Transforming an Ordinary GRAT
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A grantor retained annuity trust (GRAT) is an estate
“freezing” technique, intended to transfer wealth to the
next generation and other beneficiaries. GRATs are
designed to reduce the value of the transfer, thereby
lowering or sometimes even eliminating the gift tax
consequences of the transfer. In this Hawthorn Institute
paper, we explore how credit may be utilized to enhance
the GRAT strategy.
A GRAT is an irrevocable trust in which the grantor retains an annuity interest for a term
of years. At the end of the term, any remaining property in the GRAT will pass to the
remainder beneficiaries. The annuity interest is designed to enable the grantor to receive
a fixed percentage of the initial fair market value of the GRAT, at least annually, for the
term of the trust. Usually, the GRAT term is structured over a relatively short period
(anywhere from two to nine years). However, in the event a grantor does not survive
the term of the GRAT, all remaining property held by the GRAT will be includable in the
grantor’s estate for estate tax purposes. Moreover, a contribution to a GRAT may result
in a gift tax liability to the grantor. However, a GRAT may be structured to eliminate gift
tax liability.
The value of the gift to a GRAT may be significantly reduced, if not eliminated, by the
value of the annuity interest retained by the grantor. The value of the annuity interest is
calculated using Internal Revenue Service (IRS) valuation tables at interest rates in effect
at the time the GRAT is funded. If the fixed annuity is for a high enough amount and long
enough period, its actuarial value under IRS tables and prevailing interest rates can equal
100% of the amount originally transferred, thus “zeroing out” the GRAT and resulting in
no gift for federal gift tax purposes.
Hawthorn Institute Contributors:
Drew LaGrande J.D., LL.M.
Vice President,
Senior Wealth Planner
Randall C. Ackerman
CPA, CFP®, CTFA
Vice President,
Senior Wealth Planner
The IRS assumes that the value of the trust property will realize a certain rate of return
during the term of the GRAT. This assumed rate of return is known as the Section 7520
rate, or the hurdle rate. If the property in the GRAT outperforms the hurdle rate, the
appreciation will pass to the remainder beneficiaries free of gift taxes. With the historic
low Section 7520 interest rate (1.8% for March 2015), we believe zeroed-out GRATs may
represent an attractive opportunity to transfer wealth without gift tax consequences. This
may be especially attractive for individuals who have exhausted their lifetime federal gift
tax exemption.
For example, if a grantor contributes an asset with a value of $1 million to a
four-year, zeroed-out GRAT and the current hurdle rate is 1.8%, the annual annuity
interest to the grantor would be $261,349 during the term of the GRAT.
If the annual rate of return for the assets owned by the GRAT equals 7%, then the
remainder beneficiaries of the GRAT would receive $150,421 gift-tax free. If the
assets appreciate 10% per year, then the remainder beneficiaries of the GRAT would
receive $251,179 gift-tax free.
Transforming an Ordinary GRAT
Typically, the property transferred to a GRAT is property that is anticipated to
rapidly appreciate or property that is expected to outperform the hurdle rate. In
addition, high-yielding investment portfolios or property that can be discounted,
such as closely held business interests, are common assets that are contributed
to GRATs. Further, if the assets owned by the GRAT fail to outperform the hurdle
rate, there will be nothing to transfer to the remainder beneficiaries, resulting in
no gift tax savings.
Given today’s volatile market, many grantors may be burdened with
underperforming GRATs. These GRATs likely hold some assets that are
performing to expectations and some that are not. The appreciation in the
performing assets, during the balance of the term of the GRAT, may not make
up for the underperforming assets, thus resulting in few, if any, tax benefits
derived from the GRAT.
When faced with a volatile market, we think the grantor could consider certain
options that may be available to revitalize the underperforming GRAT. For one,
the grantor may substitute an asset held by an underperforming GRAT for
an asset of equal value, if the GRAT provides for the power of substitution. A
power of substitution is the power of the grantor to reacquire assets in a trust
in exchange for assets of equal value. Generally, this provides the grantor of a
GRAT tremendous potential flexibility in deciding which assets are contributed
to a GRAT. The grantor could potentially contribute the assets removed from the
underperforming GRAT into a new GRAT, especially if there is an expectation that
the assets contributed to the new GRAT will outperform the hurdle rate, resulting
in a transfer of wealth to the remainder beneficiaries gift-tax free.
If the grantor does not have suitable assets to substitute or if the GRAT lacks the
power of substitution, then the grantor could potentially purchase the assets held
by the underperforming GRAT in exchange for a promissory note. If permitted,
the grantor can then contribute the assets purchased from the underperforming
GRAT into a new GRAT.
If the assets owned by the GRAT have significantly increased in value and
the trustee of the GRAT wishes to secure the gain, he or she could consider
substituting the highly appreciated assets from the GRAT with cash, prior to the
end of the GRAT term. This substitution of GRAT assets with cash helps eliminate
the market volatility and preserves the appreciation achieved by the GRAT.
