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Trusts and Estates

A Section of the Virginia State Bar.

Winter 2010 Newsletter

Newsletter - Trusts and Estates

Volume 22, No. 3

Transfer Opportunities in Advance of GRAT Legislative Change: An Interim Approach to Planning

By: Francis W. Dubreuil and Stacie Milam

Authors’ Note: The restrictions on the use of grantor retained annuity trusts recently considered by the U.S. Congress would have had significant estate planning implications for families if they were enacted. But there are also fleeting planning opportunities to consider in advance of any such changes that might be proposed in the future.

With the enactment of the Small Business Jobs Act of 2010 in the form proposed by the U.S. Senate, one of the most effective wealth transfer strategies using marketable stock, “rolling” two-year GRATs, has survived a near-death experience. The initial U.S. House of Representatives version of that legislation would have severely restricted the use of grantor retained annuity trusts (GRATs) by requiring that they have at least a 10-year term and that the amount of annuity payments provided for by the GRAT not decline from year to year.

These requirements would have eliminated “rolling” two-year GRAT planning that is funded with marketable stock, which has grown to become an increasingly popular, as well as effective, wealth transfer strategy. The U.S. Senate version of the bill, which was approved by the U.S. House of Representatives without change, did not include those restrictions. Even though not adopted now, they could well be raised again during the upcoming debate on the future of the federal estate and generation-skipping transfer taxes themselves. In this article, we examine GRAT and other planning opportunities, including a loan or installment sale to an intentionally defective grantor trust (IDGT), in advance of possible GRAT legislative change under the presumption that, if passed, such legislation likely will not be retroactive. There are several key factors to consider in the decision, including the donor’s time horizon or expected mortality, the level of interest rates when the strategy is established, the timing of payments to both grantor and beneficiaries, and the ability to affect the amount of wealth transferred by scaling up the amount of capital committed to the strategy.

I. Mortality Risk

A longer GRAT term brings with it higher mortality risk—risk that the grantor may die during the term, with the resultant exposure of GRAT assets to taxation in the grantor’s estate. This is arguably the most consequential factor in the GRAT decision. A donor age 65 has the prospect of a “long planning horizon.” His mortality risk over the next decade is relatively low, with an almost 85 percent chance of surviving a GRAT of 10 years in duration (see Figure 1). But the likelihood that a male age 75 will survive beyond the 10-year term is just 63 percent, and the probability of an 85-year-old male outliving a GRAT established post-legislation is less than one in three.

Figure 1 -World Enough and Time?  Grantor Mortality Risk Rises with Longer Term GRATs

So, how might donors with different time horizons think about their transfer options, given what may be a fleeting pre-legislation planning opportunity? Someone with a reasonably long time horizon (that is, one that is at least 12 years in length) might consider establishing a pre-legislation GRAT with a two-year term funded with marketable stock to capture the benefit from a one-time “roll” of the GRAT annuity payments to two subsequently established 10-year-term GRATs. Alternatively, a donor with a more limited time horizon might consider establishing a GRAT with the longest term consistent with his mortality risk—of less than 10 but more than two years. To remove the question of mortality risk altogether, one might consider alternative strategies, such as a loan or installment sale. The key advantage of those strategies is the absence of mortality risk, where only unpaid principal and interest are subject to estate tax at the grantor’s death. But there are other factors to consider besides mortality.

II. Interest Rates

Today’s low interest rate environment is another key planning factor. Prior research shows that rolling short-term GRATs is a superior strategy to establishing longer-term GRATs (and most other alternative strategies, including installment sales) in all interest rate environments.1 However, longer-term GRATs (as well as loans and installment sales) are more likely to succeed—and are more attractive to planners—when transfer hurdle rates are lower, because they can, in effect, “lock in” the lower rate. Although the 7520 rate and applicable federal rates (AFRs) have risen from their historical lows in February 2009, they remain extremely attractive. That gives longer-term GRATs an advantage today; shorter-term GRATs have higher interest rate risk—greater exposure to higher 7520 hurdle rates when future GRATs are established.

To give a sense of the impact of the rate environment on the success of longer-term GRATs, we considered how 10-year GRATs would have performed under different historical conditions.2 The results are significant (see Figure 2): The inflation-adjusted median remainder to beneficiaries from 10-year GRATs established with $1 million in a globally diversified equity portfolio in low 7520 rate years (the lowest quartile, 1.2 percent to 3 percent) is $1.9 million, more than three times that of such GRATs established in high 7520 rate years (the highest quartile, 9.2 percent to 19.4 percent). A loan or installment sale to an IDGT can also benefit by locking in today’s low rates (the relevant AFR), which is lower than the 7520 rate in the case of a loan or purchase note term of nine years or less.

Figure 2 - Why

III. The Long and Short of the Pre-Legislation Transfer Decision

We analyzed the possibility of capitalizing on the remaining time before any legislative action by funding a two-year GRAT with marketable stock now. According to our forecasts, establishing such a GRAT will offer only a modest benefit from the ability to “roll” two annuity payments to 10-year post-legislation GRATs. However, committing some funding to a two-year GRAT prior to a potential legislative change would provide a hedge against the possibility that the legislation might in fact not be enacted, leaving rolling two-year GRATs the superior planning alternative. Short-term GRATs established prior to the enactment of the legislation also remain appealing in “opportunistic” cases: for example, if funded with pre-IPO stock or stock in a private company valued at a discount, both of which would benefit from the increase in value related to the marketability of the asset upon a completed transaction.

