ELITE ADVISOR BEST PRACTICES

Freeze, Arbitrage and Discounts Part Three (Techniques)

Grantor retained annuity trusts (GRATs) (third in a series)

By Richard L. Harris

Key Takeaways:

  • Estate planners have a number of techniques that involve freezes, arbitrage and/or discounts.
  • The GRAT is the most popular technique used by trust and estate attorneys.
  • This article will go over the GRAT technique as well as its advantages and disadvantages.


As we discussed in earlier installments of this article series, FADs have three components:

  1. Freeze: Locking in a value for an asset today so that future growth occurs outside the estate.
  2. Arbitrage: Transferring assets for a receivable that has a low interest rate, while the asset has a higher rate of return.
  3. Discounts: By having business interests that have limited rights (i.e., nonvoting, unmarketable, illiquid), the value of those interests is worth less than their share of the whole business.

Freezing, arbitraging and discounting assets are techniques that are typically used in combination with each other, not in isolation.

GRATs

The object of a GRAT is to transfer assets to children, or a trust for children, while incurring little if any value for gift tax purposes. A GRAT has these features:

  • The person who creates the trust—the grantor—sets up a GRAT so that he or she receives an annuity for a set period of time.
  • At the end of that time, if there is anything left in the trust, it goes to beneficiaries named in the trust.
  • The IRS imputes a rate of interest, calculated monthly, to determine the amount of the annuity payment.
  • The GRAT is a grantor trust—a trust that for income tax purposes is considered to be the same as the grantor. Therefore, the grantor pays any income tax on the taxable earnings inside the trust.
  • The value of the remainder interest—the gift—is calculated when the GRAT begins.
  • The GRAT is covered specifically by the Internal Revenue Code—the strongest of all tax precedents.
Real-world example

Mrs. Big owns a piece of property that is in a limited liability company (LLC). The LLC has two classes of ownership—a manager who makes all decisions regarding the LLC, and members who have an interest in the LLC and who are entitled to pro rata shares of the income of the LLC. The members have no say in the conduct of the LLC. Even if there is income generated, distributions are not required, but they are still taxable to the members.

Suppose the LLC’s value is $10 million. You are offered the opportunity to buy 10 percent, but in nonvoting membership interests. The interest is illiquid and highly unmarketable. Question: Would you pay $1 million or something less? Assuming you answered correctly (less), you can understand why that LLC interest has a discounted value in the real world.

Let’s assume that an appraisal says the value is $650,000. The grantor sets up a GRAT with a two-year term (the shortest term allowed) in July 2013. The rule is that an interest rate must be used to determine what the total annuity payments are. The rate used is called the 7520 rate, for the IRC section it relates to.

The IRS publishes this rate before the start of each month. As of press time, for July 2013 that rate is 1.4 percent. The grantor wants the remainder interest (which goes to the children after the GRAT payments have been made) to be zero. That way there is no taxable gift. Using the NumberCruncher estate planning tool, you will find that the annual annuity payment to achieve that result is determined to be $331,836. The payments have to be made in cash and/or in kind (units of the asset that was put in.)

Assuming the real estate throws off 10 percent per year and grows at 20 percent annually (a very shrewd investment) after the annuity payments have been made, then the beneficiaries will receive an asset with a value of $536,807 upon liquidation of the real estate—all without any gift taxes! In addition, because a GRAT is a grantor trust, all the income taxes during the term of the GRAT are paid by the grantor, amplifying the result. The GRAT can also be done with marketable securities or cash, without a discount. The idea is to outperform the 7520 rate.

Advantages

The primary advantage of a GRAT is the opportunity to move value down a generation without any gift tax consequences. In the case of the business interest example above, all the FAD elements are used. The “freeze” is that the grantor receives back only the value at inception, plus a nominal rate of return. The “arbitrage” is that you have a very low interest rate—1.4 percent—to beat. If you beat it—and you were pretty much assured that you would in the example—anything above that rate gets passed to the next generation. By the way, if the asset does not outperform the 7520 rate—no harm, no foul. You can distribute based only on what you have. If you don’t have enough, you distribute what remains. The “discount” comes in because the value used to determine the annuity payments from the GRAT was lower than the $1 million it would be worth if it never were separated from the whole.

Disadvantages
  • If the grantor dies, whatever is left in the GRAT is taxable in the grantor’s estate.
  • The asset can be moved down only one generation successfully. For generation-skipping transfer (GST) tax purposes, the value that goes beyond one generation is calculated at the end of the GRAT. In the example above, the full value of $536,807 is subject to that tax. (Some practitioners have techniques they use to accomplish the transfer without GST tax, but many practitioners avoid doing this.)
  • As with any gift transaction that involves discounts, the IRS can challenge the valuation used.
  • When an “in kind” distribution is made, the value of the asset has to be re-determined. If there was a discount going in, then there will be a discount coming out. In our example, if the $331,000 annuity payment were in kind, assuming the same value of the underlying asset without appreciation, then $509,000 of absolute value comes out.
  • The grantor cannot make a loan to cover the annuity payments and avoid having to take a distribution in kind.
  • Among the various tax proposals, there is one that will limit the advantage of GRATs by requiring them to have a minimum term of 10 years and a maximum term of the grantor’s life expectancy plus 10 years. The mortality risk becomes greater.

If the grantor is concerned about the recapture of the asset at death, then term life insurance is an excellent hedge against the tax consequence. The insurance should be owned by an irrevocable life insurance trust (ILIT) with the beneficiaries being the same as the GRAT. Generation skipping can be done with the ILIT.

As to why there is a proposal to limit the term of a GRAT to the grantor’s life expectancy for 10 years, consider the following.

Under the same scenario as our example, the grantor sets up a 99-year GRAT. The annuity payment is $12,174. Of course, the grantor is going to die before 99 years, so why do it?

It has to do with the particular way the value of the GRAT in the estate is determined. The IRS actually values it in the estate by taking the amount of the annuity payment and dividing it by the 7520 rate when the grantor dies. This is a play on today’s low interest rates. Suppose that when the grantor dies, that rate is 5 percent. The value that would be included in the estate is $12,174 divided by 0.05, or $243,475. That’s a lot less than what was put in. And if there is any growth either through income or capital appreciation, then that is not included. (This is a relatively new version of the GRAT that some practitioners are using.)

Conclusion

A GRAT is an important tool in estate planning. It is a no-lose situation for assets that otherwise would have been in the grantor’s estate. However, if the grantor wants to make it a sure-win situation, then using life insurance as a hedge will accomplish that goal.

The three properties of the tools in the estate planner’s tool kit are the basis for all the transactions recommended by them. Knowing these techniques allows financial planners and life insurance agents to understand the value of what they can offer compared with what attorneys can offer. The specific techniques that use the three tools mentioned above will be discussed in later pieces, along with the strengths and weaknesses of each technique.


About the Author

Richard L. Harris specializes in life insurance sales and consulting for high-net-worth individuals and their advisors. For more than four decades, he has been a trusted expert for accountants, attorneys and trust officers. A life insurance agent, he holds the professional designations of Chartered Life Underwriter, Registered Trust and Estates Practitioner, and Accredited Estate Planner. He may be reached at Richard@rlharrisllc.com or 973-470-5151.