Methods for Optimizing GRATs
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In the Hawthorn Institute white paper An Overview of
GRATs, we review the basic benefits of utilizing grantor
retained annuity trusts (GRATs) as an effective wealth
transfer strategy, as well as their basic structure
and rules. In this white paper, we discuss some
of the methods for creating even greater levels of
effectiveness in wealth transfer as part of a family
succession plan through variations in the structuring
of GRATs, asset selection, and related strategies.
The Basics of GRATs: A Review
A GRAT is an irrevocable trust to which the grantor transfers assets in exchange for a
fixed annuity for a term of years chosen by the grantor. The term is typically measured
by a fixed number of years, but it may also be measured by the grantor’s life or the
shorter (but not longer) of a fixed number of years or grantor’s life. Upon completion of
the annuity payment term, the GRAT’s remaining assets pass to the beneficiaries, either
outright or in further trust.
If the grantor’s retained annuity is set at a combination of a high enough amount and a
long enough period, its actuarial value for federal gift tax purposes can equal 100% of the
amount originally transferred, resulting in no taxable gift when subtracting this retained
annuity value from the value of the assets transferred to the GRAT. This type of GRAT is
typically referred to as a Zeroed Out GRAT.
This annuity payment term can be as short as two years. Also, the annuity can be
structured such that the payments increase by as much as 20% over the preceding
year’s amount at any time during the annuity term. Only the grantor can receive annuity
distributions during the annuity term.
A GRAT is treated as a grantor trust for federal income tax purposes. The value of
the fixed annuity retained by the transferor is subtracted from the value of the assets
transferred to the GRAT in determining the value of the gift of the remainder interest
passing to beneficiaries at the end of the annuity term for federal gift tax purposes. This
remainder interest amount is a taxable gift, potentially subject to gift tax in the year the
GRAT is created.
If the transferor dies during the term of the required annuity payments, then all or a
portion of the GRAT’s assets will be includible in his or her taxable estate.
Hawthorn Institute Resident
Martyn S. Babitz, J.D.
National Director of Estate Planning
215.585.5666
martyn.babitz@hawthorn.pnc.com
Because a grantor’s generation-skipping transfer (GST) tax exemption cannot be
allocated to a GRAT until the end of the annuity term, rather than at the GRAT’s outset
when the value of the retained annuity has been subtracted from the assets transferred
for federal transfer tax purposes, GRATs are generally not effective GST planning
vehicles. There are, however, several methods for working around this issue, which
we discuss in this paper.
Methods for Optimizing GRATs
Strategic Selection of the Length of the GRAT Annuity Term
The shortest allowable term for a GRAT is two years. Internal Revenue Code
(IRC) Section 2702(b)(1) requires payments no less frequently than annually, with
no provision for a single payment. Several Private Letter Rulings acknowledge the
validity of a two-year GRAT. The optimum annuity term requires that a number of
factors be considered.
Short-Term GRATs
The shorter the GRAT term, the higher the corresponding annuity payments to
the grantor must be in order to create a Zeroed Out GRAT (Table 1). Nevertheless,
short-term GRATs can provide advantages over longer terms.
Table 11
Table
Short-Term
GRATsand
andAnnuity
Annuity
Payments
Short-Term GRATs
Payments
Short-Term
GRATs
and
Annuity
Payments
(2.2%
Section
7520
rate;
$1
million
initial
investment)
(Section 7520 rate 2.2%; initial investment
$1 million)
GRAT Term
GRAT
Term
(Years)
(Years)
10 10
8
8
6
6
4
4
2
2
Annual
Annual
Annuity
Annuity
$112,495
$112,495
137,690
137,690
179,733
179,733
263,901
263,901
516,556
516,556
Source: Hawthorn
Source: Hawthorn
Hurdle rate is a term used
to describe the minimum average
annual investment rate of return
on a GRAT’s assets necessary to
confirm that the remaining assets
after completion of the annuity
payment term will exceed zero in
the case of a Zeroed Out GRAT, or
otherwise will exceed the amount
of the taxable gift with respect to
the projected remainder interest.
n
The mortality risk of the grantor is mitigated with a shorter term. As the
Table
2
Table 2grantor’s death will cause inclusion of all or a portion of the GRAT assets
Single-Asset
versus
Combined
GRAT
Single-Asset
versus
GRAT
in his estate,
a Combined
shorter
term
increases the likelihood that the grantor will
Single-Asset
GRAT
Combined
GRAT
survive the annuity term Single-Asset
and that all of
the remaining
assetsGRAT
will
pass to
GRAT
Combined
ABC,
Inc.
XYZ,
Inc.
$2
million
ABC, and
Inc. thereby
XYZ,be
Inc.
$2from
million
the remainder beneficiaries
excluded
the grantor’s
GRAT
GRAT
20%
annual -15%
annual
5%GRAT
annual
Net Advantage of
taxable estate.
20%
annual
-15%
annual
5%ofannual
Net Advantage
of
rate of return rate of return rate
return
Single-Asset
GRAT
n
rate of return
ratethe
of return
rateinvestment
of return
Single-Asset GRAT
ARemainder
short-termtoGRAT generally
reduces
risk of poor
Remainder
to
performance
of the GRAT
assets, increasing
the odds$87,122
of a successful GRAT
Beneficiaries
$303,578
$0
$216,456
Beneficiaries
$303,578
$0
$87,122
$216,456
that will pass some wealth
to the remainder
beneficiaries.
