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.

Short-term vs. long-term

Many practitioners today like to use short-term GRATs with terms of 2 or 3 years. These work well when the assets are easily valued, so paying back in-kind does not create additional costs of valuations. The client is not as likely to die during the term, and the client intends to create new GRATs with the in-kind payments. This is especially beneficial if the value of the assets is likely to fluctuate up and down since short-term leaps in value may be captured by the GRAT, while drops in value cause the grantor no detriment.

A major benefit of a longer term GRAT, especially in a low interest rate environment is the ability to lock in the rate. Each new GRAT created requires the use of the applicable federal rate at the time of the new GRAT. Another benefit of the longer term is the possibility that the assets in the GRAT, particularly closely held business interests, can cash flow the required GRAT payments thus avoiding the need for in-kind payments and corresponding valuations. If the business interest is subject to valuation discounts, then the available cash flow, as a percentage of the discounted value may suffice to cover GRAT payments, even if the GRAT term is relatively short. Thus for example, an asset yielding an 8% cash flow might cover a 12% 10-year payout if a one-third discount is available.

Effect of discounts

As discussed previously, the lower the 7520 rate, the more effective the GRAT can potentially be. If we assume that our 2.4% GRAT growing at 6% could be discounted by 30%, then the remainder value grows from an estimated $2,926,000 to approximately $5,838,700. Even the 6.2% GRAT which failed previously, is projected to create $2,342,200.

If the growth rate is 8%, then the 2.4% GRAT would produce $10,062,500 and the 6.2% GRAT would produce $6,095,400, or a $3,967,100 difference.

This ability to take a discount and thus reduce the annual payout is significant and should be considered in light of the current low rates.

The GRAT & the ILIT

For those agents and advisors who are working in the estate planning and business continuation market, the use of split dollar life insurance is still a very useful tool, whether it is in the form of economic benefit or in the form of a loan. With the new rules for split dollar, it is more important than ever that clients create a mechanism by which they can terminate these split dollar plans and preserve the needed life insurance coverage outside of the taxable estate.

Using a GRAT can be a very effective method of providing such a termination with the sponsor’s interest being repaid at the end of the GRAT term. By creating two identical grantor trusts, one to hold the life insurance (ILIT) and another as a GRAT, these trusts could merge after the GRAT term and if successful, repay the split dollar sponsor/grantor. (The GRAT itself, prior to the end of the fixed term, should not hold the insurance, since the proceeds might be subject to estate tax if the insured dies during the fixed term.)

Utilizing this technique is complicated and is outside the scope of this article. The client before implementing any wealth transfer strategy should always a consult with his professional legal and tax advisors.

Conclusion

Although the clouds of the economy might be dark and foreboding, a GRAT can be a silver lining to our clients whose closely held businesses will continue to be successful and grow. Using the leverage of a GRAT in this unprecedented low interest rate environment is an incredible opportunity that should not be missed.

John P. Irvin, CLU, ChFC, CPA is a corporate vice-president at The Nautilus Group, an Addison, Texas-based unit of New York Life Insurance Co. You can e-mail him at John_P_Irvin @NewYorkLife.com