ESTATE PLANNING TECHNIQUES USING GRANTOR TRUSTS February 21, 2015 Tyler D. Petersen Quinn, Johnston, Henderson, Pretorius & Cerulo 227 NE Jefferson Avenue Peoria, IL 61602 309-674-1133 tpetersen@quinnjohnston.com
A. What Grantor Trusts are Used for 1. History of Grantor Trusts. a. The early structure of the income tax did not permit joint income tax returns for married couples and there was a progressive tax rate structure. So, taxpayers were motivated to deflect income to taxpayers in lower tax brackets, to reduce taxes. Similarly, taxpayers would shift income to trusts or beneficiaries of trusts in lower tax brackets. Courts and the IRS started ruling against assignment of income as a method to deflect income to other taxpayers. In 1939, the IRS adopted regulations that provided rules for when trusts would be recognized as taxpayers separate from their grantors. The rules were known as the Clifford regulations, based on the seminal case of Helvering v. Clifford. The Clifford regulations taxed the grantor and not the trust if any of several factors applied. Then, in 1954, Congress adopted the grantor trust provisions of the Internal Revenue Code that generally followed the Clifford regulations. b. In 1948, Congress adopted joint returns for married couples which eliminated the income tax incentives to divide income between spouses, but the rate structure that remained continued to motivate income splitting between grantors and trusts created for others and the beneficiaries of those trusts. c. The Tax Reform Act of 1986 had less progressive income tax rates, and made significant changes in the incentive to divide income among multiple taxpayers. Individual tax brackets became relatively flat with the great disparity of tax rates among individuals being eliminated. Also, the lower tax brackets for trusts were eliminated in the 1986 Act. d. With the motivation to divert income for high income taxpayers to trusts or trust beneficiaries, some taxpayers decided to use the grantor trust rules so that the grantor would be treated as owning the trust for income tax purposes, or stated differently, to make each trust a grantor trust. This was desirable from a gift and estate tax standpoint i.e. grantor s estate would be reduced by paying the income taxes. It led to taxpayers to seek grantor trust status or to create an intentional grantor trust as it came to be known. 1
e. The term defective was applied first to grantor trusts when the grantor trust rules were adopted because being called a grantor trust prevented income splitting, so avoiding grantor trust status was the taxpayer goal. So, before 1987, the trust was defective if the trust income was taxable to the grantor instead of the trust or trust beneficiary. The term defective grantor trust is still used today but now grantor trust status is typically seen as a positive. f. At its core, a defective grantor trust or more technically correct, a grantor trust, reflects a grantor s intention to exploit the dichotomy between the competing income and transfer tax systems, through the inclusion of certain highly technical provisions within the governing trust document. 2. Freezing Value of Appreciating Property. Putting assets into a grantor trust permits the asset value to be frozen for purposes of determining the grantor s total adjusted taxable gifts during lifetime and total value of grantor s taxable estate at death. 3. Grantor Taxable on Income. As the grantor is taxable on income of a grantor trust, the income tax paid by the grantor is effectively a tax-free gift to the trust beneficiaries. 4. Grantor Trust Can Accumulate or Distribute Income Tax-Free. As the grantor trust pays no taxes on its income, distributions are tax-free to the beneficiaries and accumulations are tax-free to the trust. 5. Transferring Discounted Income Producing Assets. A grantor can transfer an already discounted asset, such as an interest in a family limited partnership or family limited liability company which produces an income stream and the income from the asset is taxable to the grantor. 6. Grantor Trust Qualifies as an S Corporation Shareholder. A grantor trust is a permissible shareholder of S Corporation stock, with certain limited exceptions 7. Grantor Trust Enables Grantor to Take Deductions and Qualify for Exclusions on Transferred Property. Because the grantor trust is ignored for income tax purposes, the grantor is entitled to the same exclusions and deductions to which he or she would be entitled if the property was held individually. 2