There is no
Source:
Hawthorn
Source: Hawthorn
downside risk of a “failed” GRAT in the case of a Zeroed Out GRAT. If the
investment return exceeds the IRC Section 7520 hurdle rate, then there
will be some assets remaining to pass without gift tax consequence to the
remainder beneficiaries. If not, all assets will be returned to the grantor
in the annuity payments, placing the grantor in the same position from a
wealth transfer perspective as if the GRAT were not established.
Accordingly, multiple short-term GRATs increase the likelihood that one or more
will be successful compared with one long-term GRAT, in which one or more
poor investment return years could sink the overall performance for the entire
term below the hurdle rate.
2
hawthorn.pnc.com
Methods for Optimizing GRATs
For example,
one are
10-year
termmay,
GRATin
is the
cumulative
equivalent
of five of a longer-term GRAT
GRATs
created
some
cases, make
the choice
successive
two-year
term
GRATs.
Chart
1
demonstrates
the
comparative
advisable despite the increased mortality risk and greater wealth
risk of one or more bad
transfer investment
outcome of each
approach (and
the benefit of the successive short-term
performance
years.
GRAT approach) if a grantor had started with $1 million on January 1, 2003, and
 A GRAT may provide for annual increases of as much as 20% in the annuity payments.
created either one 10-year Zeroed Out GRAT or five successive two-year Zeroed
As such, a long-term GRAT may allow for substantially lower annuity payments in the
Out GRATs, re-contributing whatever the grantor received from each GRAT in
early years. This approach can allow for greater growth in early years with less “leakage”
annuity payments
back
to each succeeding
assuming
the assets
are balance passing to remainder
for annuity
payments,
typicallyGRAT,
resulting
in a greater
ending
invested beneficiaries.
to obtain a return equivalent to that of the S&P 500®. These successive
short-term GRATs are often referred to as Rolling GRATs.
Chart 1
Chart
2
Comparative
Wealth Transfer Outcomes
IRC Section 7520 Rate, 1994 to 2014
Cumulative Remainder to Beneficiaries
$800,000
$700,000
$600,000
$500,000
$400,000
$300,000
$200,000
$100,000
$Year 2
Year 4
Year 6
Year 8
Year 10
Rolling GRATS
$259,978
$356,404
$356,404
$627,895
$720,416
Single GRAT
$51,403
$102,805
$154,208
$205,610
$257,013
Source: Hawthorn
Long-Term GRATs
For example, assume a $1 million transfer to create a 10-year Zeroed Out GRAT, a 2.2% IRC
There are also benefits of selecting a long-term annuity period for a GRAT.
Section 7520 rate, and a 10% annual investment rate of return. With equal fixed payments of
$112,495,
the remaining environment,
GRAT balance
at the end
annuitytoterm would be approximately
In a low-interest-rate
the grantor
has of
thethe
opportunity
$800,000.
Onthe
thelower
otherIRC
hand,
with
payments
increasing
annually,
“lock in”
Section
7520
rate, representing
the20%
benchmark
to the initial payment would
only be
$44,714
and
the
final
payment
would
be
$230,714;
the
resulting
GRAT remainder would
exceed in investment return over the term of the GRAT. Chart 2 (page 4)
be approximately
$985,000, almost a 25% improvement over the equal fixed payments approach.
shows the fluctuation of the Section 7520 rate over the past 20 years and the
n
relativebenefits
historic current
low rate
in 2014.
The likelihood
of significantly
Additional
of smaller
annuity
payments
in early
years underhigher
the increasing annuity
IRC Section
7520may
ratesapply
in future
years when
GRATs
payments
approach
as well.
If, forsucceeding
example, short-term
a difficult-to-value
asset is expected to be
are
created
may,
in
some
cases,
make
the
choice
of
a
longer-term
GRAT
sold at some point during the GRAT term and cash flow on the asset is low, lower annuity
payment
in thedespite
early years
may prevent
therisk
need
makerisk
distributions
advisable
the increased
mortality
andto
greater
of one or in kind, which would
require
valuation
of the asset
to determine
more
bad investment
performance
years. what fraction of it must be distributed (as well as the
possible
difficulty
of dividing
theincreases
asset to make
a fractional
distribution).
A GRAT
may provide
for annual
of as much
as 20% in
the annuity To avoid these
challenges,
the
grantor
could
contribute
cash
as
part
of
the
initial
contribution of assets to such a
payments. As such, a long-term GRAT may allow for substantially lower
GRAT
in order to fund distributions in the early years prior to sale of the other asset. The cash
annuity payments in the early years. This approach can allow for greater
contribution
required to accomplish this result could be significantly lower with an increasing
growth in early years with less “leakage” for annuity payments, typically
payment
GRAT.
resulting in a greater ending balance passing to remainder beneficiaries.
n
4
3
early years. This approach can allow for greater growth in early years with les
for annuity payments, typically resulting in a greater ending balance passing to
beneficiaries.
Methods for Optimizing GRATs
Chart
Chart 22
IRC
Section 7520
1994
to 2014
Fluctuation
of IRCRate,
Section
7520
Rate
9.0
Section 7520 Percentage Rate
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
6/94
6/96
6/98
6/00
6/02
6/04
6/06
6/08
6/10
6/12
6/14
Source: Hawthorn
For example, assume a $1 million transfer to create a 10-year Zeroed Out GRAT,
For example, assume a $1 million transfer to create a 10-year Zeroed Out GRAT, a 2.
a 2.2% IRC Section 7520 rate, and a 10% annual investment rate of return. With
Section
7520 rate, and a 10% annual investment rate of return. With equal fixed paym
equal fixed payments of $112,495, the remaining GRAT balance at the end of
$112,495, the remaining GRAT balance at the end of the annuity term would be appro
the annuity term would be approximately $800,000. On the other hand, with
$800,000.
