Planning for Your Family's Future - Is a GRAT Right for You?

By Nicholas Guido, CFP & Matt Grennell, J.D.

June 28, 2018

Planning for Your Family's Future - Is a GRAT Right for You?

A Grantor Retained Annuity Trust (GRAT) allows the grantor to remove appreciation on transferred assets from the grantor’s estate while retaining the right to receive a stream of income for the term of the GRAT. A GRAT works best with assets that are currently undervalued or are likely to have rapid appreciation over the duration of the GRAT term.

The rules governing GRATS are dictated by law.  The potential benefits you and your family may receive can be amplified by key design decisions at the formation and during administration of the GRAT. By understanding the economic trade-offs behind each decision, you can evaluate whether a GRAT makes sense for you.

Grantor: The individual setting up the trust and gifting assets.

Beneficiary: Person or entity named to receive assets or profits from the trust.

Trustee:  Entity or Person appointed or required by law to execute a trust

Irrevocable Trust: A type of trust in which the grantor effectively removes all rights of ownership to assets and the trust. Typically these trust cannot be modified.

Annuity: a fixed sum of money paid annually

The Estate Tax Landscape

The recent tax changes have eliminated the need for federal estate tax planning for an overwhelming majority of US taxpayers by making the applicable exclusion amount $11.2 million per individual, indexing for inflation. Currently the law is set to sunset in 2026.

No one knows what will happen to the tax code in 2026, but, in any scenario, there are things that can be done today to eliminate potential estate and gift tax in the future. To take advantage of current and future opportunities, it is important to have a comprehensive view of your financial life and the goals you are trying to accomplish.

Estate Planning Under Current Tax Law

Despite the increased individual estate tax exclusion ($11.2 MM), portability, and inflation indexing, certain families still require advanced estate and gift tax planning:

  • Those where the value of their estate could exceed the applicable exclusion or the applicable amount remaining at death;
  • Those who want to make lifetime gifts while still preserving the estate tax exclusion until death (for income tax purposes, with a goal of securing a tax-free step-up in cost basis);
  • Those who live in a state with estate tax planning considerations in addition to the federal rules; and
  • Those who own an interest in a private company that is/has the potential to be an IPO.

The families and situations listed above may benefit from an estate planning strategy that (1) transfers assets without gift or estate tax, (2) freezes or reduces the value of their estate, and (3) preserves as much applicable exclusion as possible. When planned effectively, a GRAT strategy can accomplish these objectives.

How a GRAT Works

A GRAT is an irrevocable trust to which the grantor contributes assets but retains the right to receive fixed annuity payments for a specified number of years (term).  Annuity payments to the grantor are calculated based on the IRS Section 7520 rate, which is based on the mid-term US Treasury yield. Due to the connection between Section 7520 and the US Treasury yield, GRAT structures become more attractive in a low rate environment.  If the assets within the GRAT do not appreciate above the Section 7520 rate for the term of GRAT, no assets will be transferred to the beneficiaries.

Technically, a gift is made when a GRAT is created. The value of the gift is calculated by determining the value of remainder interest. The remainder interest is the value of the entire asset transferred less the current value of the grantor’s annuity interest. Therefore, the larger the value of the annuity interest the lower the value of the gift.

Once the GRAT is established, the grantor will retain a qualified annuity interest, (an absolute right to receive a fixed dollar amount), the payment of which must be made at least annually. The annual payments are fixed based on the value of the assets when initially transferred to the trust.

After the initial annuity term ends, the grantor’s interest in the trust terminates and the remaining trust assets (“remainder interest”) pass to the beneficiaries named in the trust. The remaining interest may pass in trust or outright to the beneficiary based on how the GRAT is structured within the overall scope of the estate plan.

If the grantor survives the term of the trust, the appreciation of assets over the Section 7520 rate will transfer to the beneficiaries. In a zeroed-out GRAT, when the annuity payments are equal to the value of the transferred property, this transfer results in no gift tax.

Optimizing Your GRAT

Everyone faces unique choices when setting up a GRAT strategy. To make sure that you are utilizing this strategy to the fullest extent, there are key areas and questions that need to be addressed:

  • Objective: What is the goal of the GRAT within the overall estate plan?
  • Size: How much money should you fund the GRAT with?
  • Term: What length of time is ideal for your GRAT?
  • Structure: How should the income stream be structured and distributed?
  • Allocation: What type of investments should be in the GRAT? Should changes be made to the strategy throughout the term of the GRAT? How does this effect your current portfolio allocation?
  • Remainder: Should the remainder beneficiary of the GRAT be a trust or one or more individuals? If a trust is recommended, should the grantor continue to bear the burden of future income taxes (referred to as an “intentionally defective grantor trust” or “IDGT”), or should that burden fall on the trust?
  • Maintenance, Taxes, & Fees: Should the grantor pay for the expenses, taxes, and fees associated with the GRAT?

