As estate planners, we are faced with challenges and opportunities every day. Getting clients to take action in these economic times is difficult, but the opportunity to shift wealth to the next generation with little or no transfer tax cost has possibly never been better.
The small business owner
Although many small business owners continue to generate incomes at levels nearly equivalent to prior years, the values of their closely held stock may be plummeting amid the daily news of layoffs, tighter credit markets and a collapsing real estate market. The decline in asset values, while a cause for concern, has resulted in higher revenue streams as a percentage of asset value. These higher returns give small business owners an opportunity to shift closely held stock to their children and future generations.
The Grantor Retained Annuity Trust
By using a GRAT, small business owners with taxable estates and little or no gifting capacity can efficiently transfer closely held stock or partnership shares to the next generation. With a GRAT, the grantor may transfer shares or partnership interests to a fixed term trust and retain the right to receive an annuity stream paid at least annually.
The annual payments can be level or can be amounts which increase annually by a fixed percentage not to exceed 20%.
The value of the retained interest is determined by discounting the cash flow stream using the IRC? 7520 rate. At the end of the GRAT term, the remaining trust value passes to the named beneficiaries or can remain in trust. This remainder interest is valued for gift tax purposes, by deducting the present value of the retained interest from the value of the assets transferred to the GRAT. The lower the ?7520 rate, the higher the value of the retained annuity stream.
With a properly structured GRAT, it is possible to reduce the value of the gift to zero; however, many practitioners believe this amount should be a nominal gift and a gift tax return should be filed to allow the statute of limitations to begin.
Another advantage of the GRAT is that if for some reason the IRS were to challenge the calculated gift value of the transaction, the GRAT can have an adjustment clause that would effectively increase the annuity payments and thus eliminate any gift tax exposure.
Locking in the rate
In January 2009 the IRC? 7520 rate reached a historical low of 2.4%. This rate is published monthly and is equal to the 120% of the federal mid-term rate rounded to the nearest 2/10ths of 1%. The previous low rate was 3%, in July 2003, and the rate was as high as 11.6% in May 1989. As recently as August 2007, the ?7520 rate was 6.2%. The ?7520 rate for the last 10 years has averaged 5.4%.
Why does the rate matter?
As an example, let’s assume we have a client who has closely held stock valued at $10 million. If he transfers this stock to a 10-year GRAT when the ?7520 rate is 2.4%, the annual level payment required to effectively zero out the gift is $1,136,692 or an annual payout rate of approximately 11.37%. If however, the ?7520 rate is 6.2% as in August 2007, then the annual payout increases to $1,371,582 or 13.72%. While this increase of only 2.35% does not seem significant, if the underlying assets grow at an average rate of 6%, then the 2.4% GRAT would produce a remainder value of approximately $2,926,000 and the 6.2% GRAT would fail, thus producing no remainder value.
If the growth rate is 8%, then the 2.4% GRAT would produce $5,122,500 and the 6.2% GRAT would produce $1,719,700, or a $3,402,800 difference.