Written by Dwayne Holt
Arguably the most effective wealth transfer strategies in the recent past, grantor retained annuity trusts (GRAT) and sales to intentionally defective intervivos trusts (IDIT) have become even more attractive in recent months with the credit crisis and disruption in the U.S. and world markets which has caused many assets to drop in value and interest rates to decline to historical lows. The combination of these events has created a unique opportunity to gift real estate, stocks and/or other assets.
In essence, these strategies freeze the value of and return on selected assets at today's prices and yields. The appreciation from these levels along with increased yields in the future accrues to the benefit of your beneficiaries and escapes estate taxation upon your passing. A greater description of these strategies will follow after we lay out some basic facts and assumptions.
The federal estate tax rate for 2008 for estates over $2,000,000 is 45%. For 2009 the exemption increases to $3,500,000. For 2010, the estate tax is scheduled to be zero and for 2011 the exemption goes back to $1,000,000 combined with a 55% rate. It is unlikely that 2010 and 2011 will remain as stated above. More will be known after this year's presidential elections. Most states also assess estate taxes, so many taxpayers over these thresholds could face a total estate and/or inheritance tax rate greater than 50%.
Taxpayers can give $12,000 per year per recipient without incurring tax. In addition, by making payments directly to educational institutions or medical providers, taxpayers can make unlimited gifts for the benefit of others without incurring tax. Finally taxpayers can give up to $1,000,000 in their lifetime in addition to the $12,000 annual amount and unlimited educational and medical amounts without incurring tax.
The basic principle behind GRATs and sales to IDITs involves the gifting or sale of assets with the potential of significant appreciation to the next generation as opposed to lower growth assets since you want to defer the estate tax on future appreciation. Since estate taxes are paid on the value of assets, any chance to transfer assets when valuations are likely to significantly increase in value in the future is an attractive strategy. Also the ability to discount the value of assets because of their lack of marketability and/or lack of control which commonly exists with limited partner and limited liability interests are attractive vehicles to use in transferring assets.
A GRAT is a trust whereby the grantor receives an annuity for a period of years and the remainder passes to a designated beneficiary named at the outset. Gift tax is payable on the present value of the remainder interest, which is the value of the property transferred to the trust less the value of the retained annuity. A lower interest rate increases the value of the annuity and therefore reduces the value of the remainder interest. The rates which must be used with GRATs are known as the Section 7520 rates. The 7520 rate for May 2008 is 3.2%, which is the lowest it has been since July and August 2003 when it was at 3.0% and 3.2%. All income taxes on the earnings from the trust's assets are paid by the grantor.
Another strategy is to sell assets to an IDIT, where a grantor trust purchases assets from the grantor in exchange for a promissory note which must bear interest at the applicable federal rate (AFR). A down payment of approximately 10% is usually gifted to the trust by the grantor. Upon termination of the trust the assets pass to the designated beneficiary. The mid-term AFR for May 2008 is 2.74%, which, like the 7520 rate, is the lowest it has been since July and August 2003 when it was at 2.55% and 2.70%. Like the GRAT all income taxes on the trust's income are paid by the grantor and any gain on the initial sale of assets from the grantor to the trust and interest payments to the grantor are ignored for income tax purposes.
Let's start with a simple example where an individual is comfortable utilizing either the GRAT or sale to IDIT strategy with assets totaling $10 million. Furthermore, let's assume this is set up in May 2008 and a fully taxable yield of 10% is earned on the assets over the next nine years, the term of the GRAT and IDIT promissory note. To make the comparative calculations useful, we need to assume the grantor dies which we will assume occurs just after the end of the nine year GRAT.
If you believe that values will appreciate significantly due to the current disruption in the markets and your actual future returns are higher the savings increase dramatically. Combine this strategy with the limited partnerships and/or limited liability companies where you can discount the value of the asset given, the savings become much larger. For example, if you were able to take a 35% discount on the assets contributed to a GRAT or sold to a IDIT the beneficiary could receive more than $24.2 million or a savings of more than $15 million.
There are additional considerations when evaluating a GRAT. The term for a GRAT can vary as well as the annuity payments. However, the annuity payments can not exceed 120% of the prior year's payment. A risk with a GRAT is that if the grantor dies during the annuity term, part or all of the trust assets are included in the grantor's taxable estate, reducing or eliminating the benefit of this strategy. But the grantor can never be in a situation worse than if the GRAT was never formed, which is not the case with a sale to an IDIT. In addition to the examples above it is also possible to use several shorter term GRATs "Rolling GRATs" which might be an attractive alternative to a taxpayer who doesn't want to do it all at once or if they don't want to try to "time the market".
Although it is difficult and sometimes dangerous to generalize, we have found that sales to IDITs create a greater benefit due to the following reasons: (1) The hurdle rate is usually lower than for GRAT's since the AFR is usually always lower than the Section 7520 rate; (2) The ability to utilize a commercially reasonable interest only promissory note for many years; (3) Early distributions to the beneficiaries can be made from the grantor trust which is not possible using a GRAT; (4) If the grantor dies during the term of the trust only the note receivable is included in his or her estate; and (5) It is possible to design the trust to be exempt from generation skipping transfer tax which is not possible with a GRAT. However, one possible downside in sales to IDITs is if the asset declines in value by an amount greater than the benefit of having the grantor pay their income taxes they would be in a worse situation than if the sale did not occur.
Also, those taxpayers who are charitably inclined, a charitable lead annuity trust is an attractive vehicle that should be considered when interest rates are low. In this structure, the charity receives the annuity versus the grantor as in the GRAT, with the remainder going to the designated beneficiary.
If you have questions regarding matters contained in this alert please contact Dwayne Holt at 703 923 8585.
To ensure compliance with requirements imposed by the IRS, any written tax advice contained in this communication (including any attachments) was not written or intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.