Silver Lining to the Market Crash: Funding GRATs with Stock

by Prof. Robert Bloink and Prof. William H. Byrnes

Market downturns often create hidden silver linings for clients who may be much more inclined to focus on the negative. The recent market instability—and outright crash over coronavirus fears—are no different. The downturn may have actually created an opportunity for clients to transfer wealth to the next generation while minimizing transfer tax liabilities through the grantor retained annuity trust (GRAT) structure. Securities that have recently lost value may be prime assets for use in the GRAT structure, especially for clients who believe those values will eventually rebound. A smartly crafted GRAT strategy can allow clients to transfer wealth to children and grandchildren with virtually no gift tax liability—and the time to act is now.

GRATs: The Basics

AGRATessentially combines a trust that is established for a certain predetermined period of time with an annuity that pays the client, as trust creator (the grantor), a set value each year of the trust’s existence. This annuity payout is the client’s retained interest. The remaining value passes to the client’s beneficiaries, and, thus, out of his or her estate (the assets funding the GRAT can also be passed into a trust at the end of the GRAT term to delay the beneficiary’s receipt for asset protection purposes).

The value of the taxable gift to theGRATbeneficiaries is equal to the fair market value of the property transferred into theGRATminus the client’s retained interest. The client’s retained interest is the actuarially calculated value of the annuity stream he or she will retain over theGRAT’s life based on the Section 7520 rate in effect for the month in which theGRATis created. Essentially, the client receives a percentage of the value as an annuity payment over the trust term.

The goal is often to structure the GRAT so that the client’s retained interest equals the fair market value of the property at the time it is transferred to the GRAT. This would reduce the gift tax liability to zero (or near zero), allowing the client to transfer the appreciated value of the assets to his or her beneficiaries with minimal gift tax liability. The strategy works particularly well in the case of appreciating stock, because it allows the client to “freeze” the value of the stock for transfer tax purposes.

Benefits of Funding a GRAT Now

In March 2020, the Section 7520 rate used to calculate the client’s retained interest has dropped to 1.8%. Generally, a GRAT strategy is considered successful if the appreciation and income generated from the assets exceed the Section 7520 interest rate in effect when the GRAT was created. That excess value passes to the next generation free of transfer taxes.

Funding the GRAT with securities that have dropped in value—even temporarily—makes it even easier for the GRAT to succeed. Clients with existing GRATs may also be able to exchange assets within the GRAT for those that have declined in value if the GRAT contains a substitution power.

Importantly, the GRAT does not have to be a long-term planning mechanism. GRATs can be structured to take advantage of short-term fluctuations with respect to assets that are expected to appreciate substantially over only a few years.

In these cases, the client may wish to take a larger annuity amount in order to “zero out” the GRAT and minimize the taxable gift. Getting the taxable gift as close as possible to zero minimizes any gift tax liability (remembering that gift tax will only be due if the client has no remaining transfer tax exemption or exceeds the annual exclusion amount). Practically, the value of the gift can be reduced to as little as $50-$100 in some cases.

Any appreciation on the assets—which could be substantial assuming a market rebound—will pass gift-tax free. If the client dies during the GRAT period, the annuity payments are made to the estate, however, and the funding assets will remain in the client’s estate (basically, it would be as though the GRAT had never been created because the estate would receive a credit if any gift taxes had already been paid).

Further, clients should know that because the GRAT is a grantor trust, the income and deductions of the GRAT are included on the client’s own federal tax return until the principal assets are transferred out of the GRAT.

Conclusion

Transferring assets that are expected to increase substantially in value to a GRAT is one potentially valuable planning tool for transferring wealth with minimal tax liability in a down market. With proper planning and timing, gift and estate taxes can be largely avoided even for wealthy clients.