grats and gruts: evaluating estate planning...

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GRATs and GRUTs: Evaluating Estate Planning Options

Latest Strategies to Maximize Returns and Minimize Tax in Trust Formation

presents

Today's panel features:

Richard Franklin, Partner, Pillsbury Winthrop Shaw Pittman, McLean, Va.Mark Parthemer, Principal and Fiduciary Counsel, and Regional Manager of Legacy Planning, Bessemer Trust Co., Palm Beach, Fla.

Wednesday, October 7, 2009

The conference begins at:1 pm Eastern12 pm Central

11 am Mountain10 am Pacific

The audio portion of this conference will be accessible by telephone only. Please refer to the dial in instructions emailed to registrants to access the audio portion of the conference.

A Live 110-Minute Teleconference/Webinar with Interactive Q&A

GRATs And GRUTs: Evaluating Estate Planning Options Webinar

Oct. 7, 2009

Basic Definitions, Formations Of GRATs And Gruts

Richard Franklin, Pillsbury Winthrop Shaw [email protected]

Mark R. Parthemer, Esq., Bessemer [email protected]

Individual Assets

Individual Assets

become GRAT Assets

GRAT AssetsbecomeIndividual Assets

Remainder Beneficiary’s

Assets

Individual Assets

Prelude

GRAT Illustrated

Doe family trust(dynasty trust)

John transfers asset(s) to GRAT (but only once --no additional contributions allowed)

Remainder of GRAT, after 2 years, passes to the Doe family

trust

John

Is John alive?

Annuity paidto John. The

payments could be recycled into new

GRATs

Annuity paidto John’s

estate

Annuity payments for 2 years

No

John’s will/estate• John’s will should provide that annuity payments received by estate are paid immediately to QTIP marital trust for wife• This structure is designed to defer estate taxation until the wife’s death

GRAT Advantages:• Near-zero gift, using fixed-term GRAT• Valuation protection: Self-adjusting formula payments• John has investment risk during two-year term• “Grantor Trust”

Yes

Two-year GRAT• 2 years, flat annuity payments, near-zeroed-out gift• GRAT pays annuity for 2 years to John or his estate:

- First-year annuity is 52.4136% of the initial trust value (using 3.2% discount rate in effect in October 2009)

- Second-year annuity is also 52.4136% of the initial trust value- Taxable gift is about $1 per $1 million of funding

• John is the trustee• After 2 years, balance of GRAT paid to Doe family trust, if John is alive; otherwise

to a QTIP marital trust• Grantor trust for income tax purposes

GRAT BasicsGRAT structure• The grantor transfers property to a trust and retains an annuity

for a specified term of years• The value of the asset transferred to the GRAT is “frozen” at the

value of the annuity retained by the grantor • Future appreciation in the value of the asset transferred to the

GRAT (over the §7520 rate) will be transferred to the remainder beneficiaries of the GRAT without gift or estate tax (assuming the grantor survives the retained term of years)

GRUT BasicsGRUT structure• The grantor transfers property to a trust and retains a unitrust

payment right for a specified term of years – E.g., 50% of the FMV on 1/1 of each year for two years– Remainder gift would be 25.40% of GRUT assets

• Future appreciation in the value of the asset transferred to theGRUT will be shared between the grantor and the beneficiaries of the GRAT

• If the grantor survives the retained term of years, the remainder beneficiaries of GRAT will receive their share of appreciation without further gift or estate tax

• GRUTs are generally not used because GRATs more effectively allow the gift upon creation to be reduced to near zero

• The statutory and regulatory requirements for a GRUT generally track those applicable to a GRAT

GRAT RegsPaying the annuity• Treasury Reg. § 25.2702-3(b)(1)(i) requires that the grantor have an irrevocable

right to receive a fixed amount payable for each year of the term. A right of withdrawal is not sufficient

• The annuity must be paid at least annually. The issuance of a promissory note, other debt instrument, option or other financial arrangement, directly or indirectly, will not satisfy the annuity payment obligation. Treasury Reg. § 25.2702-3(b)(1)(i). Treasury Reg. §25.2702-3(d)(5) provides that GRAT created after 9/20/99 must prohibit the use of notes, other debt instruments, options or similar financial instruments to satisfy the annuity obligation. It may be acceptable if someone other than the grantor (such as the grantor’s spouse) lends to the trust. However, there is risk that the loan will be recharacterized as a prohibited additional contribution to the GRAT rather than as a bona fide debt

• The annuity amount may be payable based on either the anniversary date of the creation of the trust or the taxable year of the trust. In either situation, the annuity amount may be paid annually or more frequently, such as semi-annually, quarterly or monthly. Treasury Reg. § 25.2702-3(b)(3)

GRAT Regs (Cont.)Paying the annuity (Cont.)• An annuity amount payable based on the anniversary date of the

creation of the trust must be paid no later than 105 days after the anniversary date

• An annuity amount payable based on the taxable year of the trustmay be paid after the close of the taxable year, provided the payment is made no later than the date by which the trustee is required to file the federal income tax return of the trust for the taxable year (without regard to extensions)

