Methods for Optimizing GRATs

Transcription

1 A ceter of excellece buildig bridges from thought to actio, creatig practical, applicable strategies to help beefit you ad your family I the Hawthor Istitute white paper A Overview of GRATs, we review the basic beefits of utilizig grator retaied auity trusts (GRATs) as a effective wealth trasfer strategy, as well as their basic structure ad rules. I this white paper, we discuss some of the methods for creatig eve greater levels of effectiveess i wealth trasfer as part of a family successio pla through variatios i the structurig of GRATs, asset selectio, ad related strategies. The Basics of GRATs: A Review A GRAT is a irrevocable trust to which the grator trasfers assets i exchage for a fixed auity for a term of years chose by the grator. The term is typically measured by a fixed umber of years, but it may also be measured by the grator s life or the shorter (but ot loger) of a fixed umber of years or grator s life. Upo completio of the auity paymet term, the GRAT s remaiig assets pass to the beeficiaries, either outright or i further trust. If the grator s retaied auity is set at a combiatio of a high eough amout ad a log eough period, its actuarial value for federal gift tax purposes ca equal 100% of the amout origially trasferred, resultig i o taxable gift whe subtractig this retaied auity value from the value of the assets trasferred to the GRAT. This type of GRAT is typically referred to as a Zeroed Out GRAT. This auity paymet term ca be as short as two years. Also, the auity ca be structured such that the paymets icrease by as much as 20% over the precedig year s amout at ay time durig the auity term. Oly the grator ca receive auity distributios durig the auity term. A GRAT is treated as a grator trust for federal icome tax purposes. The value of the fixed auity retaied by the trasferor is subtracted from the value of the assets trasferred to the GRAT i determiig the value of the gift of the remaider iterest passig to beeficiaries at the ed of the auity term for federal gift tax purposes. This remaider iterest amout is a taxable gift, potetially subject to gift tax i the year the GRAT is created. If the trasferor dies durig the term of the required auity paymets, the all or a portio of the GRAT s assets will be icludible i his or her taxable estate. Hawthor Istitute Residet Marty S. Babitz, J.D. Natioal Director of Estate Plaig marty.babitz@hawthor.pc.com Because a grator s geeratio-skippig trasfer (GST) tax exemptio caot be allocated to a GRAT util the ed of the auity term, rather tha at the GRAT s outset whe the value of the retaied auity has bee subtracted from the assets trasferred for federal trasfer tax purposes, GRATs are geerally ot effective GST plaig vehicles. There are, however, several methods for workig aroud this issue, which we discuss i this paper.

2 Strategic Selectio of the Legth of the GRAT Auity Term The shortest allowable term for a GRAT is two years. Iteral Reveue Code (IRC) Sectio 2702(b)(1) requires paymets o less frequetly tha aually, with o provisio for a sigle paymet. Several Private Letter Ruligs ackowledge the validity of a two-year GRAT. The optimum auity term requires that a umber of factors be cosidered. Short-Term GRATs The shorter the GRAT term, the higher the correspodig auity paymets to the grator must be i order to create a Zeroed Out GRAT (Table 1). Nevertheless, short-term GRATs ca provide advatages over loger terms. Table 1 Short-Term GRATs ad Auity Paymets (Sectio (2.2% Sectio rate 2.2%; rate; $1 iitial millio ivestmet iitial ivestmet) $1 millio) GRAT Term Aual (Years) (Years) Auity $112, , , , , , , ,556 Source: Hawthor Source: Hawthor Hurdle rate is a term used to describe the miimum average aual ivestmet rate of retur o a GRAT s assets ecessary to cofirm that the remaiig assets after completio of the auity paymet term will exceed zero i the case of a Zeroed Out GRAT, or otherwise will exceed the amout of the taxable gift with respect to the projected remaider iterest. The mortality risk of the grator is mitigated with a shorter term. As the Table Table 2 grator s death will cause iclusio of all or a portio of the GRAT assets Sigle-Asset his estate, versus versus a Combied shorter Combied term GRAT GRAT icreases the likelihood that the grator will survive the auity term Sigle-Asset Sigle-Asset ad that all of GRAT GRAT the remaiig Combied Combied assets GRAT will GRAT pass to the remaider beeficiaries ABC, ABC, Ic. ad Ic. thereby XYZ, be Ic. excluded $2 $2 from millio millio the grator s taxable estate. 20% GRAT aual -15% GRAT aual 5% GRAT aual Net Advatage of rate 20% of aual retur -15% rate of aual retur rate 5% of aual retur Sigle-Asset Net Advatage GRAT of A Remaider short-term to GRAT geerally rate of retur reduces rate the of retur risk of poor rate ivestmet of retur Sigle-Asset GRAT Remaider performace Beeficiaries to of the GRAT $303,578 assets, icreasig $0 the odds $87,122 of a successful GRAT $216,456 Beeficiaries that will pass some wealth $303,578 to the remaider $0 beeficiaries. $87,122 There is o $216,456 Source: Hawthor dowside risk of a failed GRAT i the case of a Zeroed Out GRAT. If the ivestmet retur exceeds the IRC Sectio 7520 hurdle rate, the there will be some assets remaiig to pass without gift tax cosequece to the remaider beeficiaries. If ot, all assets will be retured to the grator i the auity paymets, placig the grator i the same positio from a wealth trasfer perspective as if the GRAT were ot established. Accordigly, multiple short-term GRATs icrease the likelihood that oe or more will be successful compared with oe log-term GRAT, i which oe or more poor ivestmet retur years could sik the overall performace for the etire term below the hurdle rate. 2 hawthor.pc.com

