Planning in turbulent times: GRATs.

Editor's note: If you would like further information about this column, please contact Ms. Lewis at [phone] or [e-mail]. The author thanks Roger Stinnett, Senior Manager, Ernst & Young LLP, for his assistance.

The changes in estate tax laws, the events of September 11 and market volatility have left many high-net-worth taxpayers wondering about the viability of some of the most frequently discussed estate-freeze techniques. On the legislative front, the Economic Growth and Tax Relief Reconciliation Act of 2001 increased the lifetime gift tax exemption and decreased tax rates (with complete elimination of estate tax in 2010). However, both taxpayers and planners should realize that uncertainty and the recent unfortunate turn of events bring a host of planning opportunities.

The main focus of this column is to highlight existing planning opportunities available through grantor retained annuity trusts (GRATs).

A GRAT is an irrevocable trust in which the grantor retains the right to annuity payments for a period of time (Sec. 2702). At the end of the trust's term, the remaining assets are transferred to beneficiaries (or to a trust for their benefit). By using a GRAT, a taxpayer with an asset that has a potential for substantial future appreciation, can transfer any appreciation in excess of the IRS discount rate (Sec. 7520) to a younger generation at a zero or minimal tax cost.

A GRAT takes advantage of rules that permit certain deferred gifts in trust to be taxed on a discounted present-value basis. The annuity payments are a qualified interest (as described in Sec. 2702(b)) and reduce the gift's value on the GRAT's formation. The major risk associated ,with GRATs is the possibility of the grantor not surviving the trust's term. If the grantor dies during the term, the total fair market value (FMV) of the GRAT's assets at the time of death is included in his or her estate; see Sec. 2036 and Letter Rulings 9448018 and 9345035.

However, the benefits are enhanced by the ability to discount the assets being transferred or sold for lack of marketability or a minority interest. This reduction in the assets' FMV reduces the taxable gift amount and the annuity retained. In addition, wealth transfer can be greatly enhanced by using a dynasty trust in combination with a GRAT.

Annuity payments can be made in cash or in-kind. However, distributing property back to the grantor reduces the chance of passing on future appreciation to the beneficiaries.

Points to ponder when considering GRATs include:

* Negligible or no taxable gift on transfer of property to a trust;

* Future appreciation (above the Sec. 7520 rate) on property transferred is removed from an estate;

* A trust can qualify as an S corporation shareholder if structured as a wholly owned grantor trust;

* Transactions between a grantor and a trust are not taxable events for income tax purposes;

* Trust property is included in a grantor's estate if he or she dies during the trust term;

* Beneficiaries obtain a carryover basis in the transferred property;

* A generation-skipping transfer (GST) tax exemption cannot be allocated until a grantor's annuity interest terminates (the grantor cannot leverage the GST exemption);

* A gift tax return must be filed reporting the actuarial value of the remainder interest (no annual exclusion is available, because the gift is of a future interest).

Who Should Use a GRAT?

GRATs make sense for taxpayers who:

* Are more conservative or need certainty against IRS challenges. The regulations provide a blueprint for establishing a GRAT.

* Have high probability of surviving a GRAT's term.

* Do not currently need to allocate a GST tax exemption to the trust (i.e., no grandchildren as beneficiaries).

* Hold hard-to-value assets (i.e., closely held or pre-initial public offering (IPO) shares).

Planning Strategies

Even though estate tax rates will be declining over the next eight years, the estate tax will return with full force in 2011. There may be some feeble hope for permanent estate tax repeal, but it is not shared by a majority of high-net-worth taxpayers. Several conditions make current turbulence advantageous for planning with GRATs. Low interest rates, depressed values and growth in the small business sector provide fertile ground for establishing a GRAT.

Low valuations. Asset values are the main drivers in determining any wealth-transfer strategy. Initiating an estate-freeze strategy during times of low asset values increases the chances of a successful wealth-transfer plan. The types of assets that should be considered as potential candidates are:

* Closely held companies that may be targets for acquisitions (either an S or C corporation);

* C corporations that are likely to undertake an IPO;

* Publicly traded stock that may be experiencing a temporary decrease in value due to market volatility; and

* Other assets with temporarily depressed values that have solid growth potential.

GRATs and low interest rates. Low interest rates reduce the annuity amount that a grantor needs to retain, allowing for any growth in excess of the Sec. 7520 rate to pass to beneficiaries gift-tax free.

Example 1: T owns an asset valued at $10,000,000 with a 10% projected annual growth rate. He wants to pass this growth to the next generation and the gift amount to be zero. The current Sec. 7520 rate is 5.6%. In July 2002, T established a two-year GRAT (following Audrey J. Walton, 115 TC 589 (2000)) to zero out the gift (i.e., to claim the value of the gift to the remainder interest holders is zero). His annuity payments are made at the end of each year. With a 54.23875% annuity rate, totaling $5,423,875 per year, he can pass on $709,862 to the beneficiaries at the end of two years (i.e., in July 2004).

However, if T implements the GRAT six months later, when the Sec. 7520 rate is 6.6% (assuming all other factors remain the same), he can transfer only $549,481 to his beneficiaries at the end of the GRAT's term. The annuity is $5,500,247 per year, with a 55.00247% annuity rate. The 1% increase in interest rates causes the remainder to decrease by $160,381.