• If the trustee reports for the taxable year pursuant to one of the alternative methods for grantor trusts (Treasury Reg. § 1.671-4(b)), the annuity payment must be made no later than the date by whichthe trustee would have been required to file the federal income tax return, Form 1041, of the trust for the taxable year (without regard to extensions) had the trustee reported under the regular method for grantor trusts (Treasury Reg. §1.671-4(a)). Treasury Reg. § 25.2702-3(b)(4)

GRAT Regs (Cont.)Paying the annuity (Cont.)• “Fixed amount” means either a dollar amount or a fraction or percentage of the

initial fair market value of the property conveyed to the trust as finally determined for gift tax purposes. Using a fraction or percentage approach mitigates the gift tax consequences of a revaluation on audit of a gift tax return - if the value is increased, the annuity will also increase so that the increase to the remainder interest will not be adjusted by the full amount of the valuation adjustment. Treasury Reg. § 25.2702-3(b)(1)(ii). his protection against valuation adjustments for hard-to-value assets is a major reason for using GRATs

• The annuity can vary from year to year, but the annuity payable in any year cannot exceed 120% percent of the annuity paid in the preceding year. Increasing the annuity amounts produces more benefit to the remainder beneficiaries if GRAT assets appreciate more than the rate used to determine the present value of the annuity

• There is no rule forbidding a decreasing annuity schedule• Income in excess of the annuity may be paid to the grantor, but the grantor’s right

to receive excess income is not taken into account in valuing the gift. Other payments could also be retained by the grantor, such as all value over $X at the end of the term. This could be used as a device to prevent transferring too much value to the remainderman

GRAT Regs (Cont.)

Incorrect valuations• Treasury Reg. § 25.2702-3(b)(2) provides that if the annuity is stated as a

percentage of the value of property contributed to the trust, the trust instrument must require corrective payments if the amount is incorrectly determined

• This revaluation opportunity does not eliminate all valuation risks, because the revaluation right does not apply to incorrect valuations when property is used to pay the annuity in kind

• A potential consequence of overvaluing property used to satisfy an annuity is disqualification of the GRAT. The theory would be that there has been a prohibited constructive addition to the GRAT when the grantor receives less than he or she is due

Short-year proration• Treasury Reg. § 25.2702-3(b)(3) requires that the trust instrument pro-rate

the annuity for any year of less than 12 months. This would mostly apply to annuities payable based on the calendar year

GRAT Regs (Cont.)No additional contributions• Treasury Reg. § 25.2702-3(b)(4) requires that the trust instrument prohibit

additional contributions to the trust. This requirement, like the preceding ones, was imported from the charitable remainder trust regulations, where it was needed to protect the requirement in § 664 that the annuity interest be worth at least 5% of the trust assets. The requirement serves no purpose in the context of a GRAT. Nevertheless, because the statute authorizes the IRS to write the rules for a GRAT, the rule is probably valid.

• The rule prohibiting additions has significance in determining whether to require that the GRAT reimburse the grantor for income tax on income accruing to the trust

• Consider whether this rule also could be a problem if a related person loans cash to the GRAT to finance payment of an annuity

• A grantor’s failure to enforce his or her right to receive the “correct” amount of property in satisfaction of the annuity could be viewed as a constructive addition

Pay only the annuitant during the term • Treasury Reg. § 25.2702-3(d)(2) requires that the governing instrument prohibit

distributions to anyone other than the grantor. This rule is reasonable, because it protects the annuity interest retained by the grantor

1

GRATs And GRUTs: Evaluating Estate Planning Options Webinar

Oct. 7, 2009

Tax Consequences

Richard Franklin, Pillsbury Winthrop Shaw [email protected]

2

Gift TaxGift of remainder

A grantor’s transfer to a GRAT is reduced by the present value of the annuity, computed using the § 7520 discount rate then in effect, but only if the GRAT satisfies the requirements of Treasury Reg. § 25.2702-3

If the requirements of the regulations are not met, and if the trust remainder benefits members of the grantor’s family, the retainedannuity is valued at zero. This valuation rule means that the value of the annuity will be taxed twice; once when the trust is funded (because the annuity is valued at zero) and a second time when the assets received in payment of the annuity are transferred bygift or at death. See Treasury Reg. §20.2702-6 for mitigation provisions

3

Gift Tax (Cont.)Walton GRATs Prior to the Walton decision, Treasury Reg. § 25.2702-3(e), Example 5

provided that the annuity must be valued as the present value of the grantor’s right to receive the annuity for a period equal to the specified term of years or his earlier death

Example 5 was found to be invalid in Walton v. Comm’r, 115 T.C. 589 (2000). In Walton, the grantor established a GRAT, pursuant to which the grantor was to receive an annuity for a term of two years. If the grantor died before the expiration of the two-year term, the annuity was to be paid to the grantor’s estate for the balance of the term. Upon expiration of the two-year term, the trust corpus was to be distributed to a designated remainder beneficiary. After considering the legislative history and purpose of § 2702, the court held that Example 5 is an unreasonable interpretation and invalid extension of section 2702. The court concluded that a retained annuity payable for a specified term of years to the grantor, or to the grantor’s estate if the grantor dies prior to expiration of the term, is a qualified interest under Sect. 2702 for the specified term of years

