a GRAT.  GRATs can accomplish an effective estate freeze with minimal or no gift tax cost.  If the GRAT is "zeroed out", the grantor only uses a very small amount of his/her applicable exclusion amount.  Over the term of the GRAT the grantor receives the value of the property transferred to the GRAT in the form of fixed annuity.  The GRAT is created by the Code and the Regulations and therefore provides a safe, predictable result.  IRC Sec. 2702 and Regs.  In a worst-case scenario the family generally is no worse off for having used a GRAT; if the GRAT succeeds wealth is successfully transferred to the remaindermen on a leveraged basis and if the GRAT fails, the grantor generally is no worse off then if he or she had not used the GRAT.  Therefore GRATs provide a significant up-side potential with a very low downside risk.   Unlike other estate freeze techniques, with a GRAT the transferor bears the entire economic risk.  GRATs are ideal for high income/high growth assets;    therefore a large amount of appreciated wealth can be transferred to future generations with only a small up-front tax consequence.

Additional planning advantages of GRATs include the following.  For gift tax purposes if the GRAT payment is expressed as a percentage of the initial fair market value of the assets transferred to the trust there is very little risk of additional gift tax if the assets are determined to be undervalued upon audit.   The GRAT is a grantor trust for income tax purposes - IRC Secs. 671-679.   The grantor's payment of income taxes on the trust income essentially is an additional tax free gift to the trust.  Rev. Rul. 2004-64.  Finally, as stated before, any property remaining in the GRAT at the end of its term will pass to the remaindermen free of additional transfer tax.

Possible disadvantages of a GRAT may include the following: 1) legal, administrative and appraisal fees; 2) the trust is irrevocable and during the term of the trust the assets are not available outright to either the grantor or the remaindermen; 3) and special trust provision must be included for S corporation stock to ensure the trust is wholly owned for grantor trust income tax purposes as well as S Corporation status.  The mortality risk of a GRAT also is a concern; the grantor must survive the term of the GRAT otherwise there will be estate tax inclusion.  However, if the grantor dies during the term of the GRAT any applicable exclusion amount (AEA) used with respect to the gift when the trust was created is restored to the Grantor.  The trust must outperform the 7520 rate during the term of the GRAT or the trust will implode and no assets will remain in the trust for the benefit of the future heirs.  The trust assets also have a carryover basis in the hands of the remainder beneficiaries.  Because of the ETIP rules [IRC Sec. 2642(f)(1)] GRATs can be a very inefficient method of GSTT planning.  The grantor cannot allocate GSTT exemption to the remainder interest until the annuity interest ends.  Also, for GSTT purposes, the GRAT's leverage ends because the value of the interest for GSTT allocation is the full value of the property when the remainder interest terminates.  Lastly, the Grantor is taxed on all of the GRAT's income which may cause a cash flow problem for the Grantor if the transaction is not properly planned.

IV.              PLANNING IDEAS

A.                 General Considerations.

The following are basic planning/financial considerations when structuring GRATs.  First, analyze the term of the trust that will be required to generate the required transfer tax planning result - longer term, shorter term, etc.  Consider the grantor's age and health keeping in mind that if the grantor dies during the term of the trust, estate tax inclusion will result.  Determine whether the current Sec. 7520 rate is favorable to accomplish a significant wealth shift.  Remember that as a general proposition in order for a GRAT to successfully transfer wealth to the remaindermen, the total return of the trust must exceed the required Sec. 7520 rate.  The "total return" is the sum of the income generated by the trust plus the appreciation in the trust assets.  The amount of the tax free transfer to the remaindermen is the future value of the assets transferred to the GRAT minus the future value of the assets transferred back to the Grantor as qualified payments. 

Planners also need to ask the following questions: 1) what actual income will the trust assets generate each year; 2) will the trust be required to return trust corpus to the grantor in a given year in order to satisfy the payment requirements; 3) at what rate will the trust assets appreciate each year; 4) will the assets require annual revaluation because trust corpus is being turned to the grantor; 5) how easy are the assets to value and what will be the cost; 6) what is the cost basis of the assets.  Usually it is best to transfer high basis assets to a GRAT because the remaindermen receive a carry-over cost basis in the assets when the GRAT terminates.