3 For example, GRATs oe are 10-year created term may, GRAT i is the some cumulative cases, make equivalet the choice of five of a loger-term GRAT successive advisable two-year despite term GRATs. the icreased Chart 1 demostrates mortality risk the ad comparative greater wealth risk of oe or more bad trasfer ivestmet outcome of each performace approach (ad years. the beefit of the successive short-term GRAT approach) if a grator had started with $1 millio o Jauary 1, 2003, ad A GRAT may provide for aual icreases of as much as 20% i the auity paymets. created either oe 10-year Zeroed Out GRAT or five successive two-year Zeroed As such, a log-term GRAT may allow for substatially lower auity paymets i the Out GRATs, re-cotributig whatever the grator received from each GRAT i early years. This approach ca allow for greater growth i early years with less leakage auity paymets for auity back paymets, to each succeedig typically GRAT, resultig assumig i a greater the assets edig are balace passig to remaider ivested beeficiaries. to obtai a retur equivalet to that of the S&P 500. These successive short-term GRATs are ofte referred to as Rollig GRATs. Chart 1 Chart Comparative 2 Wealth Trasfer Outcomes IRC Sectio 7520 Rate, 1994 to 2014 $800,000 Cumulative Remaider to Beeficiaries $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $- Year 2 Year 4 Year 6 Year 8 Year 10 Rollig GRATS $259,978 $356,404 $356,404 $627,895 $720,416 Sigle GRAT $51,403 $102,805 $154,208 $205,610 $257,013 Source: Hawthor Log-Term GRATs For example, assume a $1 millio trasfer to create a 10-year Zeroed Out GRAT, a 2.2% IRC There are also beefits of selectig a log-term auity period for a GRAT. Sectio 7520 rate, ad a 10% aual ivestmet rate of retur. With equal fixed paymets of $112,495, I a low-iterest-rate the remaiig eviromet, GRAT balace the grator at the ed has of the the opportuity auity to term would be approximately $800,000. lock i O the the lower other IRC had, Sectio with 7520 paymets rate, represetig icreasig the 20% bechmark aually, to the iitial paymet would oly be $44,714 ad the fial paymet would be $230,714; the resultig GRAT remaider would exceed i ivestmet retur over the term of the GRAT. Chart 2 (page 4) be approximately $985,000, almost a 25% improvemet over the equal fixed paymets approach. shows the fluctuatio of the Sectio 7520 rate over the past 20 years ad the Additioal relative beefits historic curret of smaller low rate auity i paymets The likelihood i early of sigificatly years uder higher the icreasig auity paymets IRC Sectio approach 7520 may rates apply i future as well. years whe If, for succeedig example, short-term a difficult-to-value GRATs asset is expected to be sold at are some created poit may, durig some the cases, GRAT make term the ad choice cash of flow a loger-term the asset GRAT is low, lower auity paymet advisable i the despite early years the icreased may prevet mortality the risk eed ad to greater make risk distributios of oe or i kid, which would require more valuatio bad ivestmet of the asset performace to determie years. what fractio of it must be distributed (as well as the possible A GRAT difficulty may provide of dividig for aual the icreases asset to make of as much a fractioal as 20% i distributio). the auity To avoid these challeges, the grator could cotribute cash as part of the iitial cotributio of assets to such a paymets. As such, a log-term GRAT may allow for substatially lower GRAT i order to fud distributios i the early years prior to sale of the other asset. The cash auity paymets i the early years. This approach ca allow for greater cotributio required to accomplish this result could be sigificatly lower with a icreasig growth i early years with less leakage for auity paymets, typically paymet GRAT. resultig i a greater edig balace passig to remaider beeficiaries. 4 3

4 early years. This approach ca allow for greater growth i early years with les for auity paymets, typically resultig i a greater edig balace passig to beeficiaries. Chart 2 IRC Fluctuatio Sectio 7520 of IRC Rate, Sectio to 2014 Rate Sectio 7520 Percetage Rate /94 6/96 6/98 6/00 6/02 6/04 6/06 6/08 6/10 6/12 6/14 Source: Hawthor For example, assume a $1 millio trasfer to create a 10-year Zeroed Out GRAT, For example, assume a $1 millio trasfer to create a 10-year Zeroed Out GRAT, a 2. a 2.2% IRC Sectio 7520 rate, ad a 10% aual ivestmet rate of retur. With Sectio 7520 rate, ad a 10% aual ivestmet rate of retur. With equal fixed paym equal fixed paymets of $112,495, the remaiig GRAT balace at the ed of $112,495, the remaiig GRAT balace at the ed of the auity term would be appro the auity term would be approximately $800,000. O the other had, with $800,000. O the other had, with paymets icreasig 20% aually, the iitial paym paymets icreasig 20% aually, the iitial paymet would oly be $44,714 oly be $44,714 ad the fial paymet would be $230,714; the resultig GRAT rema ad the fial paymet would be $230,714; the resultig GRAT remaider would be approximately $985,000, almost a 25% improvemet over the equal fixed payme be approximately $985,000, almost a 25% improvemet over the equal fixed Additioal paymets approach. beefits of smaller auity paymets i early years uder the icreasig a paymets approach may apply as well. If, for example, a difficult-to-value asset is ex Additioal beefits of smaller auity paymets i early years uder the sold at some poit durig the GRAT term ad cash flow o the asset is low, lower a icreasig auity paymets approach may apply as well. If, for example, a paymet i the early years may prevet the eed to make distributios i kid, which difficult-to-value asset is expected to be sold at some poit durig the GRAT require valuatio of the asset to determie what fractio of it must be distributed (as w term ad cash flow o the asset is low, lower auity paymet i the early possible difficulty of dividig the asset to make a fractioal distributio). To avoid th years may prevet the eed to make distributios i kid, which would require challeges, the grator could cotribute cash as part of the iitial cotributio of asset valuatio of the asset to determie what fractio of it must be distributed (as well GRAT i order to fud distributios i the early years prior to sale of the other asset. cotributio as the possible required difficulty of to dividig accomplish the asset this to result make could a fractioal be sigificatly distributio). lower with a i paymet To avoid these GRAT. challeges, the grator could cotribute cash as part of the iitial cotributio of assets to such a GRAT i order to fud distributios i the early years prior to sale of the other asset. The cash cotributio required to accomplish this result could be sigificatly lower with a icreasig paymet GRAT. 4 GRATs Measured by Grator s Life Expectacy I situatios where the life expectacy of the grator or grator s spouse is less tha the life expectacy used i the tables uder IRC Sectio 7520 for calculatig the value of a auity, we believe measurig the GRAT by the life of the grator or grator s spouse may provide a advatage over a fixed-term GRAT. Note that the auity valuatio based o the life expectacy tables uder IRC Sectio 24 hawthor.pc.com