4

Gift Tax (Cont.)Walton GRATs (Cont.) In Notice 2003-72, the IRS announced that it will follow the Tax Court’s decision in

Walton holding that Sect. 25.2702-3(e), Example 5 is invalid In new proposed regulations issued July 23, 2004, the government revised Example 5

and 6 as follows (revised language in italics): Example 5. A transfers property to an irrevocable trust, retaining the right to

receive 5 percent of the net fair market value of the trust property, valued annually, for 10 years. If A dies within the 10-year term, the unitrust amount is to be paid to A’s estate for the balance of the term. The interest of A (and A’s estate) to receive the unitrust amount for the specified term of 10 years in all events is a qualified unitrust interest for a term of 10 years.

Example 6. The facts are the same as in Example 5, except that if A dies within the 10-year term the unitrust amount will be paid to A’s estate for an additional 35 years. As in Example 5, the interest of A (and A’s estate) to receive the unitrust amount for a specified term of 10 years in all events is a qualified unitrust interest for a term of 10 years. However, the right of A’s estate to continue to receive the unitrust amount after the expiration of the 10-year term if A dies within that 10-year period is not fixed and ascertainable at the creation of the interest and is not a qualified unitrust interest.

5

Gift Tax (Cont.)Walton GRATs (Cont.)

Walton GRATs are the most advantageous, because it is now certain that they allow the gift to be determined based on an absolute term of years, thereby allowing the reminder gift to be reduced to near zero

Based on the October 2009 §7520 rate of 3.2%, the following table illustrates the percentage payouts needed to reduce the remainder gift to approximately $1 in a Walton GRAT funded with $1 million of assets with terms of two to six years (assuming annual payments at the end of the year):

11.4147318.582166

14.9235821.960155

20.2868427.031394

31.3725235.488643

47.7167052.413602

INCREASING PERCENTAGE

PAYMENTS @ 20% (first year percentage shown)

LEVEL PERCENTAGE PAYMENTS

TERM OF YEARS

6

Gift Tax (Cont.)Annuity as a percentage of GRAT assets The annuity may be expressed as a percentage of the value of the assets

transferred to the GRAT This is a well-settled method of providing protection against a large gift tax

deficiency, if values are adjusted on audit. This is a significant advantage of GRATs over the sale to a defective grantor trust

Example: Susan has a 60% limited partnership interest in a family limited partner-ship that owns an apartment building worth $10 million. Susan would like to transfer her interest to a trust for her children and more remote descendants. Susan has an appraisal that values her 60% limited partnership interest at $3 million. Thus, the appraiser is applying a 50% discount to the net asset value of Susan’s partnership interest. This discount is attributed to the lack of marketability and lack of control of Susan’s interest. Susan has limited resources to pay gift tax deficiencies and asks for protection that her appraisal will be respected

7

Gift Tax (Cont.)

Example (Cont.) Formula clauses in a GRAT to provide protection against a valuation dispute

is beyond question However, the problem with a GRAT is that the annuity must be paid at least

as often as annually. If Susan conveyed her partnership interest to a short-term GRAT, cash flow from the building would not be sufficient to timely pay the projected annuity

The alternative of annually appraising her limited partnership interest to pay the annuity in kind is expensive and inconvenient. In addition, the partnership interest paid in kind to Susan will suffer the same discount used on funding the GRAT

Susan’s sale of her annuity to the remainder trust/beneficiary of the GRAT may alleviate the cash flow problem

8

Gift Tax (Cont.)

Zeroed-out GRATs

Structure the GRAT to produce a minimal gift tax value If the property declines in value, the grantor will not have used much

unified credit or paid much gift tax, for value that was not “realized” by the donees

The risk of depreciation is borne substantially by the grantor if the gift value is nominal, and the benefit of appreciation is enjoyed entirely by remainder beneficiaries

It is also suggested that one should not completely zero out the GRAT. There should be some gift element so that you have a grantor trust (because there has been a gratuitous transfer to the trust) and so that you can argue that the Proctor case does not apply

9

Gift Tax (Cont.)

Adjusted taxable gifts/split gift election Sect. 2001(b)(2) reduces the grantor’s adjusted taxable gifts by the gift

attributable to the GRAT, to the extent it is included in the gross estate of the grantor

If the grantor and his spouse elected to split gifts to the GRAT under § 2513, the spouse’s adjusted taxable gifts will not be similarly reduced. Therefore, for gift tax planning (a different rules applies for GST purposes), it is not a good idea to make an election to split gifts in the year a GRAT is funded; provided, however, with a zeroed-out GRAT the potential downside is negligible

If other gifts to be made in the same year are intended to be split gifts, the GRAT can be disqualified from the split gift election by giving the spouse a discretionary beneficial interest in the GRAT after the retained term expires

10

Gift Tax (Cont.)

Should the grantor retain a contingent reversion or contingent GPOA? Such a retained contingent reversion or contingent GPOA is not a qualified

interest and it has no value for purposes of determining the remainder gift. If the grantor dies during the term of the GRAT, all or part of the GRAT will be included in the grantor’s estate. Therefore, if the GRAT will be included in the estate anyway, why not retain the contingent reversion, contingent general power of appointment, or contingent special power of appointment for flexibility sake?

