- A low interest rate environment (that is, a low I.R.C. Sec. 7520 rate) would increase the probability of success for a GRAT. The current 1.4% rate is a very low threshold to exceed and thereby makes GRATs useful from that perspective.
- The possible loss of discounts after year end or shortly thereafter when the Proposed Regulations are anticipated to become effective.
- Possible tax legislation of a new administration.
- The value of the discount is sufficient.
- Cash flow from the entity is adequate.
- The grantor’s life expectancy is such that the GRAT can be for a sufficient term that the results are obtainable.
- Using a tier of GRATs to increase the likelihood of the grantor outliving some.
- Insure the risk (e.g., if the longest GRAT is 10 years purchase 10 year term life insurance).
- Quantify the risk by having an actual life expectancy analysis completed for the grantor and use that knowledge to set the term of the GRAT.
- Since it is assured that the client will die prior to the end of the 99-year term this type of GRAT must be structured so that the annuity payments must continue in all events for the entirety of the 99-year term. The annuity and remainder interests cannot merge or the valuation and estate inclusion position suggested above may fail.
- Because of the need to continue annuity payments any estate tax due on the client’s death will have to be paid out of assets excluding the 99-year GRAT assets.
Using GRATs Prior to the Effective Date of the 2704 Proposed Regulations
On August 4, the Treasury Department issued Proposed Regulations that restrict or eliminate valuation discounts for family-owned businesses under IRC Sec. 2704. The Proposed Regulations will be the subject of a public hearing on December 1, 2016, and will become effective 30-days after publication as final regulations. While many commentators hope that at least some of the harsh provisions in the Proposed Regulations will be modified before becoming final, can clients afford that risk? For many family business owners, the potential loss of discounts could prove devastating to estate planning (although some commentators have suggested otherwise). For situations where discounts could be critical, or even important, practitioners should guide clients in evaluating implementing planning prior to the effective date of the Proposed Regulations. One likely planning technique to be considered for those client situations that might benefit from completing planning before the effective date is a grantor retained annuity trust (“GRAT”). But should a GRAT be applied in the traditional manner or might variations be preferable in light of the GRAT Environment:
The use of GRATs will be explained generally, and then some suggestions as to how traditional GRAT planning might be modified in light of the above factors.
A grantor retained annuity trust (“GRAT”) transfers the assets remaining at the end of the trust term to the remainder beneficiaries. This will be the excess of the appreciation of the assets given to the GRAT assets over an annuity payment that includes a return of the principal value of the gift and an interest component determined based on a mandated federal interest rate under Code Section 7520. The appreciation over this hurdle amount is transferred free of gift tax.
If the GRAT investments outperform the 7520 rate it will transfer the remaining value to the GRAT remainder beneficiaries. For example, a GRAT created in August 2016, without using any gift tax exemption, while the Section 7520 rate is 1.4% must return (i.e. appreciation and earnings) more than 1.4% to leave a balance for the remainder beneficiaries. If the GRAT assets fail to return more than the Section 7520 rate, then the annuity payments to the grantor over the GRAT term will exhaust the trust assets and no remainder passes to the beneficiaries at the end of the term. GRATs have often been structured as short term (2 year) rolling or cascading GRATs. These concepts will be explained below and then alternative approaches for the current planning environment will be suggested.
GRATs and the Proposed 2704 Regulations
The greater the value of the annuity interest, the smaller the taxable gift involved in the creation of a GRAT. A lower interest rate increases the actuarial value of the retained annuity. Thus, the same annuity payments will produce a lower taxable gift at a lower interest rate. Most important to the Proposed IRC Sec. 2704 Regulations is the impact on the value of the assets transferred to the GRAT. The lower the value, the lower the required annuity payment required to reduce the value of the gift to the GRAT to near zero. If a non-controlling interest in a family business is transferred to a GRAT prior to the effective date of the Proposed Regulations that value may be discounted, perhaps significantly. If that same GRAT is funded after the effective date of the Proposed Regulations that discount may be dramatically reduced or eliminated. This will increase the value of the gift and hence increase the amount of the annuity payment required to reduce the value of that gift to near zero. If the appropriate circumstances are present it may be possible that the cash flow from the entity can pay the annuity amount and avoid leakage of equity interests into the client/grantor’s estate. This may only be achievable if valuation discounts are available. The factors to achieve this might include:
Thus, depending on the facts, completing a GRAT prior to the effective date of the Proposed Regulations might not only be valuable to leverage more wealth out of the estate, it might be essential to the viability of the plan.