B. Types of Grantor Trusts 1. Qualified Personal Residence Trust. a. A Qualified Personal Residence Trust (QPRT) is an irrevocable trust that owns a primary or vacation home for a fixed term of years and then either continues to hold the residence for the reminder beneficiaries, or distributes the home to the remainder beneficiaries. The primary purpose of a QPRT is to remove the value of the personal residence from the estate of the grantor for federal estate tax purposes. b. In a standard QPRT, the grantor transfer the personal residence or second home, to the irrevocable trust for continued, rent-free use of the residence for the term of the QPRT. If the grantor survives the QPRT s term, the residence either passes outright to the beneficiaries of the trust or remains in trust for their benefit. c. One drawback of using a QPRT occurs if the grantor dies before the end of the term. In that situation, the value of the residence is brought back into the grantor s estate, where it will be included at its full fair market value. The residence itself is still subject to the terms of the QPRT, and would not necessarily be available to pay the increase in estate tax attributable to the personal residence. Therefore, it is important to pick a term of years that the donor is most likely to survive to achieve the estate tax savings. d. A key benefit to using the QPRT is when the residence is transferred into the QPRT, the grantor s gift is only the amount of the contingent remainder interest in the house, which is potentially much less than the actual value of the house, depending on the term of the QPRT. e. IRS regulations provide the interest rate to be used to value the gift in a QPRT. When rates are high, the gift tax value of a QPRT gift is low, but when interest rates are low, the gift tax value is higher. f. Instead of passing the property outright to the remainder beneficiaries at the end of the term, the QPRT may provide that the residence continues to be held in trust for the benefit of the remainder beneficiaries. In such an instance, the rental payments made by the grantor may not be deemed taxable income to the children, 3
depending on the terms of the resulting trust. If the resulting trust is a grantor trust for income tax purposes, the grantor will be treated as the owner of the income. Thus, the rental payments would not be subject to income tax because they would be deemed to be made by the grantor to the grantor. If no resulting trust is set up, the rent would be income to the beneficiaries. g. Having the resulting trust in such an example be a grantor trust could produce additional tax benefits because if the property is sold, the grantor, not the beneficiaries, is responsible for any capital gains. Again, this allows for a transfer of assets without estate or gift tax consequences. h. After creating a QPRT, the grantor will continue to be responsible for paying all utilities, maintenance costs, real estate taxes and ordinary repairs. If the grantor builds onto the home, however, it will be likely to be deemed an additional gift to the trust. i. One distinct disadvantage of a QPRT is that the remainder beneficiaries do not received the stepped-up basis for income tax purposes that they would have been entitled to had the residence been held by the grantor until death and included in the grantor s taxable estate. Instead, the remainder beneficiaries receive a carryover basis. It is reasonable to expect that the remainder beneficiaries will want to sell the residence at some point after the end of the QPRTs term. So, the capital gain cost must be weighed against the tax savings of using a QPRT. j. Ideal candidate for a QPRT would be an individual of any age who owns a valuable home and is willing to give the home to his or her children to reduce estate taxes and whose health is at least average for his or her age group. If the home has a high income tax basis, it s even better. 2. Grantor Retained Annuity Trust. a. A Grantor Retained Annuity Trust (GRAT) entails a lifetime transfer of cash or property into a trust in exchange for an annuity payable to the grantor for a fixed term of years. Any property remaining in trust upon expiration of the annuity term passes to the remainder beneficiary (presumably the grantor s children) at no additional gift tax cost. As it is created by the Internal Revenue Code, a GRAT offers predictable tax results. Done correctly, a GRAT can allow a grantor to 4
exclude property from their estate with minimal to no gift tax costs, yet still retain control and benefit from the trust property during the trust term. It is often said that, aside from the cost to create, there is virtually no downside estate planning risk of a GRAT. b. A GRAT is an effective estate freeze technique and is most applicable with estates that would exceed the estate tax exclusion amount. Ideal circumstances include a low interest rate environment as a lower interest rate increases the value of the annuity retained by the grantor and therefore reduces the value of the gift of the remainder interest. Other important factors are the term of the trust, the life expectancy of the grantor and the interest rate. To think of it differently, the higher the payout to the grantor (i.e. with a lower interest