Saving Estate Taxes with a Rolling Zeroed-Out GRAT Strategy
My last blog post introduced a few estate tax reduction strategies that may work well in the current low interest rate environment.Going back to last week’s post, when interest rates are low, the Applicable Federal Rates (AFRs) issued by the IRS are also low.There are good strategies to leverage those low rates and shift wealth from one generation to the next while avoiding (or reducing) estate and gift taxes.One such strategy is Rolling Zeroed-Out GRATs.
GRATs can successfully transfer wealth to the next generation (an individual’s children) free of estate and gift taxes if the rate of return on the assets subject to the transfer exceed the Section 7520 Rate, a rate equal to 120% of the mid-term AFR (see my last post for an explanation on AFRs).The Section 7520 Rate for October 2019 is just 1.8%.
What is a GRAT?
“GRAT” is the acronym for Grantor Retained Annuity Trust – a trust where the creator of the trust makes a transfer to the trust while retaining a right to receive an annuity from the trust.
What is a Zeroed-Out GRAT?
A Zeroed-Out GRAT is a GRAT where the annuity payable to the trust’s creator is set in a manner that results, mathematically, in a net gift of zero.
Important to the logic behind GRATs is that the gift is determined at the time that the GRAT is created rather than waiting to see what is actually left at the end of the annuity term.
What is a Rolling GRAT?
A rolling GRAT is actually a succession of GRATs under which the creator of the GRAT continuously creates more GRATs upon receipt of annuity payments from a prior GRAT. Once the creator receives an annuity payment, that payment is placed into a new GRAT.
How Does a GRAT Save Taxes?
Let’s get to an example with easy math.Jerry transfers $10,000,000 of securities into a GRAT that will pay him an annuity and provides that anything left after satisfying the annuity will pass into a trust for his daughter Elaine.Assume that the securities are returning 8% a year and the Section 7520 Rate at the time of the transfer is 2%. Using a Zeroed-Out GRAT with a two (2) year annuity term, the trust will pay Jerry an annuity of approximately $5,150,000 each year for a total repayment of approximately $10,300,000.The $5,150,000 was chosen because that is the annuity payment that results, mathematically, in a net gift of zero.When determining the amount of Jerry’s gift to the trust, for gift tax purposes, we take the $10,000,000, apply the Section 7520 Rate of 2%, and reduce such amount by the annuity back to Jerry.This mathematical exercise results in a gift of zero.This is logical – in determining what Jerry has actually given up, the IRS looks at what he retains in terms of the annuity.
Even though Jerry was treated as having made a gift of zero to the GRAT upon formation, because the securities return 8% a year, when the two (2) year annuity term ends, there will be around $950,000 left in the trust for Elaine.
If Jerry simply had written a check to Elaine for $950,000 (ignoring his lifetime and annual gift exemptions), the gift would have resulted in $380,000 ($950,000 * 40%) of gift taxes.By using the GRAT, Jerry is able to save $380,000 in taxes and transfer $950,000 to Elaine, free of gift tax.This result occurs because the tax laws require Jerry to determine the gift when the GRAT is created rather than wait to see what actually passes to the trust for Elaine.
How are Rolling GRATs Different?
Now let’s take our example one step further and add the “rolling” part of the Rolling Zeroed Out GRAT to the plan and refer to Jerry’s GRAT above as “GRAT 1”.When Jerry receives his first annuity payment from GRAT 1 of $5,150,000, he puts that payment into GRAT 2 which pays Jerry an annuity payment for two years based on the Section 7520 Rate at such time.When Jerry receives the second and final payment from GRAT 1, he uses that payment to create GRAT 3 and this cycle of GRATs being created for each prior GRAT’s annuity payments continues for a period of time.
When the dust settles, Jerry will always have more than the original $10,000,000 in his taxable estate (unless it has gone down in value naturally), but the Rolling Zeroed Out GRAT strategy will remove most of the growth on that $10,000,000 out of his taxable estate.
Rolling GRATs may sound like an administrative nightmare, but estate planners and trust companies manage GRATs on a routine basis. Note that all of the GRATs can pay out to the same trust for Elaine to the extent that each GRAT has assets after the annuity term so that Elaine does not end up with numerous trusts.
Further Maximizing the Rolling Zeroed-Out GRAT Strategy
The example above involving Jerry and Elaine illustrates the simplest form of using a Rolling Zeroed-Out GRAT strategy.In many circumstances, a more sophisticated GRAT strategy is warranted to maximize results.More sophisticated strategies involve using multiple Rolling Zeroed-Out GRATs at the same time and using annuity payment schedules that increase rather than using the same annuity payment each year.
We used a very simple 8% fixed return in our example above, but that is not how investment returns are actually experienced.Investment values go up and down.A portfolio of investments has winners and losers and the winners one year can be the losers in the next year.
Revisiting Jerry’s GRAT again, what if the 8% return was really the product of two equal $5,000,000 investments, one that gained 15% and one that dropped 7% and Jerry used a separate GRAT for each investment?In that case, Jerry would have been better off with two GRATs- the GRAT with the 15% gain would have ended up with around $1,070,000 passing to Elaine free of gift taxes and the GRAT with the 8% loss would have simply failed to repay the full annuity to Jerry (essentially having no tax effect).
One reason for using shorter term GRATs is similar to the reasoning for using multiple GRATs at once.As shown above, using multiple GRATs reduces the chances that losses in some investments will offset gains in other investments (reducing the effectiveness of the strategy).Using shorter term GRATs allows for isolation of investment gains and losses in the same investment.If you placed a single investment in a GRAT for ten years, that investment value will likely go up and down.If you can isolate the down years to keep from netting against the positive years, the overall benefit can be increased.
As illustrated above, GRATs are viable tools for reducing estate tax exposure in a low interest rate environment.An important fact that favors GRATs over certain other planning techniques is that there are very few opportunities for the IRS to challenge a GRAT – so long as the math was done properly and the assets are valued appropriately, a GRAT is a very safe strategy.When the value of the investments beat the Section 7520 Rate, wealth can be shifted to the next generation free of gift taxes.When the value of the investments fail to beat the Section 7520 Rate, there is no tax effect – it is as if the transaction never occurred (leaving the client/taxpayer only worse off to the extent of the cost of the plan).
Be aware, however, that there have been political rumblings (and Congressional action) that would prevent the use of GRATs with terms less than ten years. If such a rule was imposed, it would significantly stifle the use of GRATs.
As I will show in a future post, GRATs are similar to a strategy that involves sales of assets to grantor trusts for promissory notes.An advantage of the GRAT over a sale to a grantor trust is the safety of the strategy since the GRAT relies on clear tax law.A disadvantage of the GRAT is that it is only feasible for shifting wealth down one generation – a Grantor cannot allocate his or her Generation Skipping Transfer Tax Exemption to a GRAT.Consequently, it is not feasible to create “dynasty” estate plans with GRATs.
Contact Silverman Schermer Today
GRATs, like most other sophisticated estate tax reduction strategies, are complicated.This post only begins to touch on the numerous factors that must be considered before implementing an estate tax reduction strategy.It is important to use experienced advisors when contemplating such plans.Steve Schermer is a founding partner of Silverman Schermer, LLC,a boutique law firm with convenient offices in Fort Lauderdale and Miami focusing in the areas of business, estate and tax planning. The experienced team at Silverman Schermer, PLLC helps high net-worth individuals, entrepreneurs, and business owners achieve their wealth-preservation goals. Contact us today at 954-314-4000 for a confidential consultation.