R ecent interest rate cuts have created a hood that the Grantor - - PDF document

Estate Planning Alert

November 1998

Declining Interest Rates Can Mean Transfer Tax Savings (using a Grantor Retained Annuity Trust)

By: Michael N. Gooen and John M. Tassillo, Jr.

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ecent interest rate cuts have created a significant estate planning opportunity for individuals who own assets with appreciation potential. Each month, the Internal Revenue Service (“IRS”) sets an interest rate for valuing gifts of future interests in property. The November 1998 rate is 5.4%, the lowest rate in several years. By act- ing now to exploit that low rate, individuals can pass significant value to their children at a minimal transfer (gift and estate) tax cost. One vehicle for accomplishing that goal is the grantor retained annuity trust (“GRAT”). What is a GRAT? A GRAT is a trust with respect to which an individual (the “Grantor”) retains the right to receive a fixed dollar amount, in cash or in assets, each year for a term of years (the “GRAT Term”). At the end of the GRAT Term, if the Grantor is then living, the remaining balance of the GRAT (including any income or asset growth in excess of the amount used for annuity payments) will pass to the next generation free of transfer tax. At the time of the GRAT’s creation, the Grantor is treated as making a taxable gift of the remainder interest in the GRAT (that is, the right to receive assets remaining at the end of the GRAT Term). The amount of the taxable gift would be the fair market value of the gifted assets as of the date

• f the gift, discounted by two factors: (i) the length
• f the GRAT Term (that is, the delay in the next

generation’s receipt of the assets) and (ii) the likeli- hood that the Grantor would die during the GRAT

• Term. As the IRS’s assumed interest rate decreas-

es, so does the amount of the taxable gift. The gift may be sheltered by the Grantor’s unified credit (which currently affords an estate and gift tax exemption for transfers of up to $625,000; this amount is scheduled to increase to $650,000 in 1999, $675,000 in 2000-2001, $700,000 in 2002- 2003, $850,000 in 2004, $950,000 in 2005 and $1,000,000 in 2006 and thereafter). Thus, in many cases, there may be no gift tax imposed on the cre- ation of the GRAT . If the Grantor were to die during the GRAT Term, all or a portion of the trust corpus would be included in the Grantor’s estate, potentially for- feiting the transfer tax savings. On the other hand, if the Grantor were to survive the GRAT Term, the value of the gifted property—and any appreciation thereof—would escape all further gift and estate tax at the Grantor’s level! The following examples illustrate the tax savings afforded by the GRAT technique. Example: GRAT for High Yielding Marketable Securities A GRAT can be an effective technique for transferring high yielding securities. For example, assume that Mother (age 60)

• wns $1,000,000 in securities that earn a 15%

annual return (combined income and growth). If the portfolio continues to perform at that rate over 10 years, it will be worth over $4,000,000. At that

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point, the potential estate tax cost to Mother’s family if she retains the portfolio is well over $2,000,000. Now let’s assume that Mother transfers the securities portfolio to a GRAT in November 1998 and retains the right to receive an annual pay- ment of $130,000 for 10 years, after which any remaining balance will pass to her children. Applying the IRS’s actuarial assumptions and the low November 1998 interest rate, Mother’s trans- fer of the securities portfolio to the GRAT results in a taxable gift of slightly less than $90,000. At worst, if the portfolio does not grow sufficiently to cover the annuity payments, the entire portfolio’s value will be returned to Mother and she will have wasted a small percentage of her unified

• credit. However, if the portfolio achieves its

anticipated growth rate throughout the GRAT Term, over $1,400,000 will pass to Mother’s chil- dren free of transfer tax! Example: GRAT for Closely Held Business Interests A GRAT also can allow a Grantor to “freeze” the value of a closely held business for gift and estate tax purposes, thus retaining the current value (and, if desired, control of the business) while passing the anticipated appreciation in the business to the next generation. Let’s assume that Father (age 55) is the sole shareholder of Family Corp., a subchapter S cor- poration that is currently worth $1,000,000. Father anticipates that the value of his Family

• Corp. stock will appreciate by 25% in each of the

next five years. Thus, by November 2003 Father’s Family Corp. stock will be worth over $3,000,000. Father does not want to relinquish control of Family Corp. However, he is concerned about the ultimate estate tax burden his family will bear if he retains his Family Corp. stock until his death (at current rates, the potential estate tax on $3,000,000 can exceed $1,500,000). Accordingly, Father should consider a GRAT to facilitate the transfer of his Family Corp. stock to his children. Father decides to have Family Corp. recapital- ize, issuing 1% voting stock and 99% nonvoting

• stock. Father retains the voting stock, thus ensur-

ing his continued control of Family Corp. Next, in November 1998 Father transfers all of his nonvot- ing stock to a GRAT under which Father receives an annual payment of $228,000 for five years. At the end of the five year GRAT Term, any remain- ing balance of the GRAT passes outright to Father’s children. Again applying the IRS’s actuarial and inter- est rate assumptions, Father’s transfer of $990,000

• f Family Corp. stock to the GRAT results in a tax-

able gift of slightly less than $37,000. At worst, if the Family Corp. stock does not grow in value suf- ficiently to cover the annuity payments, all of the Family Corp. stock will be returned to Father and he will have wasted a small percentage of his uni- fied credit. However, if Father’s growth assump- tions are accurate and he survives the five year GRAT Term, over $1,150,000 of value will pass to his children free of transfer tax! To the extent the Family Corp. stock produces income (that is, Family Corp. pays dividends) in addition to the growth in value, the tax saving will be even greater. To keep the example straightforward, we have assumed that the Family Corp. nonvoting stock is worth its proportionate (99%) share of Family Corp.’s total value. In fact, it is likely that the gift tax value of such stock would be discounted in light of economic factors including the stock’s non- voting status and lack of marketability. Such dis- counts often can increase the amounts ultimately passing tax free under a GRAT . Additional Considerations In addition to marketable securities and busi- ness interests, almost any type of asset with appre- ciation potential can be a candidate for a GRAT ,

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including, for example, real property, precious metals and artwork. A key element in designing a GRAT is select- ing the appropriate GRAT Term. Factors to con- sider in making that decision include the antici- pated timing of appreciation in the GRAT assets, the GRAT’s liquidity (that is, the ability to fund annual payments without “giving back” growth to the Grantor) and the Grantor’s life expectancy. Although GRATs are not permitted to receive additional contributions after the initial funding, there is no limit on the number of GRATs an individual may create. For example, additional GRATs can be created and funded with the annuity payments received from the ini- tial GRAT . This flexibility allows individuals to create GRATs with differing GRAT Terms, either as a “hedge” or to reflect different expectations about the appreciation potential and liquidity of particular assets. Finally, it is possible to “turbocharge” the tax benefits of a GRAT by combining it with one or more other estate planning techniques, such as the family limited partnership. Conclusion GRATs offer individuals the opportunity to shift significant value to their children at a mini- mal transfer tax cost. Now that interest rates are low, the potential tax savings are especially dra-

• matic. Thus, this is an excellent time to consider

whether a GRAT makes sense in your situation. If you would like more information about GRAT s, or any other estate planning issue, please contact Michael N. Gooen or your Lowenstein Sandler tax advisor at 973.597.2500.

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