Cashflow concerns. Even though a short-term GRAT reduces the possibility that a grantor will not survive the term, it may also result in high annuity payments (as in Example 1). In certain circumstances, meeting annuity obligations with cash may be impossible for a short-term GRAT, forcing it to distribute principal back to the grantor. (For example, when a pending sale or IPO is expected to cause great appreciation in the near future, but the asset does not produce enough cashflow currently to meet the annuity's requirements.) In these instances, a GRAT with a longer term will be more advantageous if a taxpayer is in good health and has a high probability of surviving the term. This allows appreciating assets to remain in the trust longer and to capture future growth. Additionally, in times of low interest rates, a longer term GRAT hedges against future increases in Sec. 7520 rates and any future law changes that may apply to new GRATs.

Example 2: The facts are the same as in Example 1, except the GRAT's term is five years (July 2007) and the Sec. 7520 is 5.6%. The annuity rate is 23.48189%, totaling $2,348,189 per year. The remainder is $1,769,171.

If the remainder ($709,862) passing to beneficiaries in Example 1 maintains a 10% annual after-tax growth rate for the next three years, the estimated sum in July 2007 will be $858,933, compared to the $1,769,171 remainder in Example 2.

Back-loading annuity payments also helps to manage a GRAT's cashflow in the earlier years. Regs. Sec. 25.2702-3(b)(1) allows annuity payments to increase up to 120% each year during a GRAT's term, which may be helpful when a company has substantial startup costs in early years and expects higher cashflow in future years. Using escalating annuity payments prevents a GRAT from having to make in-kind distributions to a grantor.

Example 3: The facts are the same as in Example 2, except the trust provides for a 20% increase in annuity amounts for each year. This results in smaller annuity payments in the earlier years and a larger remainder ($1.9 million vs. $1.7 million) passing to beneficiaries. The annuity rate in the first year is 16.09114%. It increases 20% annually thereafter:

Year 1:   $ 1,609,114
Year 2:   $ 1,930,936
Year 3:   $ 2,317,124
Year 4:   $ 2,780,549
Year 5:   $ 3,336,659
Total:    $11,974,382

With a zero gift amount, the remainder is $1,980,136.

Establishing separate GRATs for different assets may also protect against overall underperformance due to a decline in one of the asset's values. If a GRAT asset has insufficient cashflow and distributes principal to meet annuity payments, it will terminate due to lack of trust corpus when all the assets have been distributed to the grantor. However, if the same GRAT held another appreciating asset with positive cashflow, it will have to use this asset to meet its total annuity obligation. This will be counter-productive to the objective of setting up the GRAT--a tax-efficient transfer of future appreciation to the next generation.

Prescription for Ailing GRATs

What if a taxpayer sets up a GRAT, but the assets do not appreciate as expected, or a business is experiencing decreased cashflow and a decline in asset value below initial values?

When cashflow is inadequate to make the annuity payments, the GRAT has to distribute assets to the grantor. In times of depressed asset values, a larger portion of assets is required to meet the annuity amount. This may speed the exhaustion of trust principal before the end of the trust term.

Asset substitution. If the taxpayer has other appreciating assets, he or she might decide to "substitute" them for assets that have lost growth potential (Sec. 675(4)). If this is done early enough during the GRAT's term, the taxpayer could preserve the wealth-transfer opportunity.

Third-party borrowing. Alternatively, the GRAT can borrow funds from an unrelated third party in an arm's-length transaction to make annuity payments. (However, under Regs. Sec. 25.2702-3(b)(1)(i), a GRAT cannot issue a note to the grantor to satisfy the annuity.) When the cost of borrowing is fairly low (as it is currently), leveraging trust assets and making payments with borrowed funds keep assets with future appreciation potential in the trust. The income tax consequences of such a loan could be income recognition to the lender, but disallowance of interest expense to the grantor trust, because of the loan's personal nature. If the third-party financing is paid off before the end of the GRAT'S term, there would be no adverse income tax consequences for the grantor. However, if the grantor dies during the GRAT's term or the GRAT terminates while the third-party notes are still outstanding, gain will be triggered to the extent of outstanding loans and will be taxable to the grantor (Letter Ruling (TAM) 200011005).

Yield enhancement. If the GRAT holds publicly traded stock with a temporarily depressed value, the GRAT can employ a yield-enhancement strategy (such as writing covered calls). A call option gives the purchaser the right to buy the underlying stock at a predetermined price (i.e., a call strike price) on a future date. The GRAT (as the seller) receives a premium for granting the buyer this right. The premium can provide cash to meet short-term needs and helps enhance the underlying stock's overall yield. The GRAT forgoes any appreciation above the call strike price; however, if the stock price is less than the call strike price on the day the option becomes due, the call option will not be exercised. The GRAT will keep the premium as well as the shares and retain the underlying stock's growth potential.

Re-GRAT. If a GRAT has terminated due to asset underperformance, the grantor could re-GRAT the asset received as annuity payments. For example, if a two-year GRAT was funded with a publicly traded growth stock at the end of 1999 (or that of a closely held company that was going to be acquired, but was not, or S flowthrough income was reduced due to economic slowdown and the corporation distributed shares back out), it might not have been able to produce the cashflow to meet its annuity payments and had to distribute trust principal back to the grantor. However, if the grantor still believes in the potential appreciation of the asset beyond the two-year GRAT term, he may consider establishing another GRAT with the property distributed to him as annuity payments. With depressed values and low interest rates, the retained annuity may be much less than the original GRAT'S.

Conclusion

Careful consideration of options and opportunities makes GRATs attractive as wealth-transfer strategies. Taxpayers who experience difficult economic times may have more realistic expectations of the results to be achieved with GRATs. Individuals who carefully take advantage of the turbulent times will be poised to capture the positive benefits of economic upturns and be able to transfer greater amounts of wealth to future generations.

Alev T. Lewis, CPA, PFS, MST
Senior Vice President
Bank of America
Westlake Village, CA