rate), the smaller deemed gift value to the grantor. The interest rate is called the Section 7520 rate or the hurdle rate and is published monthly. The taxable gift to the grantor at the time of inception of the GRAT is equal to the value transferred less the retained interest. c. A GRAT is deemed a grantor trust and so any income generated or capital gains realized within the GRAT during the GRAT term would be income taxed to the grantor, just as if the asset remained in the grantor s name. The payment of taxes by the grantor on property that will ultimately go to the benefit of the remainder beneficiaries can be viewed as an additional tax-free gift to those beneficiaries. d. For a GRAT to receive the favorable tax treatment, the following requirements must be met: i) the transfer to the GRAT must be irrevocable; ii) annuity payments must be made to the grantor at least annually; iii) payments may be in cash or in kind; iv) no additional contributions to the GRAT may be made during the trust term; and v) payments from the trust must be fixed but increases of up to 20% per annum are permissible. e. To realize the full benefit of a GRAT, the grantor must outlive the trust term. The longer the term, the smaller the taxable gift as the remainder beneficiaries must wait longer to receive the property. But, the longer the term, the higher the risk of the grantor s death during the term. If the grantor dies during the term, all or a portion of the GRAT property will be includable in the grantor s estate, with the 5
amount determined by figuring the amount of capital needed to fund the annuity amount for the balance of the term. However, even if there s a death, the calculations work out such that the family is generally no worse off, except for the cost of preparing the GRAT and any services needed to fund the GRAT. f. The key factors that make a GRAT work the best are when the assets experience significant appreciation in value during the GRAT term, where the trust property generates sizable cash flow, where gift tax valuation discounts may be available and where sequential GRATs can enhance gift tax leverage. g. Combining a trust term with a high annual payout can allow a grantor to reduce the gift tax value of a GRAT to zero or close to zero so that there will be minimal gift tax consequences upon the GRAT s inception. h. GRAT Example: Cathy had $2,000,000 in a stock portfolio and she gifted the stock to a 2 year GRAT. She expects the stock to appreciate in value by 10% annually over the next 2 years with no expectation of dividends. Assume the Section 7520 rate is 1.0%. Therefore, Cathy would receive, in two installments, value equal to her contribution plus the 1.0% assumed annual return. At the end of the 2 years, if the stock does in fact grow by 10% annually, the remainder beneficiaries will be left with the excess without any tax ramifications. So, the annual payments to Cathy would be $1,015,022 each year and the excess left to the beneficiaries would be $288,054, without any gift tax ramifications. 3. Sale to Intentionally Defective Grantor Trust. a. This estate planning technique involves a grantor selling an asset with potential for appreciation at its fair market value to a grantor trust in exchange for a promissory note at a very low interest rate. Using growing assets allows the potential for the asset appreciation, above the mandated interest rate, to be removed from the grantor s estate. Because of this, a sale to an intentionally defective grantor trust (IDGT) is said to lock in or freeze the current value of the property sold to the trust. b. This sale is not recognized from an income tax perspective. Since the IDGT is purchasing the asset for fair market value, there is no taxable gift. The installment note is treated as full and adequate consideration if the minimum interest rate 6
charged on the note is at least the applicable federal rate and the formalities of a loan are followed. c. In addition, payment of interest on the installment note is not includible in the grantor s income when received nor is the interest deductible to the trust for income tax purposes. d. To heighten the likelihood of withstanding IRS scrutiny for this strategy, the IDGT must receive funding via a gift by the grantor of a commercially reasonable amount (suggestion is typically 10% of the value of the property transferred). e. If the note is repaid before death, the cash payments received by the grantor thereon will be in the grantor s estate for estate tax purposes, but not the property sold by the grantor to the IDGT. f. Like the GRAT, a benefit of this structure is that the tax liability on whatever income is generated by the trust will be paid by the grantor, rather than by the trust, so this is essentially an additional gift to the trust. This can be a very powerful tool if substantial income tax liability is attributable to the assets transferred. g. At