How Much to Transfer?

Working to determine the appropriate size of the trust is one of the most important questions to answer while designing your GRAT strategy. The size of the GRAT will be determined by your current cash flow needs. Therefore, a thorough analysis of how the GRAT economics will interact with current cash flow needs.

A key difference between a GRAT and an outright gift is that a GRAT is only transferring growth, not principal. Therefore, a grantor may be willing/able to commit more wealth to the GRAT than a direct gift.

To accurately determine the capital to be contributed to the GRAT, we must understand all financial needs first. At Chicago Partners, we work with our clients to establish a comprehensive Financial and Cash Flow plan, as this will be the framework for determining the optimal contribution.

The Size of Your GRAT - Does It Matter?

The grantor of a GRAT can contribute as much or as little as they would like. While determining this amount, the grantor must keep in mind that they are entitled to the principal plus the Section 7520 rate as an annuity. This is when the analysis of your Financial Plan and Cash Flow plan becomes imperative because we need to ensure that the GRAT strategy will not adversely impact the grantor’s lifestyle.

In sizing the initial contribution, it’s important to recognize the trade-offs that the grantor accepts: (1) forgoing the additional portfolio growth above the Section 7520 rate; (2) paying income taxes on all assets during the term of the GRAT; and (3) fully participating in any and all losses that the portfolio may incur. The longer the term of the GRAT, the greater the potential risks are to the grantor. It is vitally important these risks are completely understood by the grantor within the context of the GRAT and larger estate plan.

Term: Long, Short, or a Combination?

Once the amount to be contributed to the GRAT has been established, determining the right term structure can increase the plans odds of success. The reason that determining the correct tenure of your GRAT is so important is because, the early years weigh more heavily on a GRAT’s overall performance, because a larger pool of assets experiences an early-year return while much of the GRAT’s annuity liabilities lie in the future.

Given that severe downturns are difficult to predict, a series of shorter-term (usually two-year) GRATs can be established to decrease this early-year performance risk. In the “rolling” GRAT structure, the grantor receives an annuity payment under the same rules as a single GRAT, but instead of retaining the annuity payment, the grantor establishes a new two-year GRAT every year (see Figure 1). A series of short-term rolling GRATs offers a much higher probability of success than a single long-term GRAT, because the rolling GRAT offers the grantor more opportunities to capture returns above the Section 7520 rate over a specific period.

Image

Figure 1

While any of the GRATs might succeed or fail, there is a better chance that at least some of the GRATs will be successful in transferring appreciated assets to the desired beneficiaries.

 

There are risks to implementing a rolling two-year GRAT strategy. The biggest risk may be a legislative change to the GRAT structure. In recent years, Congress has considered legislation that would (1) outlaw zeroed-out GRATs, requiring that the present value of the remainder interest, at inception, equal to some percentage – say 20% - of the initial contribution; and (2) mandate a minimum annuity term of 10 years for each GRAT established after the proposal becomes law. If either of these two provision are implemented, they would eliminate the effectiveness of short-term rolling GRATs and may require changes to the larger estate plan.

 

Allocation: A Key Consideration

 

Determining the appropriate investment mix is vital when trying to increase the likelihood of success for your GRAT. Given that the returns need to exceed that of the Section 7520 rate, which remains stable for your GRAT term, the allocation of assets becomes extremely important.

 

Our belief and strategy to ensure alignment between wealth transfer goals and the grantor’s financial safety, is to start with looking at the grantor’s existing asset allocation to determine if there are assets with a high return potential over the GRATs term. When utilizing a series of rolling GRATs, this will often mean choosing investments that have underperformed as of late, are positioned to have outsized returns, or are highly volatile.

 

Remainders - Trust or Individuals?

In building a successful GRAT, one must determine if it is advisable to have the GRAT remainder distributed directly to the remainder beneficiaries or retained in a taxable trust for their benefit. Our recommendation would be to evaluate the tax brackets of each individual included in the GRAT to make sure that the best strategy is implemented. Without proper administration, a GRAT’s design can be undermined.