5 7520 may ot be used if the auitat has a health coditio that creates a 50% or greater probability of death withi oe year. 1 If the grator has a projected life expectacy sigificatly less tha the life expectacy used i the Iteral Reveue Service (IRS) tables for this purpose but is less tha 50% likely to die withi oe year, a GRAT measured by the grator s life may be worth cosiderig. Because the GRAT will termiate at the grator s death (ad he will ot survive the auity term), measurig the GRAT by the grator s life will mea iclusio of at least some of the GRAT assets i the grator s taxable estate uder IRC Sectio 2036, which is determied by dividig the auity amout by the IRC Sectio 7520 rate i effect o the grator s date of death. For example, assume a 55-year-old grator i poor, but ot termial, health cotributes $1 millio to a GRAT, retaiig a $75,000 lifetime aual auity. The actuarial value of the retaied auity is $924,383 based o the curret 2.2% IRC Sectio 7520 rate. While this does ot zero out the GRAT, the gift is oly $75,617 (the $1 millio trasferred to the GRAT less the value of the grator s retaied iterest), which ca be absorbed by part of the grator s lifetime gift exclusio amout if she has at least that amout remaiig. Assume that the ivestmet retur o the GRAT assets is 12%. The grator dies 12 years later at age 67 whe the IRC Sectio 7520 rate has icreased to 5.4%, a more average iterest rate eviromet. The GRAT assets, et of auity distributios to date, total $2,085,991. The portio of this amout icludible i the grator s taxable estate is the auity amout of $75,000 divided by the Sectio 7520 rate of 5.4% at that time, or $1,388,889. Accordigly, $697,102 ($2,085,991 of total GRAT assets less the estate icludible portio of $1,388,889) is removed from the grator s taxable estate at a cost of just $75,617 of lifetime gift exclusio. Variatios i Structure Zeroed Out GRATs I the case of a Zeroed Out GRAT, because the actuarially projected remaider amout is zero, ay remaiig assets left to pass to or for the remaider beeficiaries at the close of the auity term will provide a successful result because these assets will represet wealth trasferred without ay gift tax cosequeces (that is, o lifetime gift exclusio used ad o federal gift tax paid). Should the required auity paymets completely exhaust the assets of the GRAT before the auity term eds or if the fial auity distributio is isufficiet ad exhausts the remaiig assets of the GRAT, the there will be o remaider amout passig to or for the beefit of the remaider beeficiaries. If the GRAT was ot a Zeroed Out GRAT, the either the gift tax or lifetime gift exclusio utilized with respect to the actuarially projected remaider as determied uder IRC Sectio 7520 at the time of the creatio of the GRAT will have bee wasted. 1 Treasury Regulatio (Treas. Reg.) Sectio (b)(3). 35

6 There will, however, be o such adverse cosequeces for a Zeroed Out GRAT because there was o actuarial gift amout as to the remaider iterest; thus, there is o required lifetime gift exclusio or federal gift tax payable. From a wealth trasfer perspective, other tha the cost of creatig ad admiisterig the GRAT, the trasferor is geerally i o better or worse positio tha if the GRAT had ot bee created at all. Whe creatig a Zeroed Out GRAT, we believe it is advisable to calculate the auity such that the projected remaider amout ad correspodig gift is a small amout, such as $100, rather tha zero. By so doig, the gift is egligible but allows the opportuity to file a federal gift tax retur, which commeces the ruig of the three-year statute of limitatios for the GRAT trasactio. This approach ca particularly make sese, i our opiio, i the case of a trasfer of difficult-to-value assets to a GRAT. Upo the close of the three-year statutory period, the valuatio ad correspodig auity amout will be permaetly set. Should the valuatio be challeged, adjustmet of the auity amout ca be made to prevet ay adverse federal gift tax cosequeces. Separate Sigle-Asset GRATs Just as successive short-term GRATs ca typically maximize the remaider by Table Table 1 1 isolatig good ad bad ivestmet performace, establishig separate GRATs for Table 1 Short-Term separate assets ca provide the same beefit. Short-Term GRATs GRATs ad GRATs ad Auity Auity ad Auity Paymets Paymets (2.2% (2.2% Sectio Sectio (2.2% 7520 For example, Sectio 7520 rate; rate; $ millio $1 assume rate; millio iitial grator $1 millio iitial ivestmet) ows iitial two ivestmet) stocks, ABC, Ic. ad XYZ, Ic., that GRAT GRAT Term Term GRAT he wats Term Aual Aual to cotribute Aual to a GRAT. Each is curretly worth $1 millio. Assume (Years) (Years) alteratively (Years) Auity Auity that Auity the grator establishes oe Zeroed Out GRAT ad cotributes 10 $112,495 $112,495 $112, both stocks or two separate Zeroed Out GRATs, oe for each stock. Also assume 8 137, , , a two-year 6 179, ,733 GRAT 179,733 term ad 2.2% IRC Sectio 7520 rate. Fially, assume that the 4 4 ABC 4 stock 263, ,901 grows 263,901 20% per year for each of the two years of the GRAT term while , ,556 the XYZ 2 stock declies 516,55615% each year. Table 2 demostrates the $216,456 wealth trasfer advatage of establishig separate GRATs for each stock. Source: Source: Hawthor Source: Hawthor Hawthor Table 2 Table Table 2 2 Table Sigle-Asset 2 versus Combied GRAT Sigle-Asset Sigle-Asset versus versus versus Combied GRAT Combied GRAT GRAT Sigle-Asset Sigle-Asset GRAT GRAT GRAT Combied Combied GRAT GRAT GRAT ABC, ABC, Ic. Ic. ABC, XYZ, Ic. XYZ, Ic. Ic. XYZ, $2 Ic. millio $2 millio $2 millio 20% 20% aual aual 20% -15% aual -15% aual aual -15% aual 5% aual 5% aual 5% aual Net Net Advatage Net Advatage of of of rate rate of retur of retur rate rate of retur rate of retur of retur rate of rate retur rate of retur of rate retur of retur Sigle-Asset Sigle-Asset GRAT GRAT GRAT Remaider Remaider to to to Beeficiaries Beeficiaries $303,578 $303,578 $303,578 $0 $0 $0 $87,122 $87,122 $87,122 $216,456 $216,456 $216,456 Source: Source: Hawthor Source: Hawthor Hawthor Choice of Assets Assets Yieldig Greater Tha the IRC Sectio 7520 Rate The IRC Sectio 7520 rate sets the hurdle for a GRAT, ad ivestmet retur exceedig that rate likely leads to a successful GRAT. At the curret 2.2% IRC 62 hawthor.pc.com