the end of the term of the note, the note is either repaid or refinanced. h. IDGT example: Grantor owns highly appreciable stock in a closely held company. Grantor establishes the IDGT as a grantor trust for income tax purposes. Grantor sells some portion of the shares to the IDGT and it is intended that the dividends from such shares will be sufficient to repay the purchase obligation on or before the end of the term of the IDGT. The sale occurs by transferring the stock to the IDGT for the fair market price of the stock, which is paid by delivery of a promissory note in that face amount. It is important to have a good value for the stock to withstand any possible IRS challenges. The note in the face amount of the value bears interest at the applicable federal rate at the time of closing. The note is to be repaid to the Grantor in annual installments with a final payment due at the end of the note term. The IDGT may prepay at any time. The IDGT pledges the stock to the Grantor being sold as security for payment of the note. The beneficiaries of the IDGT also guaranty payment to the Grantor. At the 7
end of the term, the IDGT pays off the note and the IDGT distributes the shares to the beneficiaries. 4. Comparison of GRATs and IDGTs a. Both are similar vehicles but contain important differences. b. An IDGT sale can have advantages over a GRAT if the grantor dies prematurely. As discussed above, if a grantor of a GRAT dies during the term, some or all of the property, including the post-transfer appreciation, will be included in the grantor s gross estate. With an IDGT, if the grantor dies while the note is still outstanding, arguably only the balance owed on the note as of the date of death is includible and the post-sale appreciation is excluded. c. Typically, the interest rate for an IDGT will be lower than for a GRAT. For February 2015, the AFR, which is applicable to IDGTs, is 0.48% for short term (3 years or less), 1.70% for midterm (3 to 9 years) and 2.41% for long term (more than 9 years), while the 7520 rate applicable to a GRAT is 2.0% for February of 2015. d. A disadvantage of a GRAT is that the donor cannot do generation-skipping transfer tax planning at inception. Because the GRAT assets will be pulled back into the estate if the donor dies during the GRAT term, the donor cannot allocate generation skipping transfer tax exemption until the end of the GRAT term, at which point the exemption required will be based on the fair market value of the remaining GRAT assets. There is no GSTT associated with a sale of assets to a grantor trust. e. One perceived benefit of a GRAT over an IDGT is that substantial authority and guidance regarding the use of GRATs has been promulgated in Treasury Regulations. There is no such certainly for IDGTs and the IRS could argue that the sale to the IDGT is nothing more than a retention of an annuity not meeting the requirements of 2702 or a retained life interest under section 2036. 8
GRANTOR RETAINED ANNUITY TRUST SAMPLE CASE STUDY Peoria County Bar Association February 21, 2015 Todd M. Sheridan, CFA David Vaughan Investments, Inc. 5823 N. Forest Park Drive Peoria, IL 61614 309-685-0033 tsheridan@dviinc.com
Mr. and Mrs. Smith are both age 60 and have recently sold their small business and retired. Their balance sheet consists almost entirely of financial assets in an investment portfolio worth $7.5 million, they have no debt, and plan to consume $250,000 annually from their assets on an inflation-adjusted basis. Their long-term goal is to provide a legacy to their children and grandchildren. The Smiths have both a high capacity and high willingness to accept risk, and anticipate investing their portfolio in an asset allocation of approximately 75% equity and 25% fixed income. They wish to review their estate planning documents as they transition into retirement, but do not express a concern about the potential for estate taxes given the recently higher current level of federal exemptions. The Smiths seek guidance from a Monte Carlo analysis of the estimated future value of their financial assets under their current financial plan. They are surprised to learn that the combination of market appreciation and their relatively modest withdrawal rate will result in a portfolio with a high probability of principal growth. In fact, the estimates indicate that absent large increases in future exemptions, an estate tax burden could become a concern at their tenyear and twenty-year planning horizons. A sample of the Monte Carlo analysis for median, lower [25 th percentile], and higher [75 th percentile] investment returns is summarized below: Assumptions: Planning scenarios beginning: Beginning assets: Annual withdrawal: Inflation assumption: Asset allocation assumption: 2015 7,500,000 250,000 2.0% 75/25 Projected Values: Figures in $Millions Market Regimes: Market IRR % Higher 7.7% Median 6.0% Lower 4.0% 28.0 21.0 14.0 7.0 0.0 Year 5 Age 64 Year 10 Age 69 13.4 9.9 21.2 12.8 7.2 7.2 Year 15 Age 74 Year 20 Age 79 Year 25 Age 84 They observe that with just average appreciation, their investments assets may grow significantly enough to expose their wealth to the impact of estate taxes. 1