 

Maintenance, Taxes, & Fees

 

Generally, the requirement is that a GRAT pays trust income and principal to the grantor which causes you to be the owner of the trust during the initial term for income tax purposes. All taxable income generated by the GRAT is taxed to you whether the income is distributed or accumulated for the benefit of the beneficiaries. The IRA may seek to treat the payment of tax by you on income accumulated in the GRAT for the benefit of the beneficiaries as an additional gift to the GRAT. Since additional gifts to the GRAT are not allowed, the IRA may take the position that the GRAT is disqualified if the GRAT income taxable to you exceeds the annuity. It is also possible that you may not want to deplete your estate by paying income tax on income and capital gains more than the annual annuity. The IRS allows the trustee to make distributions more than the annuity, but these discretionary distributions are valued at zero when you are calculating the taxable gift to the remainder.

 

If the trust does not allow the trustee to make discretionary additional payments to you, it will be hard for the IRS to take a position that you made additional gifts, even if the GRAT income allocated to you exceeds the annual annuity amount. Alternatively, if the trust reimburses you for the excess tax cost, additional gifts to the GRAT will not have been made. As a practical matter, for shorter term GRATs, the annual annuity is quite high, which lessens the possibility that allocated taxable income will exceed the annuity amount. This is an additional consideration in selecting the term of the GRAT.

Conclusion

GRATs – especially short-term rolling GRATs – represent a powerful, yet flexible tool for wealthy families to transfer assets. To truly optimize the efficiency and maximize the total benefit, your professionals need to have a detailed understanding of how the GRAT will fit into the overall estate plan at Chicago Partners.

For more information on GRAT Safety, wealth transfers, and estate planning, contact Chicago Partners today!

Nicholas Guido, CFP is a Senior Advisor at Chicago Partners Wealth Advisors. He leverages his 7 years of financial experience to help clients build comprehensive financial plans & investment portfolios.

Matt Grennell, J.D. is a Senior Advisor at Chicago Partners Wealth Advisors. Matt specializes in creating estate plans & cash flow financial plans to help clients make their financial future more secure.


1See § 2702 of the Internal Revenue Code of 1986, as amended (“Code”), and the Treasury regulations (“Treas. Reg.”) thereunder.

IMPORTANT DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners  Investment Group LLC-“CP”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from CP.  Please remember that if you are a CP client, it remains your responsibility to advise CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. CP is neither a law firm nor a certified public accounting firm, and no portion of the blog content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request. Please Note: CP does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to CP’s web site or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.

June 28, 2018

Planning for Your Family's Future - Is a GRAT Right for You?

A Grantor Retained Annuity Trust (GRAT) allows the grantor to remove appreciation on transferred assets from the grantor’s estate while retaining the right to receive a stream of income for the term of the GRAT. A GRAT works best with assets that are currently undervalued or are likely to have rapid appreciation over the duration of the GRAT term.

The rules governing GRATS are dictated by law.  The potential benefits you and your family may receive can be amplified by key design decisions at the formation and during administration of the GRAT. By understanding the economic trade-offs behind each decision, you can evaluate whether a GRAT makes sense for you.

Grantor: The individual setting up the trust and gifting assets.

Beneficiary: Person or entity named to receive assets or profits from the trust.

Trustee:  Entity or Person appointed or required by law to execute a trust

Irrevocable Trust: A type of trust in which the grantor effectively removes all rights of ownership to assets and the trust. Typically these trust cannot be modified.

Annuity: a fixed sum of money paid annually

The Estate Tax Landscape

The recent tax changes have eliminated the need for federal estate tax planning for an overwhelming majority of US taxpayers by making the applicable exclusion amount $11.2 million per individual, indexing for inflation. Currently the law is set to sunset in 2026.

No one knows what will happen to the tax code in 2026, but, in any scenario, there are things that can be done today to eliminate potential estate and gift tax in the future. To take advantage of current and future opportunities, it is important to have a comprehensive view of your financial life and the goals you are trying to accomplish.

Estate Planning Under Current Tax Law

Despite the increased individual estate tax exclusion ($11.2 MM), portability, and inflation indexing, certain families still require advanced estate and gift tax planning:

  • Those where the value of their estate could exceed the applicable exclusion or the applicable amount remaining at death;
  • Those who want to make lifetime gifts while still preserving the estate tax exclusion until death (for income tax purposes, with a goal of securing a tax-free step-up in cost basis);
  • Those who live in a state with estate tax planning considerations in addition to the federal rules; and
  • Those who own an interest in a private company that is/has the potential to be an IPO.