What about pre-legislation intermediate-term GRATs, or even long-term GRATs, pre- or post-legislation? Let’s assume that a donor is considering the alternatives of committing $1 million to a four-, seven-, 10-, or 15-year GRAT invested 100 percent in global stocks (see Figure 3). The probability of a remainder greater than $0 ranges from 70 percent for the four-year GRAT to 90 percent for the 15-year GRAT. If each remainder is held through year 15 in an IDGT that is also invested 100 percent in global stocks, the projection for the inflation-adjusted median wealth transferred ranges from $247,000 for the four-year GRAT to $881,000 for the 15-year GRAT.

Figure 3 - Varying the GRAT Term Impacts Both the Likelihood and the Magnitude of Successful Outcomes

IV. Other Alternatives: A Loan or Installment Sale to an IDGT

A donor might also consider a loan or an installment sale to an IDGT as an alternative strategy separate from or in combination with GRATs. This strategy has advantages (including reduction of mortality risk and the ability to lock in current low AFRs) as well as disadvantages (the IDGT borrower, or the installment note purchaser, bears market risk that the investments might fail to outperform the AFR). To see how these approaches compare, we looked at the range of wealth transferred by three strategies, each funded with $1 million, plus $100,000 that is contributed to an IDGT in each case so as to ensure their comparability because the loan or installment sale to an IDGT is assumed to require seed funding (see Figure 4).3 In the case of the “staggered vintage GRATs,” we assume that 25 percent of the $1 million is allocated to each of a four-, seven-, 10-, and 15-year GRAT. The proceeds of each strategy are held in the IDGT, invested 100 percent in global stocks through the end of the 15th year following the implementation of each strategy.

Figure 4 - Different Strategies Have Different Attractions:  Weighing Market Risk, Interest Rate Risk, and Mortality Risk

The loan/installment sale is the best performer in typical markets, but there’s approximately a 10 percent chance that it will result in no wealth transferred at all. That means a loss of the entire $100,000 seed gift. Also important is to note how closely the staggered-term GRATs compare with the 10-year-term GRAT, and yet mortality risk is reduced by the staggered terms. Also consider the timing of beneficiary access to the funds, as well as the pace of annuity payments to the grantor. Both are later in the case of longer-term GRATs. Staggered-term GRATs compare well with a 10-year-term GRAT in terms of total wealth transferred, but funds above the initial $100,000 gift to the IDGT can be made available to beneficiaries from the staggered GRATs beginning after year 4 (if one assumes the four-year GRAT succeeds in transferring some amount to the remainder beneficiary), with rising amounts available as other successful intermediate GRAT terms expire. And the grantor also accesses annuity payments faster in earlier years from the staggered-term GRATs. With alternative strategies, such as an installment sale, beneficiary access to trust assets and lender payment are also more flexible than with 10-year-term GRATs, but the amounts are more dependent on investment performance.

Finally, it is important to note that a distinguishing characteristic of a “near zeroed-out” GRAT is that it can be “scaled”—such a GRAT has insignificant gift tax implications regardless of the amount of capital committed to the planning. By contrast, the seed gift on a loan or installment sale to an IDGT will either use up lifetime exclusions or be subject to gift tax; therefore, only limited capital can be committed to those strategies without gift tax consequences.

V. Summary

Grantor mortality risk is arguably the primary consideration in choosing between these strategies. However, the level of interest rates when the strategy is established, the optimal timing of payments to both grantor and beneficiaries, and the ability to affect the amount of wealth transferred by scaling up the amount of capital committed to the strategy are key factors to consider in the decision. Staggered-term GRATs can compare well with a single, longer-term GRAT in terms of total wealth transferred and can reduce mortality risk as well as provide earlier beneficiary access to funds if the planning is successful.

Francis W. Dubreuil, National Managing Director, Wealth Management Group of Bernstein Global Wealth Management.

Stacie Milam, Senior Investment Planning Analyst, Wealth Management Group of Bernstein Global Wealth Management.

The Bernstein Wealth Forecasting System (WFS) uses a Monte Carlo Model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, our forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

1 David L. Weinreb and Gregory D. Singer, “Rolling Short-Term GRATs Are (Almost) Always Best,” Trusts & Estates, vol. 147, no. 8, (August 2008):18–24.

2 Our Wealth Forecasting SystemSM projects 10,000 paths of returns for a wide range of asset classes. Our forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings, and price multiples; (2) incorporate the linkages that exist between various asset classes; (3) take into account current market conditions; and (4) factor in a reasonable degree of randomness and unpredictability.

3 Although the general rule regarding the size of the seed gift under prevailing practice appears to vary, from providing for a 9-to-1 loan-to-equity ratio to ensuring 110 percent coverage of the loan or assets purchased, there is no tax or legal authority expressly sanctioning any necessary or sufficient amount.