Retaining a continent reversion or power of appointment is helpful if the grantor is married. It would allow for qualification of the GRAT payments and remainder for the marital deduction, if the grantor dies during the retained term. But if the grantor is not married, this is not a concern and the grantor does not necessarily need the right. For example, the facts of the Walton decision reflect no such contingent right in the grantor

11

Gift Tax (Cont.)Retained special vs. general power of appointment Additionally, the grantor could retain a contingent special power of

appointment over the GRAT (or the included part thereof) if death occurs during the term as distinct from a contingent general power of appointment. The contingent general power or reversion offers nothing that a broad special power would not also offer (except if the grantor would want to use the trust assets to pay debts and expenses). That is, with a Walton GRAT, the contingent power is not adding to the retained value. A contingent special power of appointment could be exercised to qualify the trust assets for the marital deduction or otherwise pass the property to anyone the grantor wants to benefit (again other than a creditor)

Whether using a contingent special power of appointment or no such retained right, the tax apportionment statutes will provide a right to recover estate taxes as needed (assuming the right is not waived). The GRAT assets, however, would not be available to pay debts and expenses without such a retained right, which in most cases will not be a concern. Not retaining any such right does forgo some flexibility as compared to retaining a contingent special power of appointment

12

Gift Tax (Cont.)

Planning in contemplation of possible legislative changes Proposals have been suggested to require a 10% remainder interest or a 10-

year retained term. If such a proposal is passed with a retroactive effective date to a time prior to establishing a GRAT, the GRAT may be invalid or result in a significantly larger taxable gift Disclaimer. The remainder beneficiary could disclaim the remainder

beneficiary’s interest in the GRAT within nine months of creation. This is useful if the remainder interest would revert to the grantor resulting in a merger

Formula approach. The GRAT could use a formula approach that defines the term of the GRAT as X years or, if more, the minimum number of years needed to be a qualified GRAT. Additionally, the GRAT could use a formula to define the annuity amount as X% of the initial fair market value of the assets or, if greater, the needed percentage to produce the minimum taxable gift allowable

13

Gift Tax (Cont.)

Planning to protect against incomplete or incorrect annuity payments

Use a clause in the GRAT that provides: If any portion of an annuity is not paid or not fully paid upon the annuity payment date, the GRAT shall terminate as to a fractional share equal to amount of said deficiency over the value of the GRAT on the annuity payment date

14

Estate TaxEstate inclusion for death during the retained term Old rules The IRS has taken the view that the entire amount of the trust is included under

§2039. PLRs 9451056 (9/26/94); 9448018 (8/30/94); 9345035 (8/13/93) However, under §2036 and Rev. Rul. 82-105, 1982-1 C.B. 133, an argument can be

made that the amount includable may be less: The amount necessary to produce income sufficient to pay the annuity under the date-of-death § 7520 interest rate

The argument that less than all of the GRAT is includable based on Rev. Rul. 82-105 would not have been available if the grantor retained a contingent right of reversion or power of appointment as to the entire GRAT. The grantor’s contingent reversion could have been limited to that portion of the GRAT which is includable in the grantor’s estate, so that he or she could qualify that portion of the trust for the marital deduction if death occurs during the term of the trust. The remaining portion can be excluded from the grantor’s estate under Rev. Rul. 82-105

If the annuity is payable to the grantor’s estate, the present value of the annuity payable to the estate is includable under § 2033 as an asset of the estate. Unless an adjustment is made to the amount includable under §§ 2036 or 2039, however, there will be double-counting

15

Estate Tax (Cont.)

Estate inclusion for death during the retained term

New rules

Treasury Reg. § 20.2036-1(c)(2)(i): “The portion of the trust's corpus includible in the decedent's gross estate for Federal estate tax purposes is that portion of the trust corpus necessary to provide the decedent's retained use or retained annuity, unitrust, or other payment (without reducing or invading principal) as determined in accordance with §20.2031-7 (or §20.2031-7A, if applicable). The portion of the trust's corpus includible in the decedent's gross estate under section 2036, however, shall not exceed the fair market value of the trust's corpus at the decedent's date of death.”

Notice of proposed rulemaking, Fed. Reg. Vol. 74, No. 82 p. 19913. 4/30/2009: Provides the method to be used to determine the includible part in the case of a graduated GRAT. Prop. Reg. § 20.2036-1(c)(2)(ii)

16

Estate Tax (Cont.)Estate inclusion for death during the retained term

New rules - illustrated

$5,806,925.00 $185,822 18.582166

$6,862,546.88 $219,602 21.960155

$8,447,309.38 $270,314 27.031394

$11,090,200.00 $354,886 35.488643

$16,379,250.00 $524,136 52.413602

AMOUNT INCLUDIBLE –SMALLER OF THEN TRUST VALUE OR

CORRESPONDING ANNUITY PAYMENTS FOR

$1 MILLION GRAT

LEVEL ANNUITY PERCENTAGES

TERM OF YEARS

17

Estate Tax (Cont.)