On the other hand, with payments increasing 20% annually, the initial paym
payments increasing 20% annually, the initial payment would only be $44,714
only
be $44,714 and the final payment would be $230,714; the resulting GRAT rema
and the final payment would be $230,714; the resulting GRAT remainder would
be
approximately $985,000, almost a 25% improvement over the equal fixed paymen
be approximately $985,000, almost a 25% improvement over the equal fixed
Additional
benefits of smaller annuity payments in early years under the increasing an
payments approach.
payments approach may apply as well. If, for example, a difficult-to-value asset is ex
Additional benefits of smaller annuity payments in early years under the
sold at some point during the GRAT term and cash flow on the asset is low, lower an
increasing annuity payments approach may apply as well. If, for example, a
payment
in the early years may prevent the need to make distributions in kind, which
difficult-to-value asset is expected to be sold at some point during the GRAT
require valuation of the asset to determine what fraction of it must be distributed (as w
term and cash flow on the asset is low, lower annuity payment in the early
possible
difficulty of dividing the asset to make a fractional distribution). To avoid th
years may prevent the need to make distributions in kind, which would require
challenges, the grantor could contribute cash as part of the initial contribution of asset
valuation of the asset to determine what fraction of it must be distributed (as well
GRAT
in order to fund distributions in the early years prior to sale of the other asset.
as the possiblerequired
difficulty of
the asset
makecould
a fractional
distribution). lower with an in
contribution
to dividing
accomplish
thistoresult
be significantly
To avoid these
challenges, the grantor could contribute cash as part of the
payment
GRAT.
initial contribution of assets to such a GRAT in order to fund distributions in the
early years prior to sale of the other asset. The cash contribution required to
accomplish this result could be significantly lower with an increasing
4
payment GRAT.
GRATs Measured by Grantor’s Life Expectancy
In situations where the life expectancy of the grantor or grantor’s spouse is less
than the life expectancy used in the tables under IRC Section 7520 for calculating
the value of an annuity, we believe measuring the GRAT by the life of the grantor
or grantor’s spouse may provide an advantage over a fixed-term GRAT. Note
that the annuity valuation based on the life expectancy tables under IRC Section
2
4
hawthorn.pnc.com
Methods for Optimizing GRATs
7520 may not be used if the annuitant has a health condition that creates a 50% or
greater probability of death within one year.1
If the grantor has a projected life expectancy significantly less than the life
expectancy used in the Internal Revenue Service (IRS) tables for this purpose but is
less than 50% likely to die within one year, a GRAT measured by the grantor’s life
may be worth considering.
Because the GRAT will terminate at the grantor’s death (and he will not survive the
annuity term), measuring the GRAT by the grantor’s life will mean inclusion of at
least some of the GRAT assets in the grantor’s taxable estate under IRC Section
2036, which is determined by dividing the annuity amount by the IRC Section 7520
rate in effect on the grantor’s date of death.
For example, assume a 55-year-old grantor in poor, but not terminal, health
contributes $1 million to a GRAT, retaining a $75,000 lifetime annual annuity.
The actuarial value of the retained annuity is $924,383 based on the current
2.2% IRC Section 7520 rate. While this does not zero out the GRAT, the gift is
only $75,617 (the $1 million transferred to the GRAT less the value of the
grantor’s retained interest), which can be absorbed by part of the grantor’s
lifetime gift exclusion amount if she has at least that amount remaining.
Assume that the investment return on the GRAT assets is 12%.
The grantor dies 12 years later at age 67 when the IRC Section 7520 rate has
increased to 5.4%, a more average interest rate environment. The GRAT assets,
net of annuity distributions to date, total $2,085,991. The portion of this amount
includible in the grantor’s taxable estate is the annuity amount of $75,000 divided
by the Section 7520 rate of 5.4% at that time, or $1,388,889. Accordingly, $697,102
($2,085,991 of total GRAT assets less the estate includible portion of $1,388,889)
is removed from the grantor’s taxable estate at a “cost” of just $75,617 of lifetime
gift exclusion.
Variations in Structure
Zeroed Out GRATs
In the case of a Zeroed Out GRAT, because the actuarially projected remainder
amount is zero, any remaining assets left to pass to or for the remainder
beneficiaries at the close of the annuity term will provide a successful result
because these assets will represent wealth transferred without any gift tax
consequences (that is, no lifetime gift exclusion used and no federal gift tax paid).
Should the required annuity payments completely exhaust the assets of the GRAT
before the annuity term ends or if the final annuity distribution is insufficient and
exhausts the remaining assets of the GRAT, then there will be no remainder
amount passing to or for the benefit of the remainder beneficiaries. If the GRAT
was not a Zeroed Out GRAT, then either the gift tax or lifetime gift exclusion utilized
with respect to the actuarially projected remainder as determined under IRC
Section 7520 at the time of the creation of the GRAT will have been wasted.
1 Treasury Regulation (Treas. Reg.) Section 25.7520-3(b)(3).
5
3
Methods for Optimizing GRATs
There will, however, be no such adverse consequences for a Zeroed Out GRAT
because there was no actuarial gift amount as to the remainder interest; thus,
there is no required lifetime gift exclusion or federal gift tax payable. From a
wealth transfer perspective, other than the cost of creating and administering the
GRAT, the transferor is generally in no better or worse position than if the GRAT
had not been created at all.