The highly appreciated, low-basis assets in the GRAT could then be held by the
grantor’s estate until the grantor’s death. These assets should also receive a
step up in basis at the grantor’s death. The GRAT remainder beneficiaries would
receive cash at the end of the GRAT term. Thus, the built-in gain could potentially
be diminished for both the grantor and the remainder beneficiaries.
If the grantor does not have the necessary liquidity to substitute cash for the highly
appreciated assets held by the GRAT, the grantor could sell assets in his or her
own investment portfolio to raise cash. However, selling assets could generate a
capital gains tax liability for the grantor. Selling assets could also affect the asset
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Transforming an Ordinary GRAT
allocation strategy that the grantor has in place. Additionally, the grantor may
have certain so-called “favorite” investments that he or she would prefer not to
liquidate.
As an additional source of liquidity, the grantor could consider credit as a source of
cash. Many factors affect the decision to borrow. For example:
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Does the grantor qualify for credit or lending?
Does the grantor want debt, especially during retirement years?
What is the current cost of debt?
Are we in a low interest rate or high interest rate environment?
The answers to these questions will ultimately help determine whether the grantor
decides to borrow funds to secure the appreciation of the assets held by an
existing GRAT or rescue assets in an underperforming GRAT. It is the advisor’s role
to be objective and provide guidance to help the grantor determine what is in the
best interest of the grantor based on his or her particular facts and circumstances.
If the grantor decides to borrow, he or she must consider how the debt is repaid.
The grantor could potentially substitute the borrowed cash in exchange for the
assets held by the GRAT. After the substitution, the GRAT will only own cash. The
GRAT makes future annuity payments to the grantor in cash, and the grantor uses
the cash to pay down the debt.
At the termination of the GRAT, there might be a second substitution. The grantor
may decide to substitute assets that he or she wants to be transferred to the
remainder beneficiaries of the GRAT in exchange for the remaining cash held by
the GRAT. The grantor could then use the cash he or she receives at termination
of the GRAT to pay down the debt.
The following example illustrates how a grantor can potentially lock in the success
of a GRAT with the use of credit.
The grantor funds a four-year, zeroed-out GRAT with $8 million of marketable
securities. The current hurdle rate is 2.2%. The grantor receives an annuity
payment of approximately $2.1 million per year during the term of the GRAT. After
four years, the remaining value of the GRAT goes to the grantor’s children.
After two years, the assets owned by the GRAT have earned an annual rate of
return of 12%. The value of the GRAT is approximately $5.6 million. The grantor
has received almost $4.2 million in annuity payments during the first two years.
The grantor is still owed about $4.2 million. If the assets held by the GRAT maintain
their current value for the next two years, then the remainder beneficiaries may be
entitled to receive approximately $1.42 million at the end of the GRAT term.
If the grantor wishes to secure the gain already earned, he or she can substitute
cash in exchange for the marketable securities held by the GRAT. The grantor’s
remainder beneficiaries would receive the appreciation earned by the marketable
securities of approximately $1.42 million.
The grantor can borrow $5.6 million using his or her investment portfolio as
security for the loan. The cash received from the loan can then be substituted in
exchange for the remaining marketable securities owned by the GRAT. Over the
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next two years, the grantor receives annuity payments in cash of approximately
$4.2 million. The grantor uses the cash received by the GRAT to pay down debt.
At termination of the GRAT, the remaining cash held by the GRAT is valued at
approximately $1.4 million. The grantor substitutes $1.4 million in marketable
securities into the GRAT in exchange for $1.4 million cash.
The grantor uses the cash to pay down debt. The grantor’s children receive
$1.4 million in marketable securities, gift-tax free.
The strategy to lock in the value of a GRAT by substituting cash is designed to
remove the volatility of the assets held by the GRAT. If the assets decrease in
value, the GRAT is protected because the assets are back in the grantor’s name.
The substitution strategy helps protect the GRAT from market downturns and the
depreciation of the assets held by the GRAT. Following the substitution of assets,
the grantor can continue the GRAT strategy. The grantor can take the assets he
or she receives by way of substitution and establish one or more new GRATs. The
grantor will be able to lock in the success of the existing GRAT and can realize
future growth in the new GRAT(s).
In our opinion, one potential downside to the substitution strategy is that if the
substituted assets continue to appreciate, the GRAT would have been more
valuable at termination had the assets been retained in the GRAT. However, if the
grantor contributes the substituted assets to one or more new GRATs, the new
GRATs could potentially participate in this appreciation.
The grantor will also incur costs associated with the creation of the GRAT and
may incur additional costs with obtaining credit. Because the grantor borrowed
cash to make the substitution, the grantor will pay interest over the term of
the loan. We think the current interest rate environment is an important factor
to consider in determining the appropriateness of the strategy. Currently, the
interest rate environment is, in our opinion, especially attractive for the use of
credit to enhance the GRAT strategy.
Conclusion
March 2015
Estate planning strategies require a thoughtful analysis of goals and objectives.
It is important to consider current and future economic, financial, and credit
market conditions and the impact on these strategies. We believe a valuable
consideration is whether locking in the success of a GRAT, or rescuing a poorly
performing GRAT, with the use of credit is an appropriate option.
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