Simple ideas to increase the planning value of GRATs include transferring assets that are expected to have rapid appreciation during the term of the GRAT,  transferring property which is temporarily depressed prior to funding the GRAT, as well as transferring stock that may be part of a post transfer IPO (initial public offering).  Significant financial and tax leverage can be obtained by using valuation discounts with respect to gifts of FLPs, FLLCs, and S Corporation stock to the GRAT.  (Compare the wealth transfer results of GRATs using assets with and without valuation discounts as illustrated in Charts 1 and 2).   Gift tax valuation discounts increase the wealth transfer leverage by reducing the required annuity payments.  The most effective property to transfer to a GRAT is property that will generate significant cash flow so that the GRAT cash flow by itself will fund the annuity payments.  Because GRATs are grantor trusts for income tax purposes, this allows the property in the trust to grow income tax free for future distribution to the heirs.  Also depending on the client's needs, planners can create many varieties of GRATs including the following: (i) standard GRAT, (ii) short term GRATs and Re-GRATing - rolling GRATs (iii) cascading or sequential GRATs, (iv) joint spousal GRATs, (v) spousal parallel or reciprocal GRATs, (vi) staggered term GRATs, (vii) GRATs with different payout rates, and (viii) GRATs with increasing or decreasing payout rates. 

B.         GRATs and Life Insurance.

Planners can "hedge" the mortality and economic risks that the GRAT will succeed by coordinating GRAT planning and the purchase of life insurance.  If the GRAT succeeds, you have leveraged the "wealth shift" to the heirs dramatically.  If the GRAT fails, the life insurance has covered the mortality risk.  Also consider transferring the remainder interest to a GST exempt life insurance trust.  Fund the life insurance trust using Crummey gifts, financing techniques such as split dollar arrangements, loans/premium financing or a combination of these techniques during the term of the GRAT.  When the GRAT terminates, the GRAT's income will fund the insurance premiums.  Remember that the GRAT is a grantor trust for income tax purposes.  Therefore, if the Grantor pays the income tax on the trust income this increases the leverage of both the GRAT and the use of life insurance because the Grantor's payment of the income tax is the equivalent of a tax free gift and the tax payments will further reduce the grantor's estate without transfer tax consequences. 

C.        GRATs and Prohibited Financing.

The donor must keep in mind that GRATs need adequate income and liquidity to make the required qualified payments.  The rate of return for the investments should exceed the Section 7520 rate or the goal of reducing the estate through a GRAT will be defeated.  If the GRAT assets do not generate sufficient income to fund the GRAT payments, GRAT assets will have to be used to make the annuity payments which can defeat the viability of the GRAT.  In the past some planners have tried to use creative financing techniques in order to make the GRAT annuity payments.  However, planners are cautioned to be very careful in considering these techniques since they can easily disqualify a GRAT.  Property subject to a loan may be characterized by the IRS as trust income for the grantor's benefit if trust cash flow is used to pay for the loan.  Payments for a loan are considered additions to the trust which is not allowed for GRATs.  The IRS may consider loan payments taxable gifts if the original taxable gift is valued based on the net value of the property (gross value less encumbrances).

The trust document must contain language that specifically prevents the trust from satisfying the payment requirements by using a note or other debt instrument, an option, or a similar financial arrangement.  Regs. 25.2702-3(b)(1)(I) and 25.2702-3(c)(1)(I). Borrowing from an unrelated party is permitted unless the transaction can be recharacterized as a step transaction and therefore the rules regarding financing of the required trust payments apply.