Controlled corporations and Sect. 2036(b) If the grantor acts as trustee and the GRAT owns stock of “controlled

corporation” §2036(b) may pull the GRAT into the taxable estate IRC § 2036(b)(2) treats a corporation as “a controlled corporation if, at

any time after the transfer of the property and during the 3-year period ending on the date of the decedent's death, the decedent owned (with the application of section 318), or had the right (either alone or in conjunction with any person) to vote, stock possessing at least 20 percent of the total combined voting power of all classes of stock.”

The concern is that if the grantor dies after the retained term, when the GRAT assets would normally be excluded from the grantor’s estate, whether §2036(b) could cause inclusion. The three-year period of Sect. 2035 would apply to the relinquishment or cessation of such voting rights. IRC § 2036(b)(3)

18

Estate Tax (Cont.)

Controlled corporations and Sect. 2036(b)

In a longer-term GRAT, the grantor as trustee should not have the power to vote the stock of a controlled corporation during the final three years of the GRAT retained term, and the grantor should not have such power in any continuing trust. In a short-term GRAT, such a power should be completely abrogated. For example, a forms provision to eliminate any concern might read as follows: “Notwithstanding any other provision herein, the Grantor (as a Trustee or

otherwise) shall have no right or power to vote any stock or other security of a controlled corporation as defined in Section 2036(b) of the Code comprising a part of the Trust Estate or to determine whether such shares should be sold or otherwise disposed of by the Trust. Only an Independent Trustee shall vote such shares.”

19

Estate Tax (Cont.)Marital deduction concerns - QTIP trust for Walton GRATs If the grantor of a Walton GRAT is married, planning to obtain the marital

deduction for the GRAT assets is critical, in the event of the grantor’s death during the retained term

Greater of annuity or income. Following the grantor’s death, during the retained term, the GRAT will need to pay the greater of the income or the annuity payment to the estate of the grantor. The grantor’s will should be structured to immediately distribute the annuity payments, without reduction for any expenses, to the surviving spouse

Other QTIP requirements. All requirements to obtain the QTIP marital deduction need to be applicable following the grantor’s death. For example, the spouse should have the power to force the trustee to make any unproductive assets productive of income and/or convert any unproductive assets to property that produces income, within a reasonable period of time. Nothing should restrict the trustee from investing the trust assets in a manner that could result in the realization of a reasonable amount of income or gain from the sale or disposition of trust assets

20

Estate Tax (Cont.)Marital deduction concerns - QTIP trust for Walton GRATs Remainder qualification for QTIP. The remainder interest in the GRAT

needs to pass in a manner that qualifies for the marital deduction. For example, the remainder interest could pass directly to the a QTIP trust for the spouse, or the grantor’s retained contingent power of appointment over the included part of the GRAT principal could be exercised to send the remainder to a QTIP trust for the spouse

A concern has been expressed that if both the remaining annuity payments and remainder pass to the spouse outright, a merger may occur, and such possibility could affect the valuation of the retained interests by the grantor upon establishing the GRAT. Assuming that both interests are not payable to the estate of the grantor, that concern seems unwarranted. Consider again the situation in which the remaining annuity payments are going through the estate, and the remainder interest is passing directly to the spouse or reaching the spouse by virtue of an exercise of a power of appointment. When the GRAT is initially established, there is no certainty that both interests will pass to the spouse. The distribution of the estate could be changed, as could the exercise of any power of appointment

21

Estate Tax (Cont.)

Marital deduction concerns - QTIP trust for Walton GRATs

Regulations on non-deductible terminable interest. Typically, annuity payments that expire prior to the spouse’s death would be classified as a non-deductible terminable interest. Treasury Reg. § 20.2056(b)-1(b). However, if the remainder of the GRAT passes to the spouse in a manner that qualifies for the marital deduction, the annuity payments are not a non-deductible terminable interest. Treasury Reg. § 20.2056(b)-1(e)(4) provides that the rules under § 20.2056(c)-1 through § 20.2056(c)-3 determine whether an interest has passed from the decedent to the spouse. See Treasury Reg. § 20.2056(c)-2(6) (“where a property interest passed from the decedent in trust, such interest is considered to have passed from him to his surviving spouse to the extent of her beneficial interest therein.”).

22

Estate Tax (Cont.)

Marital deduction concerns - QTIP trust for Walton GRATs Merger approach: Paying the remaining annuity payment from the estate to the

spouse and having the remainder interest paid to a QTIP trust is questionable as a non-deductible terminable interest. An alternative suggestion is to have both interests payable to a QTIP trust and plan for a merger, so as to ensure there is not a non-deductible terminable interest (i.e., ensure it’s OK)

Spouse/estate approach: Another suggested alternative is to simply have the remaining annuity payments distributed from the estate to the spouse, and have the GRAT provide that the remainder will pass outright to the spouse or to the spouse’s estate, if the spouse survives the grantor but not the term. There is no non-deductible terminable interest, because all interests pass to the spouse or the spouse’s estate (like the estate trust approach). Under this approach, it would be unnecessary to effect a QTIP election or all the other requirements under the QTIP approach