7 Sectio 7520 rate, there are several moderate or low risk, fixed-yield ivestmets that ca exceed this threshold, such as certai bods, mutual fuds, ad preferred stock. Pricipal value of such assets may fluctuate, but for a shorter-term GRAT this approach typically geerates some level of success. Valuatio-Discouted Assets I creatig a GRAT, the value of the assets cotributed to it will determie the level of auity paymets ecessary to accomplish a specific reductio i the value of the gift. For example, with a Zeroed Out GRAT, the value of the auity paymets as determied uder IRC Sectio 7520 must be equal to the value of the assets cotributed. Accordigly, the lower the value of the assets cotributed, the lower the auity paymets must be over a specific term of years to accomplish the desired result. Cosequetly, whe assets cotributed to a GRAT ca be discouted i value relative to their true value, the GRAT ca geerally accomplish eve greater wealth trasfer results by requirig lower aual auity paymets to the grator to accomplish the same gift reductio objective. Family Busiess Successio or Presale Plaig with GRATs I our view, oe of the most powerful possibilities for GRATs, alog with the valuatio discout available for some assets, is i cocert with a family successio pla for a closely held busiess. By trasferrig ovotig stock i a closely held busiess, a discout i value attributable to the lack of cotrol ad marketability of such iterests would be available. I additio, the trasferor, still owig the votig stock, could retai cotrol over the busiess. Furthermore, with the most commo form of closely held busiess etity, S Corporatios, the cash flow desired by the trasferor could be fuded i whole or i part by the GRAT durig the auity period, further ehacig the leverage ad efficiecy of this meas of tax-advataged busiess successio plaig. For example, assume a father who ows 100% of the stock of XYZ, Ic., a S Corporatio worth $10 millio, desires that his so ultimately succeed him as the ext geeratio of the busiess. The father plas to cotiue i the busiess for 10 more years, cotiuig to receive his ormal aual compesatio of $1 millio ad the retire. The father recapitalizes the stock from oe class to two, votig ad ovotig, exchagig each of his 100 shares of the outstadig stock for oe share of votig stock ad 99 shares of ovotig stock. The father the cotributes the ovotig stock to a 10-year Zeroed Out GRAT. As ovotig stock, the father takes a 33% valuatio discout for lack of marketability ad cotrol attributable to the stock. At a resultig value of $6.633 millio for the 99% stock iterest trasferred to the GRAT, ad a 2.2% IRC Sectio 7520 rate, the GRAT would pay $746,177 aually to the father for the 10-year auity period. Durig this 10-year period, the father could reduce his aual compesatio to $253,823, which is $746,177 less tha his customary $1 millio. 37