When creating a Zeroed Out GRAT, we believe it is advisable to calculate the
annuity such that the projected remainder amount and corresponding gift is a
small amount, such as $100, rather than zero. By so doing, the gift is negligible
but allows the opportunity to file a federal gift tax return, which commences the
running of the three-year statute of limitations for the GRAT transaction. This
approach can particularly make sense, in our opinion, in the case of a transfer
of difficult-to-value assets to a GRAT. Upon the close of the three-year statutory
period, the valuation and corresponding annuity amount will be permanently set.
Should the valuation be challenged, adjustment of the annuity amount can be
made to prevent any adverse federal gift tax consequences.
Separate Single-Asset GRATs
Just as successive short-term GRATs can typically maximize the remainder by
isolating good and bad investment performance, establishing separate GRATs for
Table
1 1Table
Table
1
separate
assets
can provide
the same benefit.
Short-Term
GRATs
and
Annuity
Payments
Short-Term
GRATs
and
Annuity
Payments
Short-Term GRATs and Annuity Payments
(2.2%
Section
7520
rate;rate;
$1
million
initial
investment)
(2.2%
Section
7520
$1rate;
million
initial
investment)
(2.2%
Section
7520
$1 million
initial investment)
For example, assume grantor owns two stocks, ABC, Inc. and XYZ, Inc., that
GRAT
Term
Annual
GRAT
Term
AnnualAnnual
GRAT
Term
he wants
to contribute to a GRAT. Each is currently worth $1 million. Assume
(Years)
Annuity
(Years)(Years)
AnnuityAnnuity
alternatively
that the grantor establishes one Zeroed Out GRAT and contributes
10 10
$112,495
$112,495
10
$112,495
or two separate Zeroed Out GRATs, one for each stock. Also assume
8 8 both8stocks
137,690
137,690
137,690
6 6 a two-year
179,733
GRAT179,733
term and 2.2% IRC Section 7520 rate. Finally, assume that the
6179,733
4 4 ABC4stock
263,901
263,901
grows263,901
20% per year for each of the two years of the GRAT term while
2 2
516,556516,556
2516,556
the XYZ stock declines 15% each year. Table 2 demonstrates the $216,456 wealth
transfer advantage of establishing separate GRATs for each stock.
Source:
Hawthorn
Source:
Hawthorn
Source: Hawthorn
Table 2
Table
2 2Table
Table
Single-Asset
versus Combined GRAT
2
Single-Asset
versus
Combined
GRAT
Single-Asset
versus
Combined
GRAT GRAT
Single-Asset
versus
Combined
Single-Asset
GRAT
GRAT
Single-Asset
GRAT Combined
Combined
GRAT GRAT
Single-Asset
GRAT
Combined
ABC,ABC,
Inc.Inc.
XYZ,
Inc.Inc.
million
XYZ,
$2 million
ABC,
Inc.
XYZ,$2
Inc.
$2 million
20%20%
annual
-15%
annual
5%
annual
Net Net
Advantage
of of
annual
-15%
annual
5% annual
Advantage
20% annual -15% annual
5% annual
Net Advantage
of
raterate
of return
of return
of return
Single-Asset
GRAT
of return
rate
of return
rate
of rate
return
Single-Asset
GRAT GRAT
raterate
of return
rate ofrate
return
of return
Single-Asset
Remainder
to to
Remainder
Remainder
to
Beneficiaries
$303,578
$0 $0
Beneficiaries
$303,578
Beneficiaries
$303,578
$87,122$87,122 $216,456
$216,456
$0 $87,122
$216,456
Source:
Hawthorn
Source:
Hawthorn
Source:
Hawthorn
Choice of Assets
Assets Yielding Greater Than the IRC Section 7520 Rate
The IRC Section 7520 rate sets the hurdle for a GRAT, and investment return
exceeding that rate likely leads to a successful GRAT. At the current 2.2% IRC
62
hawthorn.pnc.com
Methods for Optimizing GRATs
Section 7520 rate, there are several moderate or low risk, fixed-yield investments
that can exceed this threshold, such as certain bonds, mutual funds, and
preferred stock. Principal value of such assets may fluctuate, but for a
shorter-term GRAT this approach typically generates some level of success.
Valuation-Discounted Assets
In creating a GRAT, the value of the assets contributed to it will determine the
level of annuity payments necessary to accomplish a specific reduction in the
value of the gift. For example, with a Zeroed Out GRAT, the value of the annuity
payments as determined under IRC Section 7520 must be equal to the value
of the assets contributed. Accordingly, the lower the value of the assets
contributed, the lower the annuity payments must be over a specific term of
years to accomplish the desired result.
Consequently, when assets contributed to a GRAT can be discounted in value
relative to their true value, the GRAT can generally accomplish even greater
wealth transfer results by requiring lower annual annuity payments to the grantor
to accomplish the same gift reduction objective.
Family Business Succession or Presale Planning with GRATs
In our view, one of the most powerful possibilities for GRATs, along with
the valuation discount available for some assets, is in concert with a family
succession plan for a closely held business. By transferring nonvoting stock in a
closely held business, a discount in value attributable to the lack of control and
marketability of such interests would be available. In addition, the transferor, still
owning the voting stock, could retain control over the business. Furthermore, with
the most common form of closely held business entity, S Corporations, the cash
flow desired by the transferor could be funded in whole or in part by the GRAT
during the annuity period, further enhancing the leverage and efficiency of this
means of tax-advantaged business succession planning.