23

GST Tax

ETIP rules The ETIP rules of Code § 2642(f) limit a taxpayer’s right to allocate GST tax

exemption to GRATs. In effect, transfers to GRATs are complete for gift tax purposes and “leverage” the gift by allowing a retained interest to be subtracted in computing the taxable gift. But, such transfers are incomplete for GST tax purposes Allocation after the ETIP ends – Exceptional method of using GST

exemption without incurring gift tax One method for dealing with the special GST tax problems presented by

GRATs is to make an assignment of GST tax exemption in the year the ETIP ends, followed by a qualified severance. For this purpose, note that that the rule allowing qualified severances is scheduled to sunset along with the rest of EGTRRA after Dec. 31, 2010

With GRATs, calendar the termination of the ETIP period for review of the GST allocation issue

24

GST Tax (Cont.)

Per capita distribution to non-skips

Another method for dealing with the ETIP problem is to make only non-skip persons (e.g. the grantor’s children) beneficiaries of the remainder in the GRAT, and to make a compensating gift or bequest to the descendants of any child who does not survive until the remainder vests

If the predeceased ancestor exception in Code § 2651(e) becomes applicable during the donor’s lifetime, a compensating gift or bequest can be made to the children of a deceased child, who would be assigned to the generation of their deceased parent, without incurring GST tax. This assumes, of course, that the donor has sufficient assets to make an adjusting gift or bequest, and non-skip beneficiaries are living to take the remainder interest

25

GST Tax (Cont.)

Mechanics of allocation after ETIP If GST exemption is allocated to property subject to an ETIP, this allocation

cannot be revoked. However, the allocation is not effective before the ETIP terminates. Treasury Reg. § 26.2632-1(c)(1). A “timely” allocation to property that had been subject to an ETIP is made by reporting the allocation on a gift tax return filed by the due date that would have applied to a gift tax return reporting a gift made at the time of the ETIP termination

Importantly, the automatic allocation rules do apply to indirect skips subject to the ETIP rules. However, the automatic allocation is deemed to have been made only at the close of the ETIP. Thus, grantors of property subject to an ETIP would have to opt out, if desired

The election out of automatic allocation for a trust that is subject to the ETIP rule may be made on the gift tax return filed for the year the trust is established – i.e., waiting until the year in which the ETIP ends is not required. Treasury Reg. § 26.2632-1(c)(5), Example 5

26

GST Tax (Cont.)Reversion to estate to avoid GST If the assets revert to the grantor’s estate, a distribution on a per stirpes basis

is unlikely to cause GST tax to be due. Even if a child is deceased and assets pass to the deceased child’s children, the pre-deceased ancestor exception in Code § 2651(e) should shelter the disposition from GST tax by assigning the deceased child’s children to the deceased child’s generation

However if the assets do not revert to the grantor’s estate, as would typically be the case in a Walton-style fixed term GRAT, the pre-deceased ancestor exception will not apply. The pre-deceased ancestor exception is applicable only if the ancestor is deceased at the time of the first taxable transfer from which the interest passing to the donee derives Example: John creates a five-year, Walton-style GRAT. If John dies

during the GRAT, the remaining annuity payments are payable to John’s estate for the balance of the term of the annuity. The remainder factor is near zero. John’s child, Charles, dies in the third year of the term. John dies in the fourth year of the term. The remainder beneficiaries are Charles’ children. Charles’ children do not qualify for the pre-deceased ancestor exception, because Charles was living at the time of the first transfer that was subject to tax under chapter 11 or 12

27

GST Tax (Cont.)Sell the remainder interest If the remainder beneficiaries have vested and transferable remainders and

sell or gift their remainder interests to other persons, who may be skip persons with respect to the original donor, the “transferor” of the remainder (for GST tax purposes) should be the remainder beneficiaries and not the original donor. But, the IRS may not agree, as discussed below

The GST tax regulations do not discuss the GST tax treatment of assignments or transfers of trust interests, except in Example 4 of Treasury Reg. § 26.2652-1(a)(5) involving the transfer of an income interest, which is not particularly helpful

The example, which is quoted below, is susceptible to several interpretations Example. T transfers $100,000 to a trust providing that all of the net

income is to be paid to T’s child, C, for C’s lifetime. At C’s death, the trust property is to be paid to T’s grandchild. C transfers the income interest to X, an unrelated party, in a transfer that is a completed transfer for federal gift tax purposes. Because C’s transfer is a transfer of a term interest in the trust that does not affect the rights of other parties with respect to the trust property, T remains the transferor with respect to the trust

28

GST Tax (Cont.)Sell the remainder interest (Cont.) If the child is the transferor of the remainder interest for GST purposes, as the plain

words of Code § 2652(a) state, there has not been a generation-skipping transfer because the transferor’s children are not skip persons as to the transferor. This is the correct conclusion, because the child’s transfer does not violate the principle of the Code that there be a transfer tax at each generation. There is no estate depletion if the value of the remainder is actuarially sound. See, Wheeler v. United States, 116 F.3d 749 (5th Cir. 1997) (decedent’s sale of his remainder interest in a ranch in 1984 to his sons for its actuarial value calculated by the appropriate factor set forth in then applicable Treasury Regulations constitutes adequate and full consideration for purposes of Code § 2036)