8 I additio, durig this period the corporatio could make a aual divided distributio, ot made i prior years, of $754,000 to the stockholders. Further, 99% of this divided, or $746,460, would pass to the GRAT as 99% stockholder, providig sufficiet cash flow to fud the above $746,177 GRAT auity distributio to the father. Because this amout would have bee distributed to the father i ay evet, this type of GRAT is icredibly efficiet because o additioal distributios from the subject assets are beig trasferred via the GRAT back to the grator as is the case with a typical GRAT. As a pass-through etity for icome tax purposes, the corporatio s distributios to the father as compesatio or divideds (via the GRAT) will ot have a federal icome tax impact, although the amout of payroll taxes would likely be reduced. There is the potetial risk that the IRS could challege the chage i compesatio as isufficiet compesatio compared with prior years, or as some other tax avoidace device (but such tax avoidace would relate solely to payroll taxes, as the federal icome tax impact would be the same). Nevertheless, the father ad XYZ, Ic. could seemigly assert that the reduced compesatio is attributable to the father s reduced activities as he ears retiremet. Establishig a GRAT for closely held family busiess iterests also provides a opportuity for presale wealth trasfer plaig. I the case of XYZ, Ic., if the father istead determied to sell the busiess rather tha pass it to his so, he could establish a Zeroed Out GRAT with a portio of the stock prior to a sale of the busiess, takig advatage of the 33% valuatio discout as discussed above. Upo sale of the busiess, a pro rata portio of the proceeds would pass to the GRAT as partial stockholder of XYZ, providig liquidity to make the auity paymets to the father. Because the auity paymet would be based o the discouted value of the iitial assets (XYZ stock) cotributed to the GRAT, ad with a presumably greater amout paid per share i the sale of the busiess to a third party, the lesser required paymets would create the likelihood that substatial assets would remai i the GRAT followig the auity period, passig trasfer tax free to the so. Other Valuatio Discout Assets Suitable for GRATs Valuatio discouted assets could also iclude restricted stock (for example, stock that, although publicly traded, caot be sold by the ower for a period of years). Such stock, based o the restricted marketability ad liquidity, allows for a valuatio discout relative to its curret market value. Other such assets could iclude limited, or restricted, iterests i family etities such as Family Limited Parterships (FLPs) or Limited Liability Compaies (LLCs). The uderlyig operatig agreemets for such etities typically restrict the power of the ower of limited parters (LPs) or LLC members to sell, liquidate, or otherwise trasfer their iterests ad restrict or elimiate ay cotrol over decisios regardig these etities ad the uderlyig assets. As a result, a valuatio discout for lack of marketability ad cotrol are permitted, although the amout of that discout may be subject to 28 hawthor.pc.com

9 challege by the IRS. Valuatio discouts for family etities is discussed further i the Jue 2013 Hawthor Istitute white paper Family Opportuity Trusts, Part II: Leveragig the Trust. If valuatio of assets cotributed to a GRAT is fially determied by the IRS to be higher tha the value ascribed by the grator at the time of the GRAT s creatio, a automatic adjustmet icreasig the auity paymets ca be made to avoid adverse, uiteded gift tax cosequeces. As a example, assume the grator ad grator s spouse form a FLP, cotributig $10,101,010 of assets, ad receivig back the 1% geeral partership iterest ad the 99% limited partership iterests. The grator the cotributes the 99% limited partership iterests to a Zeroed Out GRAT with a 10-year term whe the IRC Sectio 7520 rate is 2.2%. The grator takes approximately a 30% valuatio discout for the lack of marketability ad cotrol attributable to the limited partership assets, thus valuig these iterests passig to the GRAT at $7 millio rather tha the $10 millio pro rata value of the uderlyig assets. The required aual auity distributio is $787,463 i order to zero out the GRAT. (This auity would have bee $1,124,947 had o valuatio discout bee take.) The aual auity is satisfied through loas take by the trustee at a iterest rate of 4%. These loas ca be provided by the grator. I additio, assume that the uderlyig assets of the GRAT appreciate at a 8% aual rate of retur. At the close of the GRAT term, the uderlyig value of the FLP assets attributable to the 99% LP iterests i the GRAT has grow to $21,589,250. The geeral parter sells the assets of the FLP ad distributes this amout to the parters, icludig the GRAT trustee as 99% limited parter, i liquidatio of the FLP. Ay gai o the sale of the assets passes through to the grator as to the 99% LP iterests because the ower, the GRAT, is a grator trust for icome tax purposes. The trustee pays off the $9,454,365 loa (icludig iterest) to the leder ad the distributes the balace of $12,134,885 to the remaider beeficiaries. Without a valuatio discout, the GRAT remaider, et of distributios ad loa repaymet, would have bee oly $8,083,004. Accordigly, the use of valuatio discouted assets has trasferred a little over $4 millio more to the remaider beeficiaries without federal gift tax cosequeces. Overseeig GRAT Performace The grator s ivestmet advisor, alog with his attorey, wealth strategist, wealth maagemet advisor, ad other professioals, should review a GRAT s ivestmet performace o a regular basis. If the GRAT performs poorly i its early years, the odds of its ultimate success dramatically declie, particularly for a shorter-term GRAT, because of the ecessity that it substatially outperform over the balace of the term. For example, if a GRAT declies i value by 20% i year 1, it will eed to ear a retur of 25%, et of auity distributios, simply to retur to the origial pricipal amout. 39

10 I such cases, the grator is well-advised to cosider purchasig GRAT assets for their value at that time ad startig over by cotributig those assets to a ew GRAT. As a grator trust, the grator ca swap cash or a promissory ote for the value of the assets without ay adverse icome tax cosequeces. Although a GRAT is prohibited from issuig a ote i satisfactio of its auity paymet requiremet, 2 there is o prohibitio of a grator reacquirig GRAT assets at fair value with a promissory ote. The ote will eed to carry a rate of iterest o less tha the Applicable Federal Rate (AFR) of iterest for itra-family loas established uder IRC Sectio 1274 to avoid adverse federal gift tax cosequeces (these rates are curretly quite low sice they geerally track rates o Treasury obligatios for similar terms). Durig the period that the promissory ote is payable by the grator to the GRAT, ad followig the GRAT s termiatio if the GRAT remaider (icludig the ote) passes to a grator trust for icome tax purposes, paymets o the ote by the grator will have o icome tax effect. If the assets recotributed to the ext GRAT do recover, this growth will iure completely to the success of the ew GRAT without the drag of the earlier years poor performace. Similarly, if a GRAT is ejoyig outstadig ivestmet performace i its early years, the grator could freeze, or lock i, the success of the GRAT to help cofirm that possible poor performace i subsequet years of the GRAT term does ot reduce the wealth trasfer already achieved or possibly etirely wipe out the gais ad cause the GRAT to fail. By purchasig the GRAT assets at their market value at that time for cash, the grator could recotribute those assets to a ew GRAT. The origial GRAT could ivest the cash coservatively to avoid ay possibility of loss, while the ew GRAT has the possibility of ejoyig further gais should the assets cotiue to perform well. Agai, the grator s purchase of the assets of the first GRAT could be accomplished with a promissory ote, cofirmig that the locked-i pricipal value plus iterest will pass to the remaider beeficiaries. Alteratively, the grator could lock i a GRAT s success prior to the ed of the auity term by purchasig the remaider iterest rather tha the actual assets for its value at that time. If the remaider beeficiary is a grator trust (rather tha idividual beeficiaries) for icome tax purposes, the the purchase will ot create adverse icome tax cosequeces. Agai, this approach help guards agaist subsequet uderperformace of the GRAT assets from a wealth trasfer perspective. The grator s purchase of the remaider iterest from the remaider beeficiary ca also mitigate mortality risk. If the grator dies prior to the ed of the auity term, the all or a substatial portio of the GRAT assets will be icluded i her taxable estate. Purchasig the remaider iterest would thus typically elimiate the risk that all or part of the remaider iterest will be dimiished by estate tax. Such a approach ca be particularly worthy of cosideratio as to a GRAT that is performig well if the grator s health has declied to the poit where her death prior to expiratio of the GRAT term is likely. 2 Treas. Reg. Sectio (b)(1)(i) hawthor.pc.com

