R ecent interest rate cuts have created a hood that the Grantor - PDF document

G Estate Planning Alert November 1998 Declining Interest Rates Can Mean Transfer Tax Savings (using a Grantor Retained Annuity Trust) By: Michael N. Gooen and John M. Tassillo, Jr. R ecent interest rate cuts have created a hood that the Grantor would die during the GRAT significant estate planning opportunity Term. As the IRS’s assumed interest rate decreas- for individuals who own assets with es, so does the amount of the taxable gift. The gift appreciation potential. may be sheltered by the Grantor’s unified credit (which currently affords an estate and gift tax Each month, the Internal Revenue Service exemption for transfers of up to $625,000; this (“IRS”) sets an interest rate for valuing gifts of amount is scheduled to increase to $650,000 in future interests in property. The November 1998 1999, $675,000 in 2000-2001, $700,000 in 2002- rate is 5.4%, the lowest rate in several years. By act- 2003, $850,000 in 2004, $950,000 in 2005 and ing now to exploit that low rate, individuals can $1,000,000 in 2006 and thereafter). Thus, in many pass significant value to their children at a minimal cases, there may be no gift tax imposed on the cre- transfer (gift and estate) tax cost. One vehicle for accomplishing that goal is the grantor retained ation of the GRAT . annuity trust (“GRAT”). If the Grantor were to die during the GRAT Term, all or a portion of the trust corpus would be What is a GRAT? included in the Grantor’s estate, potentially for- feiting the transfer tax savings. On the other hand, A GRAT is a trust with respect to which an if the Grantor were to survive the GRAT Term, the individual (the “Grantor”) retains the right to value of the gifted property—and any appreciation receive a fixed dollar amount, in cash or in assets, thereof—would escape all further gift and estate each year for a term of years (the “GRAT Term”). tax at the Grantor’s level! At the end of the GRAT Term, if the Grantor is then living, the remaining balance of the GRAT The following examples illustrate the tax savings (including any income or asset growth in excess of afforded by the GRAT technique. the amount used for annuity payments) will pass to Example: GRAT for High Yielding the next generation free of transfer tax. Marketable Securities At the time of the GRAT’s creation, the Grantor is treated as making a taxable gift of the A GRAT can be an effective technique for remainder interest in the GRAT (that is, the right transferring high yielding securities. to receive assets remaining at the end of the GRAT For example, assume that Mother (age 60) Term). The amount of the taxable gift would be the owns $1,000,000 in securities that earn a 15% fair market value of the gifted assets as of the date annual return (combined income and growth). If of the gift, discounted by two factors: (i) the length the portfolio continues to perform at that rate over of the GRAT Term (that is, the delay in the next 10 years, it will be worth over $4,000,000. At that generation’s receipt of the assets) and (ii) the likeli- This document is published by Lowenstein Sandler PC to keep clients and friends informed about current issues. It is intended to provide general information only. L Roseland, New Jersey Telephone 973.597.2500 65 Livingston Avenue www.lowenstein.com 07068-1791 Fax 973.597.2400

G point, the potential estate tax cost to Mother’s $3,000,000 can exceed $1,500,000). Accordingly, Father should consider a GRAT to facilitate the family if she retains the portfolio is well over transfer of his Family Corp. stock to his children. $2,000,000. Father decides to have Family Corp. recapital- Now let’s assume that Mother transfers the ize, issuing 1% voting stock and 99% nonvoting securities portfolio to a GRAT in November 1998 stock. Father retains the voting stock, thus ensur- and retains the right to receive an annual pay- ing his continued control of Family Corp. Next, in ment of $130,000 for 10 years, after which any November 1998 Father transfers all of his nonvot- remaining balance will pass to her children. ing stock to a GRAT under which Father receives Applying the IRS’s actuarial assumptions and the an annual payment of $228,000 for five years. At low November 1998 interest rate, Mother’s trans- the end of the five year GRAT Term, any remain- fer of the securities portfolio to the GRAT results ing balance of the GRAT passes outright to in a taxable gift of slightly less than $90,000. At Father’s children. worst, if the portfolio does not grow sufficiently to cover the annuity payments, the entire portfolio’s Again applying the IRS’s actuarial and inter- value will be returned to Mother and she will est rate assumptions, Father’s transfer of $990,000 have wasted a small percentage of her unified of Family Corp. stock to the GRAT results in a tax- credit. However, if the portfolio achieves its able gift of slightly less than $37,000. At worst, if anticipated growth rate throughout the GRAT the Family Corp. stock does not grow in value suf- Term, over $1,400,000 will pass to Mother’s chil- ficiently to cover the annuity payments, all of the dren free of transfer tax! Family Corp. stock will be returned to Father and he will have wasted a small percentage of his uni- Example: GRAT for Closely Held fied credit. However, if Father’s growth assump- Business Interests tions are accurate and he survives the five year GRAT Term, over $1,150,000 of value will pass to A GRAT also can allow a Grantor to “freeze” his children free of transfer tax! To the extent the the value of a closely held business for gift and Family Corp. stock produces income (that is, estate tax purposes, thus retaining the current Family Corp. pays dividends) in addition to the value (and, if desired, control of the business) growth in value, the tax saving will be even greater. while passing the anticipated appreciation in the To keep the example straightforward, we have business to the next generation. assumed that the Family Corp. nonvoting stock is Let’s assume that Father (age 55) is the sole worth its proportionate (99%) share of Family shareholder of Family Corp., a subchapter S cor- Corp.’s total value. In fact, it is likely that the gift poration that is currently worth $1,000,000. tax value of such stock would be discounted in Father anticipates that the value of his Family light of economic factors including the stock’s non- Corp. stock will appreciate by 25% in each of the voting status and lack of marketability. Such dis- next five years. Thus, by November 2003 counts often can increase the amounts ultimately Father’s Family Corp. stock will be worth over passing tax free under a GRAT . $3,000,000. Additional Considerations Father does not want to relinquish control of Family Corp. However, he is concerned about the ultimate estate tax burden his family will bear if In addition to marketable securities and busi- he retains his Family Corp. stock until his death ness interests, almost any type of asset with appre- (at current rates, the potential estate tax on ciation potential can be a candidate for a GRAT ,

G including, for example, real property, precious metals and artwork. A key element in designing a GRAT is select- ing the appropriate GRAT Term. Factors to con- sider in making that decision include the antici- pated timing of appreciation in the GRAT assets, the GRAT’s liquidity (that is, the ability to fund annual payments without “giving back” growth to the Grantor) and the Grantor’s life expectancy. Although GRATs are not permitted to receive additional contributions after the initial funding, there is no limit on the number of GRATs an individual may create. For example, additional GRATs can be created and funded with the annuity payments received from the ini- tial GRAT . This flexibility allows individuals to create GRATs with differing GRAT Terms, either as a “hedge” or to reflect different expectations about the appreciation potential and liquidity of particular assets. Finally, it is possible to “turbocharge” the tax benefits of a GRAT by combining it with one or more other estate planning techniques, such as the family limited partnership. Conclusion GRATs offer individuals the opportunity to shift significant value to their children at a mini- mal transfer tax cost. Now that interest rates are low, the potential tax savings are especially dra- matic. Thus, this is an excellent time to consider whether a GRAT makes sense in your situation. If you would like more information about GRAT s, or any other estate planning issue, please contact Michael N. Gooen or your Lowenstein Sandler tax advisor at 973.597.2500.