D.        GRATs and Estate Tax Inclusion.

If the grantor survives the GRAT's term the assets remaining in the GRATs are not included in the grantor's estate even if the assets have appreciated significantly.  However, the grantor's death during the term of the trust reduces the estate tax benefits because some or all of the value of the trust corpus is included in the grantor's gross estate.  The amount included in the estate is either 1) the value of the trust principle needed to provide for the remaining annuity payout under IRC 2036 (Rev. Ruls 76-273 and 82-15) or 2) the value of the entire trust corpus as of the date of the grantor's death as an annuity under IRC Sec. 2039 (PLRs 9345035, 941056 and FSA 20036012).  In the past the IRS took the position that the entire fair market value of the GRAT property was included in the grantor's estate at the date of death value.  TAM 200210009.  However, in proposed regulation 119097-05 (issued June 7, 2007) the IRS treasury indicated that IRC Sec. 2036 will be the code section applicable for determining the includable amount of the GRAT.  Therefore, it now seems that the inclusion amount of the GRAT is the value of an annual annuity (adjusted by any monthly, quarterly or semi-annual factor) divided by the Section 7520 rate on the date of death or the alternate valuation date.  If there is estate tax inclusion, the transferor's estate is entitled to a credit for any gift tax that was paid at the time the trust was created.  IRC. Sec. 2001(b)(2).

E.         GRATs and Grantor Income Tax Rules.

Most commentators agree that GRATs should be treated as grantor trusts for income tax purposes.  Therefore the grantor is taxed on the income received from the GRAT payments.  Also, the grantor could be required to report all taxable trust income depending on how the trust is structured.  IRC Sec. 671-679.  See: PLRs 9625021, 9504021 and 9451056 where the GRAT required payments from income first and then from principal.  When the Grantor pays the income tax on the income earned by the GRAT in effect there is an additional tax free transfer to the remainder beneficiaries because there are more assets left in the trust to grow transfer tax free.  Rev. Rul. 2004-64.  In addition, if properly planned, the income taxes paid by the Grantor reduce the size of his/her estate.  Recent IRS private letter rulings indicate that GRATs are not disqualified for favorable treatment under Section 2702 if they include provisions to pay for the grantor's income taxes in addition to the specified fixed annuity.  The retained right to distributions for taxes cannot be assigned value for the purpose of determining the gift tax value of the remainder interest.  PLRs 9416009, 9519029, 9345035 and 9404021, Rev. Rul. 2004-64.

F.         GRATs and Interest Rates.

The Section 7520 interest rate is used to calculate the values of the annuity interest and the transferred remainder interest when the GRATs is created.  IRC 2702(b)(2).  The gift tax value of a GRAT is determined by subtracting the value of the retained annuity from the principle's total value; therefore an increase in the annuity's value results in a decrease in the value of the remainder interest.  GRATs provide more favorable results when the Section 7520 interest rate is low than when the rate is high because the transferor's gift tax cost will be lower.  This result is dictated by the fact that the present value of the annuity interest is discounted using the Section 7520 interest rate.  Therefore when the 7520 rate is low the discount is less and the value of the annuity interest is higher.  A small time-value-of-money adjustment is required for annuities that are paid more than once a year and is based on the Section 7520 rate.       

G.        GRATs, Mortality Risk and the Marital Deduction.

Generally, the longer the term of the trust, the larger the value of the retained income interest and the smaller the value of the remainder interest for gift tax purposes.  However, the longer the term of the trust, the more likely it is the grantor might die during the term of the trust which causes estate tax inclusion.  In order to hedge this mortality risk, consider using multiple trusts with different terms, or provide for higher payments to the grantor during the early years of the trust with reduced payments in later years.  This will reduce the amount of the taxable gift.  Another way to hedge the mortality risk is to base the term of the retained interest on the joint lives of the grantor and the grantor's spouse.  In order to avoid a taxable gift to the grantor's spouse, the grantor can retain the right to revoke the survivor interest of his/her spouse.  However, note that the survivor's annuity probably does not qualify for the gift tax marital deduction.  PLR 9352017, TAM 9848004.

H.        Assets Used to Fund GRATs.

When selecting the assets used to fund the GRAT securities and real estate investments usually are best because they are more likely to appreciate in value and usually have significant cash flow to fund GRAT payments.  S Corporation stock is desirable because it can provide adequate cash flow and may have significant appreciation value.  However, GRATs normally do not qualify for the holding requirements for a Subchapter S trust (QSSTs) because they do not require all income to be paid out during the year.  This problem can be corrected if the GRAT gives the grantor a nonfiduciary right to buy or exchange trust assets in return for cash or other assets of equal value during the term of the trust.  Stock that requires the trustee to receive taxable dividends needed to make required annuity payments could be used to fund GRATs.  However, you need to make sure that dividends will in fact be paid if they are going to fund the required trust payments otherwise trust assets will have to be returned to the grantor.

