Impact of Declining Interest rates and Stock Prices

Summary:

Grantor Retained Annuity Trusts ("GRATs") are a popular estate planning tool for shifting value to heirs with little gift tax impact. The current economic environment makes GRATs great. If Tony the Tiger were an estate planner, they'd be GRRRRRAT!

What Are GRATs.

GRATs are grantor retained annuity trusts. It is an estate planning technique used to transfer value from say parents to kids with little or no gift tax. Here's how it works. You transfer assets to the trust. The trust pays you a specified annuity for a set number of years your kids (remainder beneficiaries) get whatever is left. The value of the gift is the value of the property you transfer to the trust, less the value of the annuity. Thus, the value of this annuity reduces the value of the gift. Most GRATs are structured with a modest gift value. Any appreciation in the value of the property after you transfer it to the GRAT is excluded from your estate if you survive until the end of the GRAT term. If you don't all the property is taxed in your estate, but that would have been the case had you not tried the GRAT. Thus, there is no downside to trying this technique.

How Have Declines in Interest Rates Impacted the Use of GRATs?

Interest Rates: Lower interest rates increase the value of the annuity retained by you as the grantor, and therefore reduce the value of the gift of to your kids through the GRAT (the remainder in a GRAT). Rates are near historic lows, which bodes well for using GRATs now to plan. From August 2006 to April 2008, the interest rate required to be used in determine the impact of a wide range of tax planning transactions, called the Code Sec. 7520 interest rate, has dropped from a 6.2% (August 2007) to a mere 3.4% in April 2008.

Example August 2006: If you established a GRAT, at age 70, with a $1 million dollar gift in August 2006 that paid 8% and that was intended to last 12 years. The value of the $1 million gift would be reduced by the present value of the $80,000 annual payments to you for 12 years which is $663,336. Thus, value of the gift you would have made would have been $336,664. This would have meant that you would have used up about 1/3^rd of the $1 million lifetime gift exclusion you are entitled to.

Example April 2007: Assume instead that you want to establish a GRAT in April 2008, at age 70, with a $1 million dollar gift that paid 8% and that was intended to last 12 years. The value of the $1 million gift would be reduced by the present value of the $80,000 annual payments to you for 12 years which is $777,552. This is substantially higher than the same calculation made in August of 2006 because the now lower interest rates make the worth of that payment stream (annuity of $80,000/year for 12 years) greater. Thus, value of the gift you would make now under the same facts would be $222,448. This means that you would have used only about 20% of the $1 million lifetime gift exclusion you are entitled to. The decline in interest rates has made the gift tax leverage you can squeeze out of a GRAT far more favorable.

Life Expectancy: Hey, does it make any sense for a 70 year old to wager a tax bet on outliving a 12 year GRAT? If you're taking your baby aspirin every day it might. The life expectancy for a 70 year old is 16 years, four years more than your 12 year GRAT tax bet! The probability of living to life expectancy is a hair over 51% using the Sec. 1.72 Tables. Since these tables are based on data derived from annuity sales contracts they tend to reflect data for a healthier cohort of people (since people who buy annuities tend to be a bit healthier than those who don't). Using the IRS Table 90CM life expectancy is for 13.9 years, with a bit under a 49 probability of living to that age. There is some dispute over the factors that correlate with greater longevity. Some commentators suggest that wealth provides better access to health care. Other commentators advocate that intelligence correlates with longevity. Not meaning to be elitist, but most of the cats with GRATs tend to be long on wealth and brains, so their life expectancies are likely longer than even the 1.72 Tables (but we'll leave those nuances to the actuary types like Barry).

How Have Declines in Stock Prices Impacted the Use of GRATs?

Stock Prices: Any appreciation in the value of the property after you transfer it to the GRAT, over the 7520 rate embodied in the calculations is excluded from your estate. If you feel stock prices have taken most of their downside hit already, now is an opportune time to set up a GRAT. Stock market prices have declined substantially. The S&P 500 has lost most of the gain it realized during this period. In August 2006 it was at 1,270  and is April 2008 stood at 1,370.

Example August 2006: Assume in August 2006, at age 70, you established a GRAT with a $1 million dollar gift that paid you an 8% annuity annually, and that was intended to last 12 years. For gift tax purposes the value of the $1 million gift of stocks would be reduced by the present value of the $80,000 annual payments to you for 12 years, which is $663,336. Thus, value of the gift you would have made would have been $336,664. This would have meant that you would have used up about 1/3^rd of the $1 million lifetime gift exclusion you are entitled to. However, if the mediocre market performance from August 2006 through April 2007 continued for the entire 12 year term of the GRAT the plan would be pretty near a wash. Little would be left in the GRAT for the kids beyond the amount of the calculated gift.

Example April 2007: Assume the same facts but that instead that you establish a GRAT now with a $1 million dollar gift in April 2008. Further assume (or pray!) that the market has discounted the possible recession (or actual recession, depending who you listen to) so that it's nothing but an escalator ride up from here. Or maybe the market will continue to resemble a ride at Great Adventure, but you've invested with the ultimate stock picker and realize 10% returns over the 12 year life of the GRAT (please call me with the name and number). By year 12 the GRAT pot, after paying  you $80,000/year, will be worth over $1.4 million (don't you love compounding!). From a tax perspective, that's a grand slam.

Some Additional Thoughts.

*Wall Street types will tell you that the only way to fly with GRATs is to use short term rolling GRATs. Each year you use a high pay out 2 year GRAT and set up a new GRAT each year thereafter. This approach can be used to capture upside volatility with no significant downside risk. While there is clear merit to this application (See Practical Planner, March 2007) in appropriate circumstances, and for appropriate assets, a

*longer term GRAT like that illustrated above can be appropriate.

If the remainder beneficiaries of your plan are people whose relationship falls outside the scope of how the tax law defines "family" for these purposes (e.g. a niece or nephew) then you can use a variation of the above called a GRIT (no corn involved), a "Grantor Retained Income Trust. The key benefit of a GRIT over a GRAT (don't you love acronyms?) is like a GRAT except that the value of the gift of the remainder is determined under more favorable assumptions.

*Watch out for whipsaw. If you contribute interest in an entity to a GRAT and smaller slices of the same entity are used to meet required annuity payments a greater discount may apply to these thinner slices then to what you put in. Negative leverage. Not a good thing.

*GRATs should be characterized as grantor trusts for income tax purposes. Not a simple task since many of the mechanisms that accomplish this for other types of trusts are inappropriate in the context of a GRAT.

*GRATs, like all tax acronyms, need to be cared for. You need to meet at least annually with your estate planner, CPA and those managing the GRAT assets to assure compliance with the many requirements.