11 Of course, the early success of a GRAT could also be locked i if the GRAT simply sells the assets ad reivests the proceeds i assets with little or o dowside risk. This approach, however, would result i taxable gais to the grator based o the GRAT s grator trust status. Further, the assets may ot be readily marketable, or the grator ad family may ot wat to otherwise dispose of the assets to a third party. I additio, the grator could cosider swappig cash or other high-basis assets, such as bods, for highly appreciated assets i a GRAT prior to the ed of the auity term as a tax-eutral exchage betwee grator ad the GRAT which is a grator trust for icome tax purposes. The high basis assets received by the grator could the ejoy a stepped-up basis for capital gais purposes upo the death of the grator. If the grator does ot have sufficiet cash or other high-basis assets to swap for this purpose, we believe it may be worth cosiderig a sale of some or all of the appreciated assets prior to the ed of the auity term, while the GRAT is treated as a grator trust for icome tax purposes, such that the capital gai will be taxed to the grator rather tha ultimately to the remaider beeficiaries. Because the paymet of this capital gai tax by the grator will ot be treated as a gift to the remaider beeficiaries, 3 the grator ca make a additioal free gift to the remaider beeficiaries by paymet of this tax liability. Other Plaig Cosideratios Grator Trust as Remaider Beeficiary There are advatages to a GRAT s grator trust status for icome tax purposes, icludig: The grator ca exchage or purchase assets, or receive distributios, without recogitio of icome or capital gais. The grator s paymet of icome tax liability o behalf of the trust is a free gift that allows the assets to grow outside the grator s taxable estate uecumbered by taxatio. Such favorable beefits ca be exteded by havig the remaider beeficiary of a GRAT be a grator trust for icome tax purposes. Aother importat beefit of this approach is that tax will ot be imposed o the grator if there are GRAT assets subject to debt exceedig the assets basis upo the GRAT s termiatio. A family trust that is the beeficiary of a GRAT remaider iterest ca be treated as a grator trust for icome tax purposes 4 by providig the grator the power to acquire assets of the trust by substitutig, or swappig, assets of equal value. The IRS 5 ruled that a power reserved by the grator i a ofiduciary capacity to reacquire trust assets by substitutig assets of equivalet value 6 does ot cause iclusio of the trust assets i the grator s taxable estate uder IRC Sectio 3 Reveue (Rev.) Rulig ( C.B. 7). 4 IRC Sectio 675(4)(C). 5 Rev. Rulig , I.R.B (April 21, 2008). 6 uder IRC Sectio 675(4)(C). 113

12 2036 (power to ejoy or cotrol ejoymet of trust assets) or 2038 (power to revoke trust). Such a trust is thereby ofte referred to as a defective grator trust. We believe the grator s ability to swap assets with a grator trust receivig a GRAT remaider provides additioal wealth trasfer plaig opportuities. Oe such beefit is the opportuity to purchase appreciated assets from the GRAT, which have a carry-over basis for icome tax purposes, for cash i order to have those assets obtai a stepped-up basis for capital gais tax purposes whe icluded i the grator s taxable estate upo his death. Such a cash swap for GRAT assets could also freeze the beefit of the successful GRAT by guardig agaist potetial declie i the assets value goig forward. Chagig the Trasferor for GST Purposes The predeceased paret exceptio, exemptig assets passig to or for the beefit of gradchildre if their paret (grator s child) has died, applies oly if the grator s child (ad paret of the gradchildre) is deceased upo the GRAT s creatio. If a child is livig at the time the GRAT is created, ad a trust for that child is the remaider beeficiary (with that child s childre, the grator s gradchildre, as cotiget beeficiaries), such child could be give a testametary geeral power of appoitmet over the remaider iterest. This actio would cause iclusio of that remaider i the child s taxable estate if she dies prior to the ed of the GRAT auity term. I Private Letter Rulig (April 2, 2002), it was determied that i such case the trasferor for GST tax purposes would shift 7 from grator to the deceased child, thus elimiatig GST tax cosequeces if the child s childre (or trust for them) receive the GRAT remaider. The cost of avoidig the GST tax liability is the iclusio of the GRAT remaider i the deceased child s taxable estate. Similarly, a child, as direct remaider beeficiary of a GRAT, could gift his remaider iterest to, or i trust for, his childre (the grator s gradchildre). Sice that gift is subject to federal gift tax, the trasferor of this remaider iterest for GST tax purposes should shift from the grator to the grator s child, elimiatig GST tax cocers. 8 However, i this type of situatio ivolvig a Charitable Lead Auity Trust (CLAT) rather tha a GRAT (which geerally mirrors a GRAT except that the auity paymets are made to charity rather tha the grator), the IRS ruled 9 that the idetity of the trasferor would shift for GST tax purposes oly to the extet of the preset value of the remaider iterest at the time of the gift. Thus, accordig to the IRS, if a GRAT with assets valued at $5 millio had a remaider iterest with a preset value of oly $1 millio at the time of such a gift, a shift of the trasferor for GST tax purposes would oly occur as to 20% of the gifted iterest. 7 IRC Sectio 2652(a)(1)(A). 8 IRC Sectio 2652(a)(1)(B). 9 Private Letter Rulig (November 14, 2000). 212 hawthor.pc.com

