Are you facing potentially costly estate and gift tax? Get a GRAT.

 

Let's face it: taxes hurt, especially for wealthy individuals.  A powerful estate planning strategy with the potential to minimize tax exposure for the wealthy involves GRATs, or Grantor Retained Annuity Trusts. By way of real life example, Sheldon Adelson, the casino entrepreneur, is reported to have famously passed over $500,000,000 to his eventual heirs free of estate tax. If you're an affluent person with an appreciating estate and the desire to minimize tax exposure, a GRAT may be for you.

What is a GRAT?

In a GRAT, the Grantor provides assets to a trust for a term in years of the Grantor's choosing. The trust pays the Grantor an annual annuity bearing an interest rate that is set by the IRS. This rate was 3.2% as of April 2018 (IRS, 2018).  To the extent the assets in the GRAT have remaining value after making the required annuity payments, the excess comes out of the taxable estate and passes to the beneficiaries free of estate or gift tax.

If the Grantor dies during the term of the GRAT, the remaining assets revert back to the Grantor and become includable in his or her taxable estate.

Setting up and administering a GRAT requires the services of an attorney, but the costs tend to be minimal when compared with the expected tax benefits.

What impacts a GRAT's value?

The timing and selection of the assets being contributed to the GRAT are vitally important. We have studied various time horizons, and have concluded that shorter term (ideally two years) GRATs work best. Why? Through a technique known as rolling GRATs, the first annuity payment is used to fund the next GRAT, the second annuity payment funds the second GRAT, and so on.

The key to asset selection is to identify assets with the highest possible long term appreciation potential, in the hope that the appreciation will create large residual payments to the beneficiaries.

If the assets depreciate, they can be rolled into the next succeeding GRAT at the then-current value, with more shares added.  If they then appreciate strongly, the goal of removing the appreciation in value from the taxable estate will have been magnified

In this regard, volatility is the GRAT's friend and a far more important factor than the GRAT interest rate in determining the success of the GRAT strategy.

But even if the asset has declined, the seeming failure of the GRAT can turn into a success. When that asset rolls into the new GRAT, the required annuity payment to the Grantor goes down significantly, because the amount going into the GRAT (the fair market value) is low.  That low required annuity payment means that more upside remains in the GRAT.  And if the stock appreciates to the anticipated level, the residual amount is correspondingly much higher.

Did you know...

Summary on GRATS

In summary, careful planning in the design of a GRAT requires a thoughtful approach to setting the term of the GRAT and to choosing the assets with which to fund it.  The salutary effects of utilizing appreciating, volatile assets in funding a GRAT, and of a short term rolling GRAT strategy, are illustrated in our proprietary GRAT model. 

Our firm has done extensive analytical research on how to optimize the estate planning power of GRATs.  We utilize this technique, among others, when advising our ultra-high net worth clients who want to minimize their estate and gift tax, and accordingly to maximize the amount they pass on to their heirs.

Please contact us to learn more about GRATs, and to discuss other valuable estate planning techniques that have benefited our clients.

Sources:

U.S. Department of the Treasury. Internal Revenue Service. (19 March, 2018).Section 7520 Interest Rates. Retrieved on April 27, 2018 from https://www.irs.gov/businesses/small-businesses-self-employed/section-7520-interest-rates

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