Example 1: Family business is valued at $15 million and generates an 8% dividend distribution. 10% is contributed to a GRAT before the effective date of the Proposed Regulations. The pro-rata enterprise value is $1,500,000 which is discounted to $1,000,000. The actual dividend on the 10% interest is $1,500,000 x 8% = $120,000. A ten year GRAT is created. The required annuity payment of $110,000 results in a taxable gift of $1,497.00. On this basis, the cash dividend from the equity interests will suffice to make the annual annuity payment if the transaction is consummated before the Proposed IRC Sec. 2704 Regulations become effective.
Example 2: Planning for the same family business is undertaken but the 10% interest is contributed to a GRAT after the effective date of the Proposed Regulations. The pro-rata enterprise value is $1,500,000, which cannot be discounted. The actual dividend on the 10% interest is $1,500,000 x 8% = $120,000. A ten year GRAT is created. The required annuity payment of $165,000 results in a taxable gift of $2,245.50. On this basis the cash dividend from the equity interests will not suffice to make the annual annuity after the Proposed IRC Sec. 2704 Regulations become effective. Thus, in kind payments will be required. This will require an appraisal each year. Further, the “leakage” of business equity back into the grantor’s estate will not again be able to benefit from discounts on future post-effective date transfers. This suggests several potential benefits of completing the GRAT planning before that date.
Rolling and Cascading GRATs
A common application of the GRAT technique was short term, typically two year term, GRATs, often done in a series (e.g. four GRATs each holding a different asset class). If the assets in or more of the GRATs grew substantially in value that excess would inure to the beneficiaries and the remaining GRATs (i.e., those that failed) would have used little or no exemption so that the downside is limited. This excess might simply remain in the GRAT at the end of a two year GRAT term or in some instances if significant appreciation occurred during the term (e.g., in the first year of a two year GRAT)
Historically, the unsuccessful GRATs (i.e. those that did not realize sufficient appreciation) would be recycled (or re-GRATed). A number of points should be noted concerning the application of this technique. President Obama has repeatedly recommended legislative change to curtail this short-term “rolling” GRAT technique (e.g. a minimum 10 year GRAT term). If Hillary Clinton is elected those changes may be pushed by her as part of a similar tax agenda. So even if initial GRATs can be created, the potential for future use may be limited.
Although short term so-called “rolling” GRATs has been a favored strategy, a risk of using a rolling GRAT approach is that GRATs may not survive potential changes to the estate and gift tax law by the next administration. Another risk is that if discounts are essential, or perhaps even useful, to the success of the GRAT, the reduction or elimination of discounts as a result of the Proposed Regulations are cause to re-evaluate the optimal GRAT strategy. Accordingly, one might reconsider using a longer term GRAT to secure the discounts rather than a short term GRAT that may have more leakage of the underlying discounted asset back into the grantor’s estate. Thus, while rolling GRATs may have been the favored GRAT strategy in the past, this may not be the optimal approach now.
A successful GRAT with significant upside could be “immunized” by swapping out the highly appreciated asset and substituting a low volatility asset, such as cash. This would serve to “lock in” the appreciation realized outside the taxable estate.
One difficulty with a longer term GRAT is that early success may be offset by future failure in asset performance. The client might address this risk in part through a swap power (power of substitution under IRC Sec. 675(4)(C)) to capture and immunize the volatility in a GRAT. The grantor could exercise the power of substitution when the assets inside the GRAT have appreciated to a level that freezing that level of appreciation to secure that appreciation for the benefit of the GRAT remainder beneficiaries. The grantor would substitute a less volatile asset, such as cash. The grantor can exercise a swap power over a GRAT without a negative gift tax consequence. PLR 200846001. A swap power should also succeed if the trustee has an obligation to confirm that the property substituted is of equivalent value. Rev. Rul. 2008-22, 2008-16 I.R.B. 796, Treas. Reg. Sec. 20.2036-1(c).
Mortality Risk of Longer GRATs
Another negative of a longer term GRAT is that death within the term of the GRAT will undermine the plan by likely causing a substantial portion, if not all, of the assets of the GRAT to be included in the grantor’s gross estate for Federal estate tax purposes. The probability of death within the term of a GRAT can be estimated using the 90CM mortality tables which are based upon the 1990 census. This risk might be addressed by:
Following the end of each successful GRAT term, GRAT assets could flow into separate trusts for children that remain “grantor” trusts (i.e., tax to the client) for income tax purposes. Those post-GRAT grantor trusts should include so-called “swap” powers so that the client can “swap” highly appreciated post-GRAT assets back into his or her estate in order for heirs to receive a tax-advantaged step-up in tax basis. The benefit of a post-GRAT grantor trust is generally perceived as beneficial.