The families and situations listed above may benefit from an estate planning strategy that (1) transfers assets without gift or estate tax, (2) freezes or reduces the value of their estate, and (3) preserves as much applicable exclusion as possible. When planned effectively, a GRAT strategy can accomplish these objectives.

How a GRAT Works

A GRAT is an irrevocable trust to which the grantor contributes assets but retains the right to receive fixed annuity payments for a specified number of years (term).  Annuity payments to the grantor are calculated based on the IRS Section 7520 rate, which is based on the mid-term US Treasury yield. Due to the connection between Section 7520 and the US Treasury yield, GRAT structures become more attractive in a low rate environment.  If the assets within the GRAT do not appreciate above the Section 7520 rate for the term of GRAT, no assets will be transferred to the beneficiaries.

Technically, a gift is made when a GRAT is created. The value of the gift is calculated by determining the value of remainder interest. The remainder interest is the value of the entire asset transferred less the current value of the grantor’s annuity interest. Therefore, the larger the value of the annuity interest the lower the value of the gift.

Once the GRAT is established, the grantor will retain a qualified annuity interest, (an absolute right to receive a fixed dollar amount), the payment of which must be made at least annually. The annual payments are fixed based on the value of the assets when initially transferred to the trust.

After the initial annuity term ends, the grantor’s interest in the trust terminates and the remaining trust assets (“remainder interest”) pass to the beneficiaries named in the trust. The remaining interest may pass in trust or outright to the beneficiary based on how the GRAT is structured within the overall scope of the estate plan.

If the grantor survives the term of the trust, the appreciation of assets over the Section 7520 rate will transfer to the beneficiaries. In a zeroed-out GRAT, when the annuity payments are equal to the value of the transferred property, this transfer results in no gift tax.

Optimizing Your GRAT

Everyone faces unique choices when setting up a GRAT strategy. To make sure that you are utilizing this strategy to the fullest extent, there are key areas and questions that need to be addressed:

  • Objective: What is the goal of the GRAT within the overall estate plan?
  • Size: How much money should you fund the GRAT with?
  • Term: What length of time is ideal for your GRAT?
  • Structure: How should the income stream be structured and distributed?
  • Allocation: What type of investments should be in the GRAT? Should changes be made to the strategy throughout the term of the GRAT? How does this effect your current portfolio allocation?
  • Remainder: Should the remainder beneficiary of the GRAT be a trust or one or more individuals? If a trust is recommended, should the grantor continue to bear the burden of future income taxes (referred to as an “intentionally defective grantor trust” or “IDGT”), or should that burden fall on the trust?
  • Maintenance, Taxes, & Fees: Should the grantor pay for the expenses, taxes, and fees associated with the GRAT?

How Much to Transfer?

Working to determine the appropriate size of the trust is one of the most important questions to answer while designing your GRAT strategy. The size of the GRAT will be determined by your current cash flow needs. Therefore, a thorough analysis of how the GRAT economics will interact with current cash flow needs.

A key difference between a GRAT and an outright gift is that a GRAT is only transferring growth, not principal. Therefore, a grantor may be willing/able to commit more wealth to the GRAT than a direct gift.

To accurately determine the capital to be contributed to the GRAT, we must understand all financial needs first. At Chicago Partners, we work with our clients to establish a comprehensive Financial and Cash Flow plan, as this will be the framework for determining the optimal contribution.

The Size of Your GRAT - Does It Matter?

The grantor of a GRAT can contribute as much or as little as they would like. While determining this amount, the grantor must keep in mind that they are entitled to the principal plus the Section 7520 rate as an annuity. This is when the analysis of your Financial Plan and Cash Flow plan becomes imperative because we need to ensure that the GRAT strategy will not adversely impact the grantor’s lifestyle.

In sizing the initial contribution, it’s important to recognize the trade-offs that the grantor accepts: (1) forgoing the additional portfolio growth above the Section 7520 rate; (2) paying income taxes on all assets during the term of the GRAT; and (3) fully participating in any and all losses that the portfolio may incur. The longer the term of the GRAT, the greater the potential risks are to the grantor. It is vitally important these risks are completely understood by the grantor within the context of the GRAT and larger estate plan.

Term: Long, Short, or a Combination?