The Smiths want to know how a grantor retained annuity trust might help avoid this potential problem. They consider placing $2.5 million of their assets in a 10-year term, 20% graduated payment grantor retained annuity trust, zeroed-out for no gift tax or use of lifetime exemption at funding. The current 7520 rate is 2.0%. The Smiths want to know how such a GRAT will impact their balance sheet and start by reviewing the mechanics: Assumptions: Cash flows: Funded Amount: 2,500,000 Funding contribution from Term: 10 the Grantor to the Trust: 2,500,000 7520 Rate: 2.0% Graduated Annuity: 20% Annuity payments from the Trust to Grantor: Year 1 110,311 Year 2 132,373 Year 3 158,848 Year 4 190,617 Year 5 228,741 Year 6 274,489 Year 7 329,386 Year 8 395,264 Year 9 474,317 Year 10 569,180 Total 2,863,525 Recognizing these are the required cash flows of the grantor retained annuity trust, the Smiths are interested in knowing how such a GRAT might perform in the future if it were funded with a portion of their financial assets. They review the following chart which depicts the floor of the GRAT implied by the 7520 rate, along with projected market values implied by investment results of their financial assets for median, lower than average, and higher than average returns consistent with their assumed asset allocation: Market Value Projections: $3,400,000 Funded: $ 2,500,000 Years: 10 $2,720,000 7520 Rate: 2.00% Total Annuity: $ 2,863,525 IRR inside GRAT: $2,040,000 Median Scenario: 7.23% Lower Scenario: 25th n-tile 2.77% $1,360,000 Higher Scenario: 75th n-tile 9.03% GRAT Value Projections: Floor Median Lower Scenario: 25% percentile $680,000 Higher Scenario: 75% percentile $- 1.2015 1.2016 1.2017 1.2018 1.2019 1.2020 1.2021 1.2022 1.2023 1.2024 1.2025 2
The Smiths want to drill further down to analyze just the implied residual value from the market value projections, so they study the following: Residual Value Projections: Median: $ 1,413,766 Lower Scenario: 25th n-tile $ 162,521 Higher Scenario: 75th n-tile $ 2,097,224 $2,100,000 $1,650,000 Assumptions: Results from 500 random return streams modeled from the historical results Ibbotson stock and bond total return indices including dividends and income. Does not include any fees or expenses. GRAT annuity payments calculated on the basis of maximum annual 20% graduated increase and $0 gift at funding. $1,200,000 $750,000 $300,000 $(150,000) 1.2015 1.2016 1.2017 1.2018 1.2019 1.2020 1.2021 1.2022 1.2023 1.2024 1.2025 They notice the current lower level of the 7520 rate relative to past history appears to provide an enhanced opportunity that the GRAT will produce some level of residual value that will flow to their beneficiaries without any gift tax. They want to know how their original projected values from their baseline financial plan are impacted by the implied results of the GRAT, so they review a revised Monte Carlo analysis that reduces the value of their portfolio by the implied ten-year residual value: Projected Values: Market Regimes: Market IRR % Higher 7.6% Median 5.8% Lower 3.7% 24.0 18.0 12.0 6.0 0.0 Year 5 Age 64 Year 10 Age 69 Figures in $Millions 16.6 11.3 8.5 10.4 7.0 6.8 Year 15 Age 74 Year 20 Age 79 Year 25 Age 84 Finally, they review a summary table comparing the revised Monte Carlo analysis to the original to quantify the potential for estate tax savings: GRAT Impact 10 Year Horizon Impact @ 45% Tax Rate 20 Year Horizon Impact @ 45% Tax Rate Higher 2.1 0.9 4.6 2.1 Median 1.4 0.6 2.4 1.1 Lower 0.2 0.1 0.4 0.2 Figures in $Millions 3
The Smiths have observed that a grantor retained annuity trust may be helpful to reduce or avoid the potential of federal estate tax from the future appreciation of their financial assets. As a final step in making their decision to fund a GRAT, they review a short list of practical considerations: Drafting considerations: Relatively low cost to implement Must survive the term of the GRAT to reap the benefit No downside, other than minimal cost of the document Beneficiary(s) can be specified as individuals or other irrevocable trusts as needed for planning and/or control purposes Investment considerations: Ability to fund initial amount and annual annuity payments with in-kind movement of securities rather than having to liquidate and pay in cash Power of substitution, creating the opportunity to move securities in and out of the GRAT portfolio and effectively manage the investment risk higher or lower Sale of securities just prior to maturity, keeping the tax liability for capital gain with the Grantor and establishing new cost basis equal to fair market value for the beneficiary(s) 4