For example, assume a father who owns 100% of the stock of XYZ, Inc., an
S Corporation worth $10 million, desires that his son ultimately succeed him as
the next generation of the business. The father plans to continue in the business
for 10 more years, continuing to receive his normal annual compensation of
$1 million and then retire. The father recapitalizes the stock from one class to
two, voting and nonvoting, exchanging each of his 100 shares of the outstanding
stock for one share of voting stock and 99 shares of nonvoting stock.
The father then contributes the nonvoting stock to a 10-year Zeroed Out
GRAT. As nonvoting stock, the father takes a 33% valuation discount for lack
of marketability and control attributable to the stock. At a resulting value of
$6.633 million for the 99% stock interest transferred to the GRAT, and a
2.2% IRC Section 7520 rate, the GRAT would pay $746,177 annually to the
father for the 10-year annuity period. During this 10-year period, the father
could reduce his annual compensation to $253,823, which is $746,177 less
than his customary $1 million.
73
Methods for Optimizing GRATs
In addition, during this period the corporation could make an annual dividend
distribution, not made in prior years, of $754,000 to the stockholders. Further,
99% of this dividend, or $746,460, would pass to the GRAT as 99% stockholder,
providing sufficient cash flow to fund the above $746,177 GRAT annuity
distribution to the father. Because this amount would have been distributed to the
father in any event, this type of GRAT is incredibly efficient because no additional
distributions from the subject assets are being transferred via the GRAT back to
the grantor as is the case with a typical GRAT.
As a pass-through entity for income tax purposes, the corporation’s distributions
to the father as compensation or dividends (via the GRAT) will not have a
federal income tax impact, although the amount of payroll taxes would likely
be reduced. There is the potential risk that the IRS could challenge the change
in compensation as insufficient compensation compared with prior years,
or as some other tax avoidance device (but such tax avoidance would relate
solely to payroll taxes, as the federal income tax impact would be the same).
Nevertheless, the father and XYZ, Inc. could seemingly assert that the reduced
compensation is attributable to the father’s reduced activities as he nears
retirement.
Establishing a GRAT for closely held family business interests also provides an
opportunity for presale wealth transfer planning. In the case of XYZ, Inc., if the
father instead determined to sell the business rather than pass it to his son,
he could establish a Zeroed Out GRAT with a portion of the stock prior to a sale
of the business, taking advantage of the 33% valuation discount as discussed
above. Upon sale of the business, a pro rata portion of the proceeds would pass
to the GRAT as partial stockholder of XYZ, providing liquidity to make the annuity
payments to the father. Because the annuity payment would be based on the
discounted value of the initial assets (XYZ stock) contributed to the GRAT, and
with a presumably greater amount paid per share in the sale of the business
to a third party, the lesser required payments would create the likelihood that
substantial assets would remain in the GRAT following the annuity period,
passing transfer tax free to the son.
Other Valuation Discount Assets Suitable for GRATs
Valuation discounted assets could also include restricted stock (for example,
stock that, although publicly traded, cannot be sold by the owner for a period of
years). Such stock, based on the restricted marketability and liquidity, allows for a
valuation discount relative to its current market value.
Other such assets could include limited, or restricted, interests in family
entities such as Family Limited Partnerships (FLPs) or Limited Liability
Companies (LLCs). The underlying operating agreements for such entities
typically restrict the power of the owner of limited partners (LPs) or LLC
members to sell, liquidate, or otherwise transfer their interests and restrict
or eliminate any control over decisions regarding these entities and the
underlying assets. As a result, a valuation discount for lack of marketability and
control are permitted, although the amount of that discount may be subject to
8
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Methods for Optimizing GRATs
challenge by the IRS. Valuation discounts for family entities is discussed
further in the June 2013 Hawthorn Institute white paper Family Opportunity
Trusts, Part II: Leveraging the Trust.
If valuation of assets contributed to a GRAT is finally determined by the IRS to be
higher than the value ascribed by the grantor at the time of the GRAT’s creation,
an automatic adjustment increasing the annuity payments can be made to avoid
adverse, unintended gift tax consequences.
As an example, assume the grantor and grantor’s spouse form a FLP,
contributing $10,101,010 of assets, and receiving back the 1% general partnership
interest and the 99% limited partnership interests. The grantor then contributes
the 99% limited partnership interests to a Zeroed Out GRAT with a 10-year term
when the IRC Section 7520 rate is 2.2%. The grantor takes approximately a 30%
valuation discount for the lack of marketability and control attributable to the
limited partnership assets, thus valuing these interests passing to the GRAT at
$7 million rather than the $10 million pro rata value of the underlying assets.
The required annual annuity distribution is $787,463 in order to zero out the
GRAT. (This annuity would have been $1,124,947 had no valuation discount been
taken.) The annual annuity is satisfied through loans taken by the trustee at
an interest rate of 4%. These loans can be provided by the grantor. In addition,
assume that the underlying assets of the GRAT appreciate at an 8% annual rate
of return.
At the close of the GRAT term, the underlying value of the FLP assets attributable
to the 99% LP interests in the GRAT has grown to $21,589,250. The general
partner sells the assets of the FLP and distributes this amount to the partners,
including the GRAT trustee as 99% limited partner, in liquidation of the FLP.
Any gain on the sale of the assets passes through to the grantor as to the
99% LP interests because the owner, the GRAT, is a grantor trust for income
tax purposes. The trustee pays off the $9,454,365 loan (including interest) to
the lender and then distributes the balance of $12,134,885 to the remainder
beneficiaries.
