As our clients’ wealth grows, we look to bring effective planning techniques to their attention. One such area of planning is around gift taxes. When clients have amassed a significant amount of wealth that will cover their future needs and goals and also puts them in a position where their estate might be subjected to taxes, they may start considering techniques that can help them transfer their wealth to the next generation in a more tax-efficient manner. One such technique is a Grantor Retained Annuity Trust (GRAT).
What is a GRAT?
A Grantor Retained Annuity Trust (GRAT) is a planning tool that may transfer substantially appreciating assets to family members and pay little to no gift tax. GRATs are an advanced planning tool requiring the family office to work closely with the client’s estate and tax advisors to create, implement, and manage.
Why should a client consider a GRAT?
Clients who face a large estate tax liability may use a GRAT to lock in the value of all or a portion of an asset that is expected to significantly appreciated. For example, if a client owns an asset worth $1,000,000 as of September 2021 which the client expects to appreciate at 8.0% annually for the next two years, the client can transfer nearly all the appreciation to their children or family members nearly tax-free.
How is a GRAT created?
With the guidance of a qualified attorney, the client will establish an irrevocable trust that will exist for a certain period, often two years. The individual establishing the trust, the grantor, pays a tax on the value of the gift when the trust is established. As we will see, this tax is very low given how the value of the gift is calculated for tax purposes. The assets are placed into the trust and the trust pays an annuity to the grantor every year. The present value of the annuity is roughly equal to the value of the assets transferred into the GRAT.
Exhibit 1:
In Exhibit 1 above, we are contributing an asset with a value of $1,000,000 to the GRAT. As of the funding of the GRAT, the §7520 rate is 1.00% and the IRS annuity factor from IRS Publication 1457 Table B is 1.9704. Given these factors, we see that the client contributes the asset and receives an annuity payment each year of $500,000.00 for the two-year term of this GRAT. In this scenario, the client will be deemed to have retained $985,200.00 of the asset they contributed at the start and passed $126,400.00 to the beneficiaries of which $111,600.00 is tax-free and $14,800 is subject to gift tax.
In Exhibit 2 below, we see that by allowing the annuity payments to increase overtime at the maximum amount allowed (20%) we can further optimize the amount transferred from $126,400.00 to $130,036.36. This is because more of the asset remains in the trust and is subject to annual appreciation. The reader should note that the value of the gift is the same in both examples. This is because the gift amount is calculated at the funding of the GRAT, not at the end.
Exhibit 2:
However, as we can see in Exhibit 3 there is more that we can do on the planning front in this technique. Given that a client would generally want to pay less tax, we can further reduce the tax by increasing the retained annuity. In this example, we add an excess annuity amount of $7,500. This reduces the value of the gift to just $22.00 and the tax to just $8.80! Not bad when one considers that this has allowed a total transfer of $114,436.36 to the next generation.
Exhibit 3:
We chose an asset with an assumed annual appreciation rate of 8% in each of the above examples. However, let us consider one final example, exhibit 4 below. If we consider funding a GRAT with an asset that we believe will have very high appreciation, we can see the power of this tool. If a client had contributed a diversified pool of US small-value stocks in March of 2020, at the market low, as of August 2021 those securities would have been up 129.6%. It is worth also noting that the §7520 rate in March of 2020 was 1.80% which changes our IRS Annuity Factor to 1.9473 and would cause us to consider a different excess annuity amount, in this case, $13,531. We can see now that the potential transfer to the beneficiaries is an incredible $3,657,805.09!!
Exhibit 4:
As with any planning technique, a grantor-retained annuity trust is unique to the specific facts and circumstances of the client. The family office needs to work closely with the client’s estate and tax advisors to bring relevant techniques to light for the client and to properly construct, implement, and manage the overall financial structure for the client.
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