Attempting to Protect the Value Accumulated in a GRAT

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1 INSIGHTS Attempting to Protect the Value Accumulated in a GRAT The primary goal of a GRAT is the ability to allow assets to potentially increase in value, then have the appreciated amounts pass on to beneficiaries without any gift tax consequences for the grantor. Executive summary A Grantor Retained Annuity Trust (GRAT) is a unique and valuable tool that may provide an opportunity for those who have accumulated wealth to transfer it in a tax-efficient manner. The primary goal of a GRAT is the ability to allow assets to potentially increase in value, then have the appreciated amounts pass on to beneficiaries without any gift tax consequences for the grantor. Since GRATs are most effective when funded with assets that have the potential to appreciate significantly in value, there is the possibility that they also could fluctuate in value. If assets within a GRAT have appreciated, one consideration for grantors is to lock-in the value accumulated in the GRAT. Specifically, this involves moving appreciated assets out of the GRAT and replacing them with assets that may be more stable. In this way, the risk of price volatility may be reduced or potentially even eliminated, with the goal of preserving the wealth accumulated for beneficiaries of the GRAT. For grantors who don t have available cash or low volatility assets to substitute for the original GRAT assets, it may be wise to consider the potential benefits of obtaining financing. The borrowed cash would be substituted for the appreciated assets, potentially preserving accumulated wealth within the GRAT. In today s low interest rate environment, the use of financing with a GRAT may be particularly compelling. While the lock-in strategy may limit additional growth within the existing GRAT, individuals retain the ability to roll appreciated (and more price-volatile) assets from the initial GRAT to a new GRAT. This creates the potential to accumulate additional appreciation on those assets that can again be passed to beneficiaries in a tax-efficient manner. Important disclosures provided on page 6.

2 Maintaining the potential benefits accumulated in a GRAT The primary gift and estate tax benefits of a GRAT are realized if assets placed in the trust appreciate in value. This value passes on to beneficiaries with no tax consequences. Earning significant appreciation in a GRAT is one challenge. But especially in the case of an asset that may experience price volatility, trying to maintain that value becomes even more important. If assets lose value that was attained earlier in a more favorable market environment, some or all of the tax benefit the reason the GRAT was established in the first place is lost. Therefore, it is important to consider strategies that may protect the value of appreciated assets, seeking to preserve both the wealth accumulated for beneficiaries and the tax benefits for the grantor of the trust. Unlike a typical investment account where an asset that has appreciated in value may be sold to lock-in a gain, that option is not attractive in a GRAT. Tax benefits are sacrificed by doing so. In addition, selling an asset with additional appreciation potential eliminates the opportunity to take advantage of future opportunities to pass assets to beneficiaries in a tax-advantaged way. One strategy to consider in these circumstances is to attempt to lock-in the current value of the asset/assets while still maintaining the potential for future growth in value. Most GRATs allow the flexibility to substitute assets for existing assets in the GRAT. This means that you can replace current appreciated GRAT assets with those believed to be more stable assets, such as cash-equivalent investments. Typically, these can include Certificates of Deposit, U.S. Treasury bills or other short-term securities that historically don t fluctuate in price. How the lock-in process within a GRAT typically works After a GRAT has been established and if assets inside the GRAT have increased in value, here is the basic process the grantor can follow to lock-in appreciation: 1. Move assets out of the GRAT that are at risk of losing value Assets that have appreciated inside the GRAT but are at risk of fluctuating in value can be removed from the GRAT. This may enable the value that has been attained inside the initial GRAT to be preserved for the designated beneficiaries while at the same time retaining the potential tax advantages for the grantor. 2. Replace the GRAT assets that have been moved with new assets The grantor can assign a different set of assets to the GRAT, to match the value of assets that were moved out of the trust. The objective is to choose assets that may hold their value regardless of market conditions, in contrast to the potential volatility that may have affected the original GRAT assets. (See more below about possibilities to consider for replacement assets.) 3. Roll original assets to a new GRAT Because the original GRAT assets did not have to be sold to lock-in their value, the tax benefits of using these assets in another GRAT are retained. Tax laws allow the assets replaced in the GRAT to be rolled into a new GRAT, created under terms similar to the original trust. This allows the designated assets to continue to potentially appreciate in value for a set period of time, possibly creating even more tax-advantaged value for beneficiaries without jeopardizing the gains already earned in the original GRAT. This process can be repeated, allowing the potential for appreciating assets to continue to generate growth that can be passed on to beneficiaries with no gift tax consequences to the grantor. As assets appreciate over time, the lock-in strategy can again be applied in each subsequent GRAT, which may ensure that the gains are protected for beneficiaries. This process may result in significant value being passed on to future generations with no gift tax liability for the grantor over the course of the grantor s lifetime. Financing new assets for the GRAT An important consideration is to determine the source of assets that will be used to replace those that have appreciated in value inside the GRAT. A grantor can consider using assets from his or her current portfolio. Two choices include: 1. Transferring existing assets that may have less volatility (such as CDs) into the GRAT. Important disclosures provided on page 6. Page 2