13 Sale of Remaider Iterest to GST Tax Exempt Trust A chage i trasferor from the grator to a child for GST tax purposes may fully or partially elimiate GST tax cosideratios with respect to a GRAT remaider passig to, or i trust, for gradchildre or subsequet geeratios of the grator. However, the chage will correspodigly subject the ew trasferor (the grator s child) to federal gift tax or estate tax o the trasfer. We believe aother meas is available, however, to help accomplish effective geeratio-skippig plaig with GRATs without subjectig the itermediate geeratio to federal gift or estate tax. If the grator creates or has created a trust apart from the GRAT to which she has allocated GST tax exemptio to make this trust GST tax exempt, ad such trust is a grator trust for icome tax purposes, it could potetially purchase a GRAT remaider from the remaider beeficiaries. Such GRAT remaider beeficiaries are typically oskip persos for GST tax purposes, such as childre or trusts for childre, sice allocatio of GST tax exemptio with respect to a GRAT caot be made util the ed of the GRAT auity term, which provides o efficiet leverage or certaity for geeratio-skippig plaig. Ideally, the GRAT remaider beeficiary would be a trust for childre that is a grator trust for icome tax purposes as to the GRAT s grator. The trust that is the beeficiary of the GRAT remaider could the sell the remaider iterest to the GST tax-exempt trust for its actuarial fair market value at that time. Such a trasactio would be a sale, ot a gift, such that GST tax exemptio eed ot be allocated. I additio, as a trasactio betwee two trusts that are grator trusts for icome tax purposes as to the grator of the GRAT, o icome tax or capital gais tax cosequeces would result from this trasactio. For example, assume grator cotributes $5 millio to a five-year GRAT with the beeficiary of the remaider iterest beig a trust for grator s childre (Trust 1). Grator also creates Trust 2 for his family, giftig $5 millio to this trust ad allocatig $5 millio of his lifetime gift exclusio ad GST tax exemptio to this gift to make it etirely GST tax exempt. Both of these trusts are grator trusts for icome tax purposes as to the grator. I year 2 of the GRAT, the actuarial value of the remaider iterest is $4.25 millio. Trust 1 sells its GRAT remaider iterest to Trust 2 at this time for $4.25 millio. I year 5, followig the last auity paymet to grator, the GRAT termiates ad the remaiig assets, ow worth $7 millio, are paid to Trust 2, which ows the remaider iterest. The GRAT has ow bee successful i ot oly trasferrig sigificat wealth to grator s family but also i keepig the remaider assets, ad their subsequet growth, permaetly outside the taxable estates of the Trust 2 family beeficiaries. Sice i may states a trust ca last i perpetuity, these GRAT remaider assets ad their growth may be excluded from the taxable estates of may geeratios of the grator s family, as illustrated i Chart 3 (page 14). 13 3

14 remaider assets, ad their subsequet growth, permaetly outside the taxable estate Trust 2 family beeficiaries. Sice i may states a trust ca last i perpetuity, these G remaider assets ad their growth may be excluded from the taxable estates of may g of the grator s family, as illustrated i Chart 3. Chart 3 Growth of Trust Assets Chart Growth at 3% Growth of Trust Assets 120 Growth at 3% with 40% Estate Tax 100 Millios of Dollars Year Source: Hawthor Spedthrift Clauses A typical boilerplate trust trust provisio provisio allowed allowed uder state uder law state prohibits law prohibits beeficiaries beeficiaries fro assigig from assigig their their trust trust iterest to to aother perso or etity. This provisio is typically adv i is typically that it helps advatageous protect a i beeficiary s that it helps protect iterest a beeficiary s from creditors iterest claims. from creditors claims. Because there are ofte wealth trasfer plaig advatages of havig a GRAT beef actually Because there trasfer are his ofte or wealth her iterest, trasfer however, plaig advatages such a spedthrift of havig a provisio GRAT should, barr cocers beeficiary with actually respect trasfer to the her beeficiaries, iterest, however, perhaps such a be spedthrift omitted provisio from a GRAT docume trusts should, holdig barrig GRAT creditor remaider cocers with iterests, respect to so the as beeficiaries, ot to prohibit perhaps plaig possibilities a opportuities. be omitted from a GRAT documet, ad from trusts holdig GRAT remaider iterests, so as ot to prohibit plaig possibilities ad other opportuities. Marital Deductio Plaig for Grator Predeceasig Auity Term AMarital married Deductio grator Plaig ca typically for Grator deal with Predeceasig the potetial Auity iclusio Term of GRAT assets i hi estate through marital deductio plaig. Merely havig the GRAT paymets pass to A married grator ca typically deal with the potetial iclusio of GRAT assets grator s estate ad the to his spouse will ot qualify for the marital deductio for es i his taxable estate through marital deductio plaig. Merely havig the GRAT purposes if the GRAT remaider will pass to other beeficiaries such as childre. 10 paymets pass to the grator s estate ad the to his spouse will ot qualify for the marital deductio for estate tax purposes if the GRAT remaider will pass to other beeficiaries such as childre Istead, the GRAT could provide that, if GRAT assets are icluded i the grator s taxable estate, both remaiig auity paymets ad the remaider will pass to the survivig spouse, thus qualifyig for the marital deductio. Such a approach could also be accomplished by havig the GRAT provide a testametary power 10 This type of iterest is a oqualifyig termiable iterest uder IRC Sectio 2056(b)(1). 214 hawthor.pc.com

