The volatility last August was disheartening to many investors, particularly those who saw their equity investments drop in value. But the depressed prices can offer a silver lining for high net worth individuals.
If you believe there will be a significant bounce back in the price of an asset, consider making a gift, either outright or via trust, of the asset before it has its significant bump-up in value. A commonly used estate planning technique to take advantage of this potential opportunity is the grantor retained annuity trust or GRAT.
A person establishes a GRAT in order to pass wealth to future generations, such as to the children, in a way that can incur little to no gift or estate taxes. Essentially, an individual makes a gift to a trust and sets terms to pay themselves back an annuity over a period of years. It is as if they are making a loan back to themselves; and by paying themselves this annuity, the size of the gift is reduced in the eyes of the IRS. Quite often, grantors set up the GRAT to be “zeroed-out” (i.e., to pay themselves back in full, thus creating a $0 gift amount when filing a gift tax return).
The interest rate on the loan is dictated by the IRS. For mid-term loans, the rate is called the 7520 rate, named after the section of the Internal Revenue Code. The 7520 rate dropped from 5.8% in September to 5.2% in October and remains at 5.2% for November. The reduction in the loan rate means that grantors can reimburse themselves a lower amount during the GRAT term, which helps to make GRATs more attractive today.
When transferring an asset to a GRAT, it may seem like a large number that is going to the children, but keep in mind that if the trust is structured to pay back the principal and interest in full, all that is really being gifted out is some of the appreciation on the asset. As in the example below, this technique works best when the asset within the trust appreciates greatly during the GRAT term.
For example, let’s say Adam decides to set up a GRAT and place $1 million of assets into the trust. By providing himself with an annual payout of $232,253 for 5 years from the trust, he is paying himself back the entire $1 million plus interest during the trust term. The GRAT is therefore considered to be “zeroed-out” for gift and estate tax purposes.
Now, if he were able to achieve a 15% return each year on these assets, there would be $445,419 remaining in the GRAT at the end of 5 years. This $445,419 would transfer to his chosen beneficiaries in the trust without any gift or estate taxes due.
The grantor runs the risk that a GRAT’s investments will not earn as much as the loan rate. If, in our example, the return were less than 5.2% per year, then Adam would have not accomplished any tax benefit. If a client is interested in using this strategy for more than one asset, it is typically better to set up a separate GRAT for each asset. That way, an asset that performs poorly does not reduce the effectiveness of another GRAT that holds an outstanding performer.
Finally, for the GRAT to be effective, grantors must also outlive the GRAT term. If they don’t survive the period of years, the trust assets will not escape estate taxation. The example illustrates a 5-year GRAT, but often the trusts are set up as 2- or 3-year terms, thus making it more likely that the grantor will outlive the period.
Also, when using a GRAT for a single stock, calculations have shown that there is a higher probability of success in establishing a short-term GRAT and then creating what is sometimes referred to as “cascading GRATs.” In this structure, you set up a 2- or 3-year GRAT that rolls into a new GRAT at the end of each term while also establishing additional GRATs for the annuity portions to all flow eventually into one trust.
Matt Gordon, , is managing director of financial Planning at Lenox Advisors, New York, N.Y. You can email him at .