The interest rates issued by the IRS, commonly referred to as Section 7520 rates, coupled with a depressed stock market, afford clients a unique estate planning opportunity by utilizing what is referred to as a short term Grantor Retained Annuity Trust (GRAT).
A GRAT is a trust established by a client for the benefit of himself. The idea behind the trust is that over the term of the trust (frequently as short as two or three years) the assets transferred to the trust, plus an amount equal to the income assumed by the IRS to be earned on the investment, is paid back to the Grantor. At the end of the trust, if the income exceeds that assumed by the IRS, the balance is distributable gift tax free to the children or other beneficiaries.
For instance, if a dollar is placed in a trust, over the term of a three year trust, the dollar plus interest at the assumed IRS interest rate is paid back to the Grantor in equal installments. The IRS assumes that there is little or nothing left in the trust at the end of the trust.
Because the trust is a “Grantor Trust” for income tax purposes, there is no income tax consequence produced by creating the trust, transferring the assets to the trust, or distributing the assets back to the Grantor. Income earned by the trust is taxed as received to the Grantor.
But if the Grantor receives everything back that the Grantor put in the trust, plus interest, then why would we do the trust? The answer is simple. If the trust earns more than the return assumed by the IRS, assets are left in the trust at the end of the term which pass gift tax free to the children or other beneficiaries.
Consider the following example. Steve, age 61, has an estate large enough to generate estate tax concerns. Steve has planned his estate but is concerned that future appreciation of the assets in his estate will result in unnecessary estate tax to be paid by his children at his death.
One of Steve’s investments is a substantial concentration of stock in XYZ Bank. The stock has traded over the years between $35 and $45. However, because of difficulties in the stock market and the banking industry, the stock is now trading between $18 and $22 per share.
The stock pays a dividend of approximately one dollar per share per year, which is approximately a 5% dividend. Steve believes that the stock is a good long term investment and plans to keep the stock. Steve feels that once the banking industry recovers, and XYZ Bank in particular, eliminates operating issues and once the stock market in general improves, that the stock will likely move back into the $35 to $45 range. It could double in value.
Steve establishes a three year GRAT in March 2008. Steve transfers $1 million worth of stock into the GRAT. Under current IRS Section 7520 rates, the trust will pay Steve approximately $358,000 per year at the end of the first, second and third years. Over the three years, the entire $1 million, plus interest at 3.6%, will be returned to Steve. Stock can be used to make the payments to Steve.
Assuming Steve is right in his assumptions that the stock will grow in value over the next three years and further assuming that the stock does grow at an annual growth rate of 10% per annum, moving from $20 per share at the time the trust is created to $26.60 at the end of the third year, approximately $250,000 will remain in the trust at the end of the third year after the three annual payments have been made to Steve. This $250,000 can stay in the trust for the children or be distributed outright to them. It is a tax free gift.
But what if the trust does nothing for the first two years? What if the stock was $20 when the trust was created and what if the stock did not move for two full years but then experienced a 25% increase in the third year? The balance in the trust at the end of the third year after all payments were made to Steve would still exceed $125,000.
If the stock does nothing over the three years, that is, it stays exactly where it was in value when the trust was created, there is still approximately $30,000 left in the trust because of the dividends. This goes to the children tax free.
In establishing the trust, Steve has made a gift. However, because the trust provides that Steve will receive back all that has he put in, plus interest, the taxable gift that Steve makes when he transfers the $1 million into the trust is only $19,000. This taxable gift does not fall within Steve’s gift tax exemptions. He uses $19,000 of his lifetime exemption for federal gift tax purposes and pays no federal tax. He does owe slightly more than $1,000 in State of Tennessee gift taxes if he is a Tennessee resident. If he is a Mississippi or Arkansas resident, he owes no state gift tax.
The utilization of a short term GRAT can be structured so that it runs for as little as two years or for several years. Studies have shown that the shorter the term, the more likely the benefit. Two year GRATs might be the best.
After the first year, what if the stock still has not increased in value? Steve still believes that the stock will increase in value. In the example above, Steve received back at the end of the first year approximately one-third of the assets that he put in the trust. What does he do? The answer is simple. He creates a second identical GRAT. It has the same terms as the first GRAT although the assumed interest rate may have changed. He takes the assets which were distributed back to him from the first GRAT, adds some additional stock and starts a second GRAT containing substantial identical terms.
The goal is to continue to roll the investments out of one GRAT and into another GRAT and wait patiently until the stock does what you assume it will do, which is to jump substantially when the stock market and the banking industry improve, and XYZ Bank in particular starts producing positive returns in the market. This technique is commonly referred to as a “Rolling GRAT” since stock rolled out of one GRAT is rolled into the next GRAT.
The down side of this technique is if the stock does nothing, the assets placed into the GRAT come back to the Grantor. The Grantor incurs a transaction cost in the preparation of the trust, fees in the management of the trust, and fees for the preparation of tax returns. On the other hand, if the stock substantially outperforms the assumed IRS return, establishing a GRAT or a series of Rolling GRATs is an excellent technique to move appreciation to the children or other beneficiaries without substantial gift tax costs.
A. Stephen McDaniel, 3-2008
Williams, McDaniel, Wolfe & Womack, P.C.
5521 Murray Avenue, Memphis, Tennessee 38119