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Impact of Declining Interest rates and Stock Prices
Summary:
Grantor Retained Annuity Trusts (“GRATs”) are a popular estate
planning tool for shifting value to heirs with little gift tax impact. The
current economic environment makes GRATs great. If Tony the Tiger were an
estate planner, they’d be GRRRRRAT!
What Are GRATs.
GRATs are grantor
retained annuity trusts. It is an estate planning technique used to transfer
value from say parents to kids with little or no gift tax. Here’s how it works.
You transfer assets to the trust. The trust pays you a specified annuity for a
set number of years your kids (remainder beneficiaries) get whatever is left.
The value of the gift is the value of the property you transfer to the trust,
less the value of the annuity. Thus, the value of this annuity reduces the
value of the gift. Most GRATs are structured with a modest gift value. Any
appreciation in the value of the property after you transfer it to the GRAT is
excluded from your estate if you survive until the end of the GRAT term. If you
don’t all the property is taxed in your estate, but that would have been the
case had you not tried the GRAT. Thus, there is no downside to trying this
technique.
How Have
Declines in Interest Rates Impacted the Use of GRATs?
Interest Rates:
Lower interest rates increase the value of the annuity retained by you as the grantor,
and therefore reduce the value of the gift of to your kids through the GRAT
(the remainder in a GRAT). Rates are near historic lows, which bodes well for
using GRATs now to plan. From August 2006 to April 2008, the interest rate
required to be used in determine the impact of a wide range of tax planning
transactions, called the Code Sec. 7520 interest rate, has dropped from a 6.2%
(August 2007) to a mere 3.4% in April 2008.
Example August
2006: If you established a GRAT, at age 70, with a $1 million dollar gift
in August 2006 that paid 8% and that was intended to last 12 years. The value
of the $1 million gift would be reduced by the present value of the $80,000
annual payments to you for 12 years which is $663,336. Thus, value of the gift
you would have made would have been $336,664. This would have meant that you
would have used up about 1/3rd of the $1 million lifetime gift
exclusion you are entitled to.
Example April
2007: Assume instead that you want to establish a GRAT in April 2008, at
age 70, with a $1 million dollar gift that paid 8% and that was intended to
last 12 years. The value of the $1 million gift would be reduced by the present
value of the $80,000 annual payments to you for 12 years which is $777,552.
This is substantially higher than the same calculation made in August of 2006
because the now lower interest rates make the worth of that payment stream
(annuity of $80,000/year for 12 years) greater. Thus, value of the gift you
would make now under the same facts would be $222,448. This means that you
would have used only about 20% of the $1 million lifetime gift exclusion you
are entitled to. The decline in interest rates has made the gift tax leverage
you can squeeze out of a GRAT far more favorable.
Life
Expectancy: Hey, does it make any sense for a 70 year old to wager a tax
bet on outliving a 12 year GRAT? If you’re taking your baby aspirin every day
it might. The life expectancy for a 70 year old is 16 years, four years more
than your 12 year GRAT tax bet! The probability of living to life expectancy is
a hair over 51% using the Sec. 1.72 Tables. Since these tables are based on
data derived from annuity sales contracts they tend to reflect data for a
healthier cohort of people (since people who buy annuities tend to be a bit
healthier than those who don’t). Using the IRS Table 90CM life expectancy is
for 13.9 years, with a bit under a 49 probability of living to that age. There
is some dispute over the factors that correlate with greater longevity. Some
commentators suggest that wealth provides better access to health care. Other
commentators advocate that intelligence correlates with longevity. Not meaning
to be elitist, but most of the cats with GRATs tend to be long on wealth and
brains, so their life expectancies are likely longer than even the 1.72 Tables
(but we’ll leave those nuances to the actuary types like Barry).
How Have
Declines in Stock Prices Impacted the Use of GRATs?
Stock Prices:
Any appreciation in the value of the property after you transfer it to the
GRAT, over the 7520 rate embodied in the calculations is excluded from your
estate. If you feel stock prices have taken most of their downside hit already,
now is an opportune time to set up a GRAT. Stock market prices have declined
substantially. The S&P 500 has lost most of the gain it realized during
this period. In August 2006 it was at 1,270 and is April 2008 stood at 1,370.
Example August
2006: Assume in August 2006, at age 70, you established a GRAT with a $1
million dollar gift that paid you an 8% annuity annually, and that was intended
to last 12 years. For gift tax purposes the value of the $1 million gift of
stocks would be reduced by the present value of the $80,000 annual payments to
you for 12 years, which is $663,336. Thus, value of the gift you would have
made would have been $336,664. This would have meant that you would have used
up about 1/3rd of the $1 million lifetime gift exclusion you are
entitled to. However, if the mediocre market performance from August 2006
through April 2007 continued for the entire 12 year term of the GRAT the plan
would be pretty near a wash. Little would be left in the GRAT for the kids
beyond the amount of the calculated gift.
Example April
2007: Assume the same facts but that instead that you establish a GRAT now
with a $1 million dollar gift in April 2008. Further assume (or pray!) that the
market has discounted the possible recession (or actual recession, depending
who you listen to) so that it’s nothing but an escalator ride up from here. Or
maybe the market will continue to resemble a ride at Great Adventure, but
you’ve invested with the ultimate stock picker and realize 10% returns over the
12 year life of the GRAT (please call me with the name and number). By year 12
the GRAT pot, after paying you
$80,000/year, will be worth over $1.4 million (don’t you love compounding!).
From a tax perspective, that’s a grand slam.
Some
Additional Thoughts.
*Wall Street
types will tell you that the only way to fly with GRATs is to use short term rolling
GRATs. Each year you use a high
pay out 2 year GRAT and set up a new GRAT each year thereafter. This approach
can be used to capture upside volatility with no significant downside risk.
While there is clear merit to this application (See Practical Planner, March
2007) in appropriate circumstances, and for appropriate assets, a
*longer term GRAT
like that illustrated above can be appropriate.
If the remainder
beneficiaries of your plan are people whose relationship falls outside the
scope of how the tax law defines “family” for these purposes (e.g. a niece or
nephew) then you can use a variation of the above called a GRIT (no corn
involved), a “Grantor Retained Income Trust. The key benefit of a GRIT over a
GRAT (don’t you love acronyms?) is like a GRAT except that the value of the gift
of the remainder is determined under more favorable assumptions.
*Watch out for
whipsaw. If you contribute interest in an entity to a GRAT and smaller slices
of the same entity are used to meet required annuity payments a greater
discount may apply to these thinner slices then to what you put in. Negative
leverage. Not a good thing.
*GRATs should be
characterized as grantor trusts for income tax purposes. Not a simple task
since many of the mechanisms that accomplish this for other types of trusts are
inappropriate in the context of a GRAT.
*GRATs, like all
tax acronyms, need to be cared for. You need to meet at least annually with
your estate planner, CPA and those managing the GRAT assets to assure
compliance with the many requirements.
*Busted GRATs will be
common for those GRATs hit by the sub-prime downdraft. If the GRAT pays out all
its depreciated assets to the grantor, it implodes. Don’t despair, terminate
the empty GRAT and start all over again.