Without a valuation discount, the GRAT remainder, net of distributions and loan
repayment, would have been only $8,083,004. Accordingly, the use of valuation
discounted assets has transferred a little over $4 million more to the remainder
beneficiaries without federal gift tax consequences.
Overseeing GRAT Performance
The grantor’s investment advisor, along with his attorney, wealth strategist,
wealth management advisor, and other professionals, should review a GRAT’s
investment performance on a regular basis. If the GRAT performs poorly in its
early years, the odds of its ultimate success dramatically decline, particularly for
a shorter-term GRAT, because of the necessity that it substantially outperform
over the balance of the term. For example, if a GRAT declines in value by 20% in
year 1, it will need to earn a return of 25%, net of annuity distributions, simply to
return to the original principal amount.
9
3
Methods for Optimizing GRATs
In such cases, the grantor is well-advised to consider purchasing GRAT assets
for their value at that time and “starting over” by contributing those assets to a
new GRAT. As a grantor trust, the grantor can swap cash or a promissory note for
the value of the assets without any adverse income tax consequences. Although
a GRAT is prohibited from issuing a note in satisfaction of its annuity payment
requirement,2 there is no prohibition of a grantor reacquiring GRAT assets at fair
value with a promissory note. The note will need to carry a rate of interest no less
than the Applicable Federal Rate (AFR) of interest for intra-family loans established
under IRC Section 1274 to avoid adverse federal gift tax consequences (these rates
are currently quite low since they generally track rates on Treasury obligations
for similar terms). During the period that the promissory note is payable by the
grantor to the GRAT, and following the GRAT’s termination if the GRAT remainder
(including the note) passes to a grantor trust for income tax purposes, payments on
the note by the grantor will have no income tax effect. If the assets recontributed to
the next GRAT do recover, this growth will inure completely to the success of the
new GRAT without the drag of the earlier years’ poor performance.
Similarly, if a GRAT is enjoying outstanding investment performance in its early
years, the grantor could “freeze,” or lock in, the success of the GRAT to help
confirm that possible poor performance in subsequent years of the GRAT term
does not reduce the wealth transfer already achieved or possibly entirely wipe
out the gains and cause the GRAT to fail. By purchasing the GRAT assets at their
market value at that time for cash, the grantor could recontribute those assets to
a new GRAT. The original GRAT could invest the cash conservatively to avoid any
possibility of loss, while the new GRAT has the possibility of enjoying further gains
should the assets continue to perform well. Again, the grantor’s purchase of the
assets of the first GRAT could be accomplished with a promissory note, confirming
that the locked-in principal value plus interest will pass to the remainder
beneficiaries.
Alternatively, the grantor could lock in a GRAT’s success prior to the end of the
annuity term by purchasing the remainder interest rather than the actual assets
for its value at that time. If the remainder beneficiary is a grantor trust (rather
than individual beneficiaries) for income tax purposes, then the purchase will
not create adverse income tax consequences. Again, this approach help guards
against subsequent underperformance of the GRAT assets from a wealth transfer
perspective.
The grantor’s purchase of the remainder interest from the remainder beneficiary
can also mitigate mortality risk. If the grantor dies prior to the end of the annuity
term, then all or a substantial portion of the GRAT assets will be included in her
taxable estate. Purchasing the remainder interest would thus typically eliminate
the risk that all or part of the remainder interest will be diminished by estate tax.
Such an approach can be particularly worthy of consideration as to a GRAT that is
performing well if the grantor’s health has declined to the point where her death
prior to expiration of the GRAT term is likely.
2 Treas. Reg. Section 25.2702-3(b)(1)(i).
2
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Methods for Optimizing GRATs
Of course, the early success of a GRAT could also be locked in if the GRAT simply
sells the assets and reinvests the proceeds in assets with little or no downside
risk. This approach, however, would result in taxable gains to the grantor based
on the GRAT’s grantor trust status. Further, the assets may not be readily
marketable, or the grantor and family may not want to otherwise dispose of the
assets to a third party.
In addition, the grantor could consider swapping cash or other high-basis assets,
such as bonds, for highly appreciated assets in a GRAT prior to the end of the
annuity term as a tax-neutral exchange between grantor and the GRAT which is
a grantor trust for income tax purposes. The high basis assets received by the
grantor could then enjoy a stepped-up basis for capital gains purposes upon
the death of the grantor. If the grantor does not have sufficient cash or other
high-basis assets to swap for this purpose, we believe it may be worth
considering a sale of some or all of the appreciated assets prior to the end of
the annuity term, while the GRAT is treated as a grantor trust for income tax
purposes, such that the capital gain will be taxed to the grantor rather than
ultimately to the remainder beneficiaries. Because the payment of this capital
gain tax by the grantor will not be treated as a gift to the remainder beneficiaries,3
the grantor can make an additional “free gift” to the remainder beneficiaries by
payment of this tax liability.
Other Planning Considerations
Grantor Trust as Remainder Beneficiary
There are advantages to a GRAT’s grantor trust status for income tax purposes,
including:
n
n
The grantor can exchange or purchase assets, or receive distributions,
without recognition of income or capital gains.
The grantor’s payment of income tax liability on behalf of the trust is a
“free” gift that allows the assets to grow outside the grantor’s taxable
estate unencumbered by taxation.
Such favorable benefits can be extended by having the remainder beneficiary of
a GRAT be a grantor trust for income tax purposes. Another important benefit
of this approach is that tax will not be imposed on the grantor if there are GRAT
assets subject to debt exceeding the assets’ basis upon the GRAT’s termination.