3 2. Liquidating assets not currently held in the GRAT and using the proceeds to fund the purchase of short-term assets to be placed in the GRAT. However, this could result in capital gains taxes that may negate much of the tax savings that were sought by creating the GRAT in the first place. Using existing assets is not always a workable or financially reasonable option. For many people, a more effective approach, particularly given the favorable interest rate environment that exists today, is to arrange financing to meet the funding need. U.S. Bank can help you assess financing alternatives and determine what strategy may be most appropriate for you. How the financing process works for a GRAT appreciation lock-in A typical strategy is to try to protect the value accumulated in the GRAT over a short period of time, often two years or less. 1 Different forms of loans are available, and the most appropriate structure can be determined for each individual situation. Like most situations, there are two basic steps involved in the financing process: Step 1 Obtaining the loan The loan process will identify the most favorable terms for the grantor. A key element that needs to be identified is how best to secure the loan. In most cases, this can be done in one of two ways: 1. The grantor uses existing assets (outside of the GRAT) as collateral for the loan; or 2. The grantor pledges a combination of annuity payments from the GRAT to pay back part of the loan, with the remainder repaid with other assets from outside the GRAT. Step 2 Repaying the loan The amount of the loan may vary, but in most cases it will consist of the remaining GRAT principal (the amount of principal not yet repaid to the grantor) and the appreciated value. For most borrowers, the source of loan repayment will be represented by: 1. Annuity payments, representing remaining principal and interest that are made to the grantor over the outstanding term of the GRAT. 2. Funds from other assets owned by the grantor outside of the GRAT. This is used to pay the remainder of the loan that represents the portion of the GRAT s value attributed to asset appreciation that will eventually be paid out to beneficiaries, as well as interest on the loan. An example of how GRAT appreciation lock-in financing works A grantor established a GRAT by placing an asset with a current value of $2 million in the trust and setting the term of the trust at three years. The grantor named two children as beneficiaries. Then: After two years, the asset appreciated in value by $1 million. During the initial two years of the three-year GRAT term, the grantor received annuity payments of approximately $1.4 million (representing a portion of the initial value placed into the GRAT plus interest). That left a value of $1.6 million in the GRAT, of which $1 million will be passed along tax-free to the beneficiaries (representing the appreciated value of the asset) and the remainder, plus interest, repaid to the grantor in the last year of the GRAT term. Then, the grantor determined that locking in the appreciated value of the GRAT was the most appropriate step in an attempt to preserve the benefits of the trust. At that point: The grantor borrowed $1.6 million to provide the cash needed to replace the asset that was held in the GRAT. That original GRAT asset, with an appreciated value of $1.6 million, was rolled to a new GRAT with a term of two or more years to allow the potential for additional tax-advantaged appreciation to occur. When the term of the second GRAT expired, any appreciated value will again pass on to beneficiaries with no gift tax implications. The grantor used a combination of GRAT annuity payments and personal assets to repay the loan. Important disclosures provided on page 6. Page 3

