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- Annuities: Variable Annuities Annuities are hot. The tax rules vary with the circumstances. Advisors must be aware of these intricacies when discussing annuities with clients.
Although it might seem that your clients have little in common with the inside executives at Twitter, the company’s initial public offering (IPO) documents would indicate otherwise.
The Twitter executives developed a plan to reduce their eventual gift and estate taxes in advance of their IPO, which could, of course, cause the value of the company to skyrocket.
(Indeed, the shares were trading around $43 Friday morning after the offering was priced Wednesday evening at $26 a share. But how the company performs in the longer term remains to be seen - Ed.)
A closer look at the planning strategies employed by Twitter shows that your client does not have to be sitting on the next hot silicon valley IPO to benefit from their use. Even if your client does not own pre-IPO shares, the freeze and discounting strategies used can save them from a hefty tax bill.
Twitter’s Trust Strategy
Twitter’s IPO documents indicate that both its chairman and largest shareholder have transferred substantial amounts of their stock holdings into what the documents call “annuity trusts,” which are believed to be grantor retained annuity trusts (GRATs). Further, the company’s chief executive and his spouse transferred shares into an irrevocable gift trust.
The rationale behind these trust strategies is simple — the executives anticipated the value of their pre-IPO shares to grow substantially and logically wish to shelter this appreciation from taxes to the greatest extent possible.
The strategy works — and can work equally well for your clients — because it freezes the value of the shares at their pre-IPO prices for transfer tax purposes.
Mechanics of the Trusts
A GRAT essentially combines a trust that is established for a certain predetermined period of time with an annuity that pays the trust creator (the grantor) a set value each year of the trust’s existence. This annuity payout is the grantor’s retained interest. The remaining value passes to the grantor’s beneficiaries, and, thus, out of the grantor’s estate.
The value of the taxable gift to the GRAT beneficiaries is equal to the fair market value of the property transferred into the GRAT minus the grantor’s retained interest. The grantor’s retained interest is the actuarially calculated value of the annuity stream he will retain over the GRAT’s life based on the Section 7520 rate in effect for the month in which the GRAT is created. In a low interest rate environment, the GRAT strategy can substantially reduce the value of the taxable gift, resulting in lower transfer taxes generally.
The primary downside of the GRAT strategy is that the grantor must outlive the trust term for it to work. In the case of the Twitter executives, who are all under 50 years old, the odds are good that the strategy will succeed.
The gift trust, similarly, seeks to move any post-IPO appreciation on the shares out of the eventual taxable estate, this time by taking advantage of the high gift-tax exemption levels that are currently in effect. The CEO of Twitter and his wife funded the gift trust with an amount that was about equal to the gift tax exemption—then around $10 million per couple—thereby freezing the value of the assets for tax purposes and keeping any subsequent appreciation out of their taxable estate.
The IPO documents also indicate that at least one Twitter executive combined his trust strategy with a strategy designed to discount the value of his shares. This strategy involves transferring ownership of the shares to a privately held limited liability company (LLC), which essentially reduces their value because they are less marketable than shares owned outright by an individual.
Rather than simply giving an outright ownership interest in the shares, which would cause them to be valued at their fair market value, the Twitter executive can give ownership interests in the LLC that controls those shares, thus reducing the value of the gift.
While this strategy can substantially reduce the transfer taxes on the gift, the downside is that control over the shares becomes more limited.
Your clients do not have to be multimillionaires in order for these strategies to work; any client who has assets that are expected to appreciate in value can benefit from a well-crafted trust strategy.
For more on GRATs, please see "The Clock Is Ticking on GRATs"
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