There is a variation of the different applications of traditional GRAT planning discussed above that might warrant consideration as part of the planning done to capture discounts before the effective date of the Proposed Regulations, with consideration to the legislative risks to future rolling GRATs, and the current historically low interest rates. This technique is known as a 99-year GRAT and applies the GRAT technique in a manner that appears to comply with the technical requirements of the Treasury Regulations and which seeks to take advantage of the potential for a significant increase in interest rates between the date the GRAT is established (at today’s historically low rates) and the date of the client’s death. It might be anticipated that the current historically low interest rates may increase by that time. If the interest rates rise sufficiently the 99 year GRAT approach could significantly reduce the portion of the entity interests the client contributed to such a GRAT that is included in his estate. If the client completes a 99 year GRAT prior to the effective date of the Proposed Regulations then discounts may be permitted. If the client dies following the effective date of the Regulations, and more than three years after the transfer, it may be possible that the payment back to the client’s estate on death may not be subjected to discounts. If this in fact were the case, it would provide additional advantage to a 99 year GRAT.
A key risk of the 99-year GRAT technique is forecasting interest rates. But while there is certainly no assurance that interest rates will be meaningfully higher on the client’s death, perhaps that can be assumed to be a sufficient likelihood so that some discounted entity interests could be committed to this technique regardless. One of the risks with this strategy is that the IRS does not approve of the technique and proposals have been made for Congress to legislatively eliminate this approach. So while this is no doubt a proverbial “red flag” approach there may still be an opportunity to benefit from this.
Using this concept the client could fund a 99-year GRAT, valuing a non-controlling interest in a family enterprise at a discounted value before the effective date of the Proposed Regulations. The client would also determine the annuity payment due each year during the 99-year term based on the current 1.4% IRC Section 7520 interest rate. On the client’s death the amount of the assets in the GRAT that must be included in his estate should be based on annuity at determined annuity by then current 7520 rate so if rate has increased. In other words, the only portion of the failed GRAT corpus to be included in the client’s estate should arguably be the amount of principal necessary to produce the same annuity payment calculated at the then higher 7520 (interest) rate. Treas. Reg. Sec. 20.2036-1(c)(2).
If the interpretation some commentators have given to the Proposed Regulations is correct, the discount will apply going in to the GRAT since it is consummated prior to the effective date of the Proposed Regulations but the discount may arguably not apply “coming out” of the GRAT since discounts will then be prohibited if the amount included in the client’s estate is paid in kind. Regardless of whether this benefit is available, it would appear that the consummation of a GRAT with discounted private equity prior to the effective date of the Proposed Regulations could provide significant additional estate tax planning leverage because the annuity payment will be established with consideration to that discount. Thus, consider creating a GRAT (potentially a 99-year GRAT) before discounts are lost.
Example 1. The client contributes $1 million to a 99-year GRAT in July 2016 when the 7520 rate is 1.8% An annuity of $21,700 nearly zeros out the value of the GRAT leaving a current gift value of $582.63. Assume that in year six the client dies and the then 7520 rate increases to 6%. The amount of the GRAT that must be included in the client’s estate is $21,700/.06 = $361,667. In other words, at the higher interest rate only $361,667 of principal of the GRAT is required to be included in the client’s estate to generate the $21,700 initial annuity amount. The 99 year GRAT approach could address the risks of the Proposed Regulations, future prospective changes to GRATs, etc.
Example 2. The client contributes a non-controlling interest in a family business whose gross value (percentage interest multiplied by enterprise value) is $1,500,000. Because the GRAT is funded prior to the effective date of the Proposed 2704 Regulations this value is discounted by 33% to $1 million. The interest is given to a 99-year GRAT when the 7520 rate is 1.8%. An annuity of $21,700 nearly zeros out the value of the GRAT leaving a current gift value of $582.63. Assume that in year six the client dies and the then 7520 rate increases to 6%. The amount of the GRAT that must be included in the client’s estate is $21,700/.06 = $361,667. In other words, at the higher interest rate only $361,667 of principal of the GRAT is required to be included in the client’s estate to generate the $21,700 initial annuity amount.
Example 3. The client contributes a non-controlling interest in a family business whose gross value (percentage interest multiplied by enterprise value) is $1,500,000. Because the GRAT is funded after the effective date of the Proposed 2704 Regulations this value cannot be discounted. The interest is given to a 99-year GRAT when the 7520 rate is 1.8%. An annuity of $32,550 nearly zeros out the value of the GRAT leaving a current gift value of $873.94. Assume that in year six the client dies and the then 7520 rate increases to 6%. The amount of the GRAT that must be included in the client’s estate is $32,550/.06 = $542,500. In other words, at the higher interest rate, but without discounts $542,500 of principal of the GRAT is required to be included in the client’s estate to generate the increased non-discounted $32,550 initial annuity amount.
Some of the considerations in structuring a 99-year GRAT plan include:
Practitioners should review all potential client planning situations that might benefit from valuation discounts. If the benefits might be significant planning should be completed prior to the effective date of the Proposed Regulations. However, in evaluating planning options practitioners should carefully consider how planning techniques might be modified to better fit the current environment.
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