A family trust that is the beneficiary of a GRAT remainder interest can be treated
as a grantor trust for income tax purposes4 by providing the grantor the power
to acquire assets of the trust by substituting, or swapping, assets of equal value.
The IRS5 ruled that a power reserved by the grantor in a nonfiduciary capacity to
reacquire trust assets by substituting assets of equivalent value6 does not cause
inclusion of the trust assets in the grantor’s taxable estate under IRC Section
3 Revenue (Rev.) Ruling 2004-64 (2004-2 C.B. 7).
4 IRC Section 675(4)(C).
5 Rev. Ruling 2008-22, I.R.B. 2008-16 (April 21, 2008).
6 under IRC Section 675(4)(C).
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Methods for Optimizing GRATs
2036 (power to enjoy or control enjoyment of trust assets) or 2038 (power to
revoke trust). Such a trust is thereby often referred to as a defective grantor trust.
We believe the grantor’s ability to swap assets with a grantor trust receiving a
GRAT remainder provides additional wealth transfer planning opportunities. One
such benefit is the opportunity to purchase appreciated assets from the GRAT,
which have a carry-over basis for income tax purposes, for cash in order to have
those assets obtain a stepped-up basis for capital gains tax purposes when
included in the grantor’s taxable estate upon his death. Such a cash swap for
GRAT assets could also freeze the benefit of the successful GRAT by guarding
against potential decline in the assets’ value going forward.
Changing the Transferor for GST Purposes
The predeceased parent exception, exempting assets passing to or for the
benefit of grandchildren if their parent (grantor’s child) has died, applies only
if the grantor’s child (and parent of the grandchildren) is deceased upon the
GRAT’s creation. If a child is living at the time the GRAT is created, and a
trust for that child is the remainder beneficiary (with that child’s children, the
grantor’s grandchildren, as contingent beneficiaries), such child could be given
a testamentary general power of appointment over the remainder interest. This
action would cause inclusion of that remainder in the child’s taxable estate if she
dies prior to the end of the GRAT annuity term. In Private Letter Ruling 200227022
(April 2, 2002), it was determined that in such case the transferor for GST tax
purposes would shift7 from grantor to the deceased child, thus eliminating GST
tax consequences if the child’s children (or trust for them) receive the GRAT
remainder. The “cost” of avoiding the GST tax liability is the inclusion of the GRAT
remainder in the deceased child’s taxable estate.
Similarly, a child, as direct remainder beneficiary of a GRAT, could gift his
remainder interest to, or in trust for, his children (the grantor’s grandchildren).
Since that gift is subject to federal gift tax, the transferor of this remainder
interest for GST tax purposes should shift from the grantor to the grantor’s
child, eliminating GST tax concerns.8 However, in this type of situation involving
a Charitable Lead Annuity Trust (CLAT) rather than a GRAT (which generally
mirrors a GRAT except that the annuity payments are made to charity rather than
the grantor), the IRS ruled9 that the identity of the transferor would shift for GST
tax purposes only to the extent of the present value of the remainder interest at
the time of the gift. Thus, according to the IRS, if a GRAT with assets valued at
$5 million had a remainder interest with a present value of only $1 million at the
time of such a gift, a shift of the transferor for GST tax purposes would only occur
as to 20% of the gifted interest.
7 IRC Section 2652(a)(1)(A).
8 IRC Section 2652(a)(1)(B).
9 Private Letter Ruling 200107015 (November 14, 2000).
2
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Methods for Optimizing GRATs
Sale of Remainder Interest to GST Tax Exempt Trust
A change in transferor from the grantor to a child for GST tax purposes may fully
or partially eliminate GST tax considerations with respect to a GRAT remainder
passing to, or in trust, for grandchildren or subsequent generations of the grantor.
However, the change will correspondingly subject the new transferor (the grantor’s
child) to federal gift tax or estate tax on the transfer. We believe another means is
available, however, to help accomplish effective generation-skipping planning with
GRATs without subjecting the intermediate generation to federal gift or estate tax.
If the grantor creates or has created a trust apart from the GRAT to which she has
allocated GST tax exemption to make this trust GST tax exempt, and such trust
is a grantor trust for income tax purposes, it could potentially purchase a GRAT
remainder from the remainder beneficiaries. Such GRAT remainder beneficiaries
are typically “nonskip” persons for GST tax purposes, such as children or trusts
for children, since allocation of GST tax exemption with respect to a GRAT cannot
be made until the end of the GRAT annuity term, which provides no efficient
leverage or certainty for generation-skipping planning. Ideally, the GRAT remainder
beneficiary would be a trust for children that is a grantor trust for income tax
purposes as to the GRAT’s grantor. The trust that is the beneficiary of the GRAT
remainder could then sell the remainder interest to the GST tax-exempt trust for
its actuarial fair market value at that time.
Such a transaction would be a sale, not a gift, such that GST tax exemption need
not be allocated. In addition, as a transaction between two trusts that are grantor
trusts for income tax purposes as to the grantor of the GRAT, no income tax or
capital gains tax consequences would result from this transaction.
For example, assume grantor contributes $5 million to a five-year GRAT with the
beneficiary of the remainder interest being a trust for grantor’s children (Trust
1). Grantor also creates Trust 2 for his family, gifting $5 million to this trust and
allocating $5 million of his lifetime gift exclusion and GST tax exemption to this gift
to make it entirely GST tax exempt. Both of these trusts are grantor trusts
for income tax purposes as to the grantor.