4 Why consider a GRAT A Grantor Retained Annuity Trust is an irrevocable trust (one that can t be reversed once it is legally in place). The grantor establishes a GRAT and directs assets to the trust. By doing this, the grantor relinquishes ownership and control of the assets to the trust. In a typical GRAT designed to potentially minimize gift tax consequences, annuity payments are directed to the grantor from the GRAT over the term of the trust representing the total value originally directed to the GRAT plus an assumed interest rate (specified by the IRS). All earnings and appreciation generated by assets held in the trust that exceed a hurdle rate of interest applied by the IRS accrue with no gift tax implications. Therefore, the most effective way to utilize a GRAT is to direct assets that have the potential for significant appreciation over the term of the GRAT. That s because at the time the term expires, the appreciated assets accumulated in the GRAT are distributed to named beneficiaries. Assets that may be appropriate for placement in a GRAT include: stocks bonds business interests real estate When a GRAT is established, the fair market value of any assets placed in the GRAT must be determined. A combination of the fair market value of the asset at the time the GRAT is established along with a hurdle interest rate represent the grantor s total gift to the GRAT. However, no gift is recognized and gift taxes are avoided if the grantor chooses to receive annuity payments equal to the total value of the gift over the term of the GRAT. In many cases, individuals with a large, concentrated stock position (such as accumulated company stock) will choose to put a portion of that stock into a GRAT so any future appreciation could be directed to beneficiaries without gift tax consequences. This may be an effective way to begin shifting wealth to future generations. Children, grandchildren and others may benefit from continued appreciation of the asset while the grantor may benefit by potentially avoiding gift or estate tax consequences. When establishing a GRAT, it is important that the term of the trust is appropriate for your circumstances. If the grantor should die before the term of the GRAT ends, all of the assets in the GRAT, including any appreciation, revert to the estate of the grantor. Any potential tax benefits sought by establishing the GRAT would be lost. You should avoid creating a GRAT for a term of years that extends beyond your own life expectancy. Important points to consider If the grantor does not survive the term of the trust, the tax benefit will be lost. The transfer of assets can still occur, but gift or estate taxes may apply. It is possible that assets placed in a GRAT when it is established will not appreciate in value beyond the IRS hurdle interest rate. As a result, the objective of transferring assets to beneficiaries without gift tax consequences would not be realized. Grantors should assess the net cost of a loan if financing is used and weigh it against the potential tax savings realized by using the lock-in strategy and substituting borrowed funds for appreciated assets in the GRAT. Depending on the structure of the loan, interest rates can fluctuate, which may result in higher borrowing costs over time. If the market value of assets securing the loan used in GRAT appreciation lock-in strategy were to decline in value, either additional collateral may be required or the loan balance reduced to avoid a margin call. Tax laws are subject to change and could affect the ability to structure trusts in the most desirable way. Important disclosures provided on page 6. Page 4

5 Conclusion If you have not yet established a Grantor Retained Annuity Trust but think it might be a beneficial strategy for you, talk to your Wealth Management Advisor to find out if it fits your needs. 2 Be sure to include a tax professional (CPA) and attorney in the conversation to determine if a GRAT can be an effective tool to potentially limit the tax impact of a wealth transfer to family members and others. If you already have a GRAT with assets that have appreciated in value, you should consider the potential benefits of locking in that value. U.S. Bank can help you assess strategies to substitute low volatility assets in place of already appreciated assets in an attempt to protect the value that has accumulated inside of the GRAT. We can also recommend strategies to finance the purchase of assets to place in the GRAT in a potentially cost-effective way, and help you determine how to transfer assets to future generations while possibly limiting the tax impact. Your Wealth Management Advisor can also explain more about how GRAT appreciation lock-in financing can potentially protect the interests of the grantor of the trust and its beneficiaries. GRAT appreciation lock-in financing Second GRAT Heirs receive appreciated value of the second trust at end of its term Appreciated assets rolled to second GRAT Grantor Retained Annuity Trust (GRAT) Principal plus interest repaid to grantor Grantor of GRAT Grantor purchases short-term assets for the trust to replace appreciated assets Grantor repays loan to bank Heirs to the trust Heirs receive appreciated value of the original trust at end of trust term Bank provides financing for purchase of replacement assets Bank Important disclosures provided on page 6. Page 5

6 Contributed by: Jerry Anderson Senior Vice President, Wealth Management Advisor Jeff Arnold Senior Vice President, Manager, Twin Cities Private Banking Elizabeth Heidel Vice President, Wealth Management Advisor David Mook Chief Private Banking Officer Amber Mrnak Vice President, Private Banker Sally Mullen Chief Fiduciary Officer Robert Webster Senior Vice President, National Director of Wealth Planning 1 A typical rollover GRAT term is 2-3 years under current law. Proposals have been introduced in Congress that would require GRATs to be set for a minimum of ten years, though these proposals have not yet been passed into law. 2 Neither U.S. Bank nor its representatives may provide tax or legal advice. Any tax information provided reflects our opinion and is not intended to be exhaustive. Investors should consult with their tax advisor or legal counsel for advice and information concerning their particular situation. reserve.usbank.com Investment products are: Not a Deposit Not FDIC Insured May Lose Value Not Bank Guaranteed Not Insured by Any Federal Government Agency Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. Investing in fixed income securities (debt securities) are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer term debt securities. Investments in lower rated and non rated securities present a greater risk of loss to principal and interest than higher rated securities. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risks related to renting properties (such as rental defaults) U.S. Bank N.A. (3/14) Page 6