On the other hand, if the grantor of the trust is considered to be the transferor for GST purposes, then a generation-skipping transfer will occur when the GRAT term expires

If the child sells, rather than gifts, the remainder, the consideration necessary to avoid gift tax should be based on the actuarial value of the remainder at the time the sale is made, using applicable gift tax valuation principles. If one assumes that the actuarial tables are correct, the parties should be in the same economic position as if the transferor made a sale of any other property that was invested and appreciated at the same rate as the GRAT assets

29

GST Tax (Cont.)Sell the remainder interest (Cont.) The IRS ruled that where the remainder beneficiary of a charitable lead annuity trust

(CLAT) makes a gift of his remainder interest, the remainder beneficiary is the transferor for GST purposes only to the extent of the percentage that the value of the remainder interest bears to the value of the trust at the time of the beneficiary’s transfer, and that the original grantor remains the transferor as to the balance. PLR 200107015. The analysis in this ruling relies solely on the policy behind Code § 2642(e). As explained previously, Code § 2642(e) provides specific rules for the assignment of GST tax exemption to a CLAT. Admittedly the scheme of Code § 2642(e) would be circumvented if remainder beneficiaries could transfer their remainder interests and assign GST exemption to the property using the discounted value of the remainder at the time of the assignment. However, the statutory analysis for the conclusion in the ruling is flawed. Treasury Reg. § 26.2652-1 defines the transferor for GST purposes as the individual with respect to whom property was most recently subject to federal estate or gift tax. That person was the remainder beneficiary

The holding in PLR 200107015 was based on Code § 2642(e). The application of this ruling to other types of trusts, such as GRATs, is uncertain. Although Code § 2642(f) prevents the assignment of GST exemption to property during the period that would be includable in the transferor’s estate, it is not clear that the purpose of the ETIP rule is to prevent leveraging of the GST exemption. Code § 2642(f) applies even where there is no leveraging. For example, an interest that would cause inclusion in the estate under Code § 2036, such as a power to control beneficial enjoyment, does not cause any leveraging of the GST exemption but nevertheless prevents assignment of GST tax exemption

30

GST Tax (Cont.)Sell the remainder interest (Cont.) In addition, the Service’s position could be avoided if a taxpayer were to reverse the

transfer of the remainder interest shortly before the term expires If the identity of the holder of the remainder interest at the term interest’s conclusion

determines whether a GST transfer occurs at that time, then a purchase of a remainder interest also could be used to avoid a GST transfer at the end of a GRAT if the remainder beneficiary is a skip person. A GST transfer may be avoided if a non-skip person purchases the remainder interest from a remainder beneficiary who is a skip person before the remainder interest vests

If a non-skip remainder beneficiary transfers the remainder interest by gift or sale to a trust (the “remainder trust”), which is a non-skip person because it has both skip and non-skip persons as beneficiaries, a taxable termination is avoided at the end of the GRAT term regardless of the identity of the transferor for GST tax purposes. Even if the transfer is not effective to change the transferor, GST tax could be deferred by postponing distributions until the GST tax was repealed or using a qualified severance, as discussed above. If the grantor of the remainder trust timely allocates GST exemption to the trust equal to his or her gift to the trust, the trust will have a zero inclusion ratio. A person who sells property to the trust is not a transferor for GST tax purposes, because there is no gift and no addition to the trust. Moreover, the inclusion ratio is not changed unless additions are made to the trust

31

GST Tax (Cont.)Sell the remainder interest (Cont.) For transfers of remainders to be possible, the remainder beneficiaries must

have interests that are assignable. If a transfer of a remainder is contemplated, spendthrift clauses should be modified to allow assignments of beneficial interests. Even if there is a spendthrift clause that prevents an assignment of the remainder interest, the remainder beneficiary could enter into a contract with a generation-skipping trust promising to convey an amount equal to the value of the remainder interest at the end of the term of the GRAT, which achieves the same economic result. See David A. Handler & Steven J. Oshins, GRAT Remainder Sale to a Dynasty Trust, Tr. & Est., December, 1999, at 33

If the remainder beneficiary is a trust rather than an individual, the trustee of the remainder trust may be given the power to sell the trust’s remainder interest to another person or trust. However, this may not be as effective as a gift or sale of a remainder interest by an individual beneficiary. The Service may apply a substance-over-form or step-transaction theory to disregard the conveyance from one trust to the other. Although the same arguments could apply to a transfer made by an individual remainder beneficiary, the trust-to-trust transfer appears more vulnerable

32

GST Tax (Cont.)Split gift election The rules governing gift-splitting for gift tax purposes under Code §2513

differ from the rules governing gift-splitting for GST tax purposes under Code §2652(a)(2). This difference in gift-splitting rules may be of particular use with respect to gifts that have an ETIP period, such as GRATs

Gift-splitting for GST purposes of such trusts may be quite useful in order to allow allocation of both spouses’ GST exemptions to what may be a significant value for the trust at the end of the ETIP period. Additionally, if one is using a Walton-style GRAT having a near-zero remainder value, any potential loss of the applicable gift exclusion amount is minimized

For gift tax purposes, gifts to a spouse, including interests in trusts, cannot be gift-split, although a gift to a spouse of an interest in a trust that is ascertainable in value at the time of the gift may be severed from the other trust interests, permitting the remaining trust interests to be gift split. Treasury Reg. §25.2513-1(b)(4). On the other hand, for GST tax purposes, Treasury Reg. §26.2652-1(a)(4) provides that the electing spouse is treated as the transferor of one-half the property transferred, “regardless of the interest the electing spouse is actually deemed to have transferred under section 2513”

33

GST Tax (Cont.)