V.                 CONCLUSION - INTRODUCTION TO PART TWO.

Part two of this article will discuss advanced planning considerations with GRATs including: 1) planning with zeroed-out-Walton GRATs; 2) planning to solve the GSTT/GRAT problem; 3) planning to hedge the economic risks of GRATS; 4) combining GRATs with disregarded entities; 5) combining GRATs with remainder sales to IDITs; 6) GRATs and S Corporation stock; 7) using SCINs to hedge GRAT mortality risk; 8) qualifying the GRAT for the marital deduction; 9) enhancing the economic performance of GRATs; 10) business and investment opportunity planning with GRATs; and 11) GRATs as an alternate to QPRTs.

 

 

 

Bibliography

 

  1. Bernstein Wealth Management Research.  Keeping It In the Family: Planning for Efficient Wealth Transfer.  Alliance Capital Management L.P. 2005
  2. Blattmachr, Jonathan G. and Diana S.C. Zeydel.  GRATs vs. Installment Sales and Other Competing Strategies.  Chapter 16, Thirty-Second Annual Notre Dame Tax and Estate Planning Institute. 2006.
  3. Keebler, Robert S.  The Mathematics of Gifting & Inter Vivos Sales.  2004 AICPA Advanced Estate Planning Conference.
  4. Mezzullo, Louis A. Successful Family Business Succession Planning.  National Law Foundation, 2004.
  5. Mulligan, Michael D.  Installment Sale to a Intentionally Defective Irrevocable Trust: Is It Better Than A GRAT?  Chapter 13, Twenty-sixth Annual Notre Dame Tax and Estate Planning Institute 2000.
  6. Oshins, Richard A. Cutting Edge Techniques to Enhance Popular High-end Wealth Shifting Strategies.  Chapter 4, State Bar of Texas: Leverage Gifting Transactions in the New Millennium. 2006.
  7. Practitioner's Publishing Company.  Guide to Practical Estate Planning.  Fort Worth, 2005.
  8. Practitioner's Publishing Company.  Guide to Business Succession Planning.  Fort Worth, 2005.
  9. Ness, Theodore, et al. Tax Planning for Dispositions of Business Interests, Warren, Gorham & Lamont, 1985.
  10. Siegel, Steven G. QPRTs, GRAT and SCIN: Planning and Drafting with Forms.  National Law Foundation, 2003.
  11. Weinstock, Harold and Martin Newmann.  Planning an Estate: A Guidebook of Principles and Techniques.  Fourth edition.  Eagon: West Group, 2002.
  12. Zaritsky, Howard M., et al, Structuring Estate Freezes Under Chapter 14, Warren,.  Gorham & Lamont, 2003.

*This Bibliography is not cited formally.


[1] The ideas presented in Section one have been gleaned from a number of authors, most importantly Robert S.

 Keebler, The Mathematics of Gifting & Inter Vivos Sales.  2004 AICPA Advanced Estate Planning Conference.

Robert Alexander

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Attorney Robert G. Alexander is the President and majority shareholder of Alexander & Klemmer, S.C., located in Milwaukee, Wisconsin and "Of Counsel" to Gonzalez, Saggio & Harlan, LLP, a highly respected national law firm with offices located in major cities throughout the United States. He earned a B.A. in English from the University of Wisconsin-Madison, J.D. from the University of Wisconsin-Madison Law School, and an LL.M. in Taxation from DePaul University. Mr. Alexander entered into private practice in 1978 and concentrates his practice in the areas of domestic and international wealth transfer, asset protection and family business planning, including federal estate and gift taxation; trust and estate administration; fiduciary income taxation; life insurance planning; retirement planning; charitable planning; business organization and succession planning and international tax planning. He has earned professional designations as a Board Certified Estate Planning Law Specialist (EPLS) as accredited by the American Bar Association, and as an Accredited Estate Planner (AEP) by the National Association of Estate Planners and Councils (NAEPC). He is AV rated by Martindale-Hubbell, its highest rating.