15 of appoitmet to the grator over ay GRAT assets icluded i his estate, which could be exercised i favor of the grator s spouse. Alteratively, the icludible assets ad remaiig auity paymets could pass directly uder the GRAT s provisios, or by exercise of the grator s power of appoitmet provided uder the GRAT, to a marital deductio trust such as a qualified termiable iterest property (QTIP) trust. I such cases, to meet the qualificatio for the marital deductio the GRAT should provide that, if i ay year followig the grator s death the GRAT icome exceeds the required auity paymet, the such excess icome will be paid to the marital trust (the survivig spouse should also have the power to compel the GRAT trustee to ivest the assets to provide reasoable icome). 11 Trust for Spouse as GRAT Remaider Beeficiary GRATs are typically iteded to beefit descedats. Alog these lies, the remaider iterest commoly will pass to childre, or a trust for childre, to avoid impositio of GST tax followig termiatio of the GRAT, as discussed above. A spouse, however, ca also be a beeficiary, alog with descedats, of a trust receivig the GRAT remaider without such beeficial iterest causig iclusio of the remaider assets i the spouse s or grator s taxable estate. Icludig a spouse as beeficiary provides safety et access to the assets if eeded durig the spouse s remaiig lifetime. Cappig a GRAT A grator typically will wat to maximize the potetial wealth trasfer i establishig a GRAT. I some cases, however, the grator may wat to persoally ejoy gais o the GRAT assets, beyod his auity paymets, that exceed a certai appreciatio target. Or the grator might be cocered that the remaider beeficiaries may thereby receive too great a widfall at the GRAT s termiatio. I such cases, the GRAT could provide that, to the extet the GRAT remaider exceeds a specific amout, such excess will revert to the grator. Such a provisio would retur assets to the grator s taxable estate that would have bee excluded as part of the GRAT remaider. I our view, such a structure may evertheless be ecessary to help satisfy oe or both of the cocers oted above such that the grator feels comfortable goig forward with the GRAT. 11 IRC Sectio 2056(b)(7). 15 3

16 Coclusio We believe GRATs represet a critically importat wealth trasfer tool that should be cosidered ad evaluated i almost every situatio ivolvig family or closely held busiess successio plaig. The effectiveess of GRATs for such purpose ca be magified through optimizatio strategies discussed i this paper, icludig the opportuity to beefit multiple geeratios of a family. As such, a GRAT ca geerally be a valuable part of a family s legacy pla whether implemeted i its basic form or combied with some of the variables that ca augmet its efficacy as a wealth trasfer vehicle. GRATs represet a effective wealth trasfer tool with geerally little dowside risk, i our opiio. Combied with the ability to remove substatial value from oe s taxable estate with little or o gift tax cost, GRATs have cosequetly come uder fire i recet years as the govermet s eed to arrow the budget deficit gap icreases. I recet years, the U.S. Treasury Departmet has proposed the followig restrictios o GRATs: a miimum auity term of 10 years; decreases i the auity amout durig the GRAT term prohibited; ad a requiremet that the actuarial remaider at the outset of the GRAT be greater tha zero (thus elimiatig Zeroed Out GRATs). I additio, uder recet Treasury Departmet proposals, the portio of assets i a trust received i a swap trasactio betwee a grator ad a trust that is a grator trust for icome tax purposes with respect to the grator would be subject to federal gift or estate tax. This chage would make subsequet trasactios betwee a grator ad a GRAT to ehace their effectiveess o loger geerally feasible. Note also that as iterest rates icrease, the hurdle rate for a GRAT s success icreases as well. Accordigly, we believe it advisable to cosider ad implemet GRATs ad the related strategies discussed above while favorable tax ad iterest rate eviromets exist. November 2014 The PNC Fiacial Services Group, Ic. ( PNC ) uses the marketig ame Hawthor, PNC Family Wealth ( Hawthor ) to provide ivestmet cosultig ad wealth maagemet, fiduciary services, FDIC-isured bakig products ad services ad ledig of fuds through its subsidiary, PNC Bak, Natioal Associatio ( PNC Bak ), which is a Member FDIC, ad uses the marketig ame Hawthor, PNC Family Wealth to provide specific fiduciary ad agecy services through its subsidiary, PNC Delaware Trust Compay. PNC does ot provide legal, tax or accoutig advice uless, with respect to tax advice, uless, with respect to tax advice, PNC Bak has etered ito a writte tax services agreemet. PNC does ot provide services i ay jurisdictio i which it is ot authorized to coduct busiess. PNC does ot provide services i ay jurisdictio i which it is ot authorized to coduct busiess. PNC Bak is ot registered as a muicipal advisor uder the Dodd-Frak Wall Street Reform ad Cosumer Protectio Act ( Act ). Ivestmet maagemet ad related products ad services provided to a muicipal etity or obligated perso regardig proceeds of muicipal securities (as such terms are defied i the Act) will be provided by PNC Capital Advisors, LLC, a wholly-owed subsidiary of PNC Bak ad SEC registered ivestmet adviser. Hawthor, PNC Family Wealth is a registered trademark of The PNC Fiacial Services Group, Ic. Ivestmets: Not FDIC Isured. No Bak Guaratee. May Lose Value The PNC Fiacial Services Group, Ic. All rights reserved. 2 hawthor.pc.com