In year 2 of the GRAT, the actuarial value of the remainder interest is
$4.25 million. Trust 1 sells its GRAT remainder interest to Trust 2 at this time
for $4.25 million. In year 5, following the last annuity payment to grantor, the
GRAT terminates and the remaining assets, now worth $7 million, are paid to
Trust 2, which owns the remainder interest. The GRAT has now been successful
in not only transferring significant wealth to grantor’s family but also in keeping
the remainder assets, and their subsequent growth, permanently outside the
taxable estates of the Trust 2 family beneficiaries. Since in many states a trust
can last in perpetuity, these GRAT remainder assets and their growth may be
excluded from the taxable estates of many generations of the grantor’s family,
as illustrated in Chart 3 (page 14).
13
3
Methods for Optimizing GRATs
remainder assets, and their subsequent growth, permanently outside the taxable estate
Trust 2 family beneficiaries. Since in many states a trust can last in perpetuity, these G
remainder assets and their growth may be excluded from the taxable estates of many g
of the grantor’s family, as illustrated in Chart 3.
Chart 3
Growth of Trust Assets
140 3
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purposes if the GRAT remainder will pass to other beneficiaries such as children.10
payments pass to the grantor’s estate and then to his spouse will not qualify for
the marital deduction for estate tax purposes if the GRAT remainder will pass to
other beneficiaries such as children.10
13
Instead, the GRAT could provide that, if GRAT assets are included in the grantor’s
taxable estate, both remaining annuity payments and the remainder will pass to
the surviving spouse, thus qualifying for the marital deduction. Such an approach
could also be accomplished by having the GRAT provide a testamentary power
10 This type of interest is a nonqualifying terminable interest under IRC Section 2056(b)(1).
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Methods for Optimizing GRATs
of appointment to the grantor over any GRAT assets included in his estate, which
could be exercised in favor of the grantor’s spouse.
Alternatively, the includible assets and remaining annuity payments could pass
directly under the GRAT’s provisions, or by exercise of the grantor’s power of
appointment provided under the GRAT, to a marital deduction trust such as
a qualified terminable interest property (QTIP) trust. In such cases, to meet
the qualification for the marital deduction the GRAT should provide that, if in
any year following the grantor’s death the GRAT income exceeds the required
annuity payment, then such excess income will be paid to the marital trust (the
surviving spouse should also have the power to compel the GRAT trustee to
invest the assets to provide reasonable income).11
Trust for Spouse as GRAT Remainder Beneficiary
GRATs are typically intended to benefit descendants. Along these lines, the
remainder interest commonly will pass to children, or a trust for children, to avoid
imposition of GST tax following termination of the GRAT, as discussed above.
A spouse, however, can also be a beneficiary, along with descendants, of a trust
receiving the GRAT remainder without such beneficial interest causing inclusion
of the remainder assets in the spouse’s or grantor’s taxable estate. Including a
spouse as beneficiary provides “safety net” access to the assets if needed during
the spouse’s remaining lifetime.
Capping a GRAT
A grantor typically will want to maximize the potential wealth transfer in
establishing a GRAT. In some cases, however, the grantor may want to personally
enjoy gains on the GRAT assets, beyond his annuity payments, that exceed a
certain appreciation target. Or the grantor might be concerned that the remainder
beneficiaries may thereby receive too great a windfall at the GRAT’s termination.
In such cases, the GRAT could provide that, to the extent the GRAT remainder
exceeds a specific amount, such excess will revert to the grantor. Such a provision
would return assets to the grantor’s taxable estate that would have been excluded
as part of the GRAT remainder. In our view, such a structure may nevertheless be
necessary to help satisfy one or both of the concerns noted above such that the
grantor feels comfortable going forward with the GRAT.
11 IRC Section 2056(b)(7).
3
15
Methods for Optimizing GRATs
Conclusion
We believe GRATs represent a critically important wealth transfer tool that
should be considered and evaluated in almost every situation involving family
or closely held business succession planning. The effectiveness of GRATs for
such purpose can be magnified through optimization strategies discussed in this
paper, including the opportunity to benefit multiple generations of a family. As
such, a GRAT can generally be a valuable part of a family’s legacy plan whether
implemented in its basic form or combined with some of the variables that can
augment its efficacy as a wealth transfer vehicle.
GRATs represent an effective wealth transfer tool with generally little downside
risk, in our opinion. Combined with the ability to remove substantial value from
one’s taxable estate with little or no gift tax cost, GRATs have consequently come
under fire in recent years as the government’s need to narrow the budget deficit
gap increases. In recent years, the U.S. Treasury Department has proposed the
following restrictions on GRATs:
n
a minimum annuity term of 10 years;
n
decreases in the annuity amount during the GRAT term prohibited; and
n
a requirement that the actuarial remainder at the outset of the GRAT be
greater than zero (thus eliminating Zeroed Out GRATs).
In addition, under recent Treasury Department proposals, the portion of
assets in a trust received in a swap transaction between a grantor and a trust
that is a grantor trust for income tax purposes with respect to the grantor
would be subject to federal gift or estate tax. This change would make
subsequent transactions between a grantor and a GRAT to enhance their
effectiveness no longer generally feasible. Note also that as interest rates
increase, the hurdle rate for a GRAT’s success increases as well.
Accordingly, we believe it advisable to consider and implement GRATs and
the related strategies discussed above while favorable tax and interest rate
environments exist.
November 2014
The PNC Financial Services Group, Inc. (“PNC”) uses the marketing name Hawthorn, PNC Family Wealth® (“Hawthorn”) to provide investment consulting and
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