Once the amount to be contributed to the GRAT has been established, determining the right term structure can increase the plans odds of success. The reason that determining the correct tenure of your GRAT is so important is because, the early years weigh more heavily on a GRAT’s overall performance, because a larger pool of assets experiences an early-year return while much of the GRAT’s annuity liabilities lie in the future.

Given that severe downturns are difficult to predict, a series of shorter-term (usually two-year) GRATs can be established to decrease this early-year performance risk. In the “rolling” GRAT structure, the grantor receives an annuity payment under the same rules as a single GRAT, but instead of retaining the annuity payment, the grantor establishes a new two-year GRAT every year (see Figure 1). A series of short-term rolling GRATs offers a much higher probability of success than a single long-term GRAT, because the rolling GRAT offers the grantor more opportunities to capture returns above the Section 7520 rate over a specific period.

Image

While any of the GRATs might succeed or fail, there is a better chance that at least some of the GRATs will be successful in transferring appreciated assets to the desired beneficiaries.

There are risks to implementing a rolling two-year GRAT strategy. The biggest risk may be a legislative change to the GRAT structure. In recent years, Congress has considered legislation that would (1) outlaw zeroed-out GRATs, requiring that the present value of the remainder interest, at inception, equal to some percentage – say 20% - of the initial contribution; and (2) mandate a minimum annuity term of 10 years for each GRAT established after the proposal becomes law. If either of these two provision are implemented, they would eliminate the effectiveness of short-term rolling GRATs and may require changes to the larger estate plan.

Allocation: A Key Consideration

Determining the appropriate investment mix is vital when trying to increase the likelihood of success for your GRAT. Given that the returns need to exceed that of the Section 7520 rate, which remains stable for your GRAT term, the allocation of assets becomes extremely important.

Our belief and strategy to ensure alignment between wealth transfer goals and the grantor’s financial safety, is to start with looking at the grantor’s existing asset allocation to determine if there are assets with a high return potential over the GRATs term. When utilizing a series of rolling GRATs, this will often mean choosing investments that have underperformed as of late, are positioned to have outsized returns, or are highly volatile.

Remainders - Trust or Individuals?

In building a successful GRAT, one must determine if it is advisable to have the GRAT remainder distributed directly to the remainder beneficiaries or retained in a taxable trust for their benefit. Our recommendation would be to evaluate the tax brackets of each individual included in the GRAT to make sure that the best strategy is implemented. Without proper administration, a GRAT’s design can be undermined.

Maintenance, Taxes, & Fees

Generally, the requirement is that a GRAT pays trust income and principal to the grantor which causes you to be the owner of the trust during the initial term for income tax purposes. All taxable income generated by the GRAT is taxed to you whether the income is distributed or accumulated for the benefit of the beneficiaries. The IRA may seek to treat the payment of tax by you on income accumulated in the GRAT for the benefit of the beneficiaries as an additional gift to the GRAT. Since additional gifts to the GRAT are not allowed, the IRA may take the position that the GRAT is disqualified if the GRAT income taxable to you exceeds the annuity. It is also possible that you may not want to deplete your estate by paying income tax on income and capital gains more than the annual annuity. The IRS allows the trustee to make distributions more than the annuity, but these discretionary distributions are valued at zero when you are calculating the taxable gift to the remainder.

If the trust does not allow the trustee to make discretionary additional payments to you, it will be hard for the IRS to take a position that you made additional gifts, even if the GRAT income allocated to you exceeds the annual annuity amount. Alternatively, if the trust reimburses you for the excess tax cost, additional gifts to the GRAT will not have been made. As a practical matter, for shorter term GRATs, the annual annuity is quite high, which lessens the possibility that allocated taxable income will exceed the annuity amount. This is an additional consideration in selecting the term of the GRAT.

Conclusion

GRATs – especially short-term rolling GRATs – represent a powerful, yet flexible tool for wealthy families to transfer assets. To truly optimize the efficiency and maximize the total benefit, your professionals need to have a detailed understanding of how the GRAT will fit into the overall estate plan at Chicago Partners.

Nicholas Guido, CFP is a Senior Advisor at Chicago Partners Wealth Advisors. He leverages his 7 years of financial experience to help clients build comprehensive financial plans & investment portfolios.

Matt Grennell, J.D. is a Senior Advisor at Chicago Partners Wealth Advisors. Matt specializes in creating estate plans & cash flow financial plans to help clients make their financial future more secure.


Important Disclosure Information

Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Investment Group LLC (“CP”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CP. Please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. CP is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.