Split gift election (Cont.) In PLR 200218001, husband made gifts in trust which provided that the

trustees had the right to make distributions among wife, the child, child’s descendants and surviving spouses of child’s descendants for health, support, maintenance or education. Wife consented to gift split

The PLR first rules that for gift tax purposes, because the trustee’s distributing power was subject to an ascertainable standard, wife’s interest in the trust was severable. Hence, the gift to the trust to the extent not attributable to the wife’s interest was eligible for gift-splitting

Nevertheless, the ruling goes on to hold that for GST tax purposes, because of Treasury Reg. §26.2652-1(a)(4), wife and husband will each be treated as the transferor of half of the gifts to the trust, despite the fact that the split is not 50-50 for gift tax purposes

34

GST Tax (Cont.)Split gift election (Cont.) It is unclear whether a gift must be eligible for splitting under Sect. 2513 before the non-donor

spouse will be treated for GST purposes as a transferor of one half of the property. Treasury Reg. Sect. 26.2652-1(a)(4) provides that the electing spouse will be treated as such a transferor “in the case of a transfer with respect to which the donor’s spouse makes an election under section 2513.” Arguably, this regulation could be read to allow a split for allocation of GST exemption purposes, regardless of whether the gift may be split for gift tax purposes. If so, it would be possible to use the electing spouse’s GST exemption without using his or her gift tax exemption

For example, the non-donor spouse could elect to split the donor’s gift to a GRAT, provided that the non-donor spouse would enjoy a discretionary interest in trust property following the retained term. Gift-splitting under Sect. 2513 would not be permitted in this case, because the non-donor spouse’s interest would not be ascertainable and severable as described in Treasury Reg. Sect. 25.2513-1(b)(4). However, under the reading of Sect. 26.2652-1(a)(4) suggested above, an election could be made to treat the “electing” spouse as the transferor of one-half of the donor spouse’s gift

Assuming this is not the case, and that the gift must qualify for gift splitting under Sect. 2513 before the non-donor spouse will be treated as a one-half transferor for GST purposes, the lack of ascertainability and severability in the example above could be remedied in a number of ways. The spouse’s interest in the GRAT remainder could be limited by an ascertainable standard, as discussed in PLR 200218001 cited above; or, the spouse’s interest might be limited to some, but not all, of the remainder trust

35

GST Tax (Cont.)

Split gift election (Cont.)

How small may the ascertainable and severable interest be before it will be deemed de minimus, for purposes of permitting gift splitting under Sect. 2513?

For example, assume one spouse gives $3 million to a GRAT which,following the retained term, requires the trustee to distribute 1% of the trust’s net income to someone other than the non-donor spouse; and the balance of the trust may be distributed to the non-donor spouse in the trustee’s sole discretion. The non-donor spouse’s interest in the trust is ascertainable and severable. Under a literal reading of Sect. 26.2652-1(a)(4), because a 2513 election with respect to the gift is made, the non-donor spouse will be treated as a transferor of one-half of the entire gift and may allocate GST exemption to one-half of the trust at the close of the ETIP

36

Income TaxWhy grantor trust treatment is important Grantor trust status is desirable for a GRAT, both during and after the term

of the annuity, for the following reasons: In-kind distributions don’t trigger gain. Payment of the annuity

obligation in kind will not result in recognition of gain. Cf., Rev. Rul. 68-392, 1968-2 C.B. 284 (distribution of appreciated property in payment of annuity from a non-grantor trust is treated as if the trustee sold the property for cash and distributed the cash in satisfaction of the annuity obligation); Rev. Rul. 85-13, 1985-1 C.B. 184 (exchanges between grantor and grantor trust are not taxable, because grantor is deemed to own property held in a grantor trust); PLRs 9736028 and 9736029 (6/9/97); 9735034 (6/2/97); 9707005 (11/6/96); 9352017 (9/30/93); 9352007 (9/28/93); 9351005 (9/16/93); 9239015 (6/25/92)(finding no gain recognized when annuity is satisfied with appreciated property owned by a grantor trust of which the annuitant is the owner)

S corporation shareholder. The GRAT will be qualified to hold stock in an S corporation, which is an asset particularly suitable for ownership by a GRAT

37

Income Tax (Cont.)Why grantor trust treatment is important (Cont.)

Liabilities in excess of basis. Contributions to the GRAT of property subject to liabilities in excess of basis (e.g., a partnership interest) will not cause income to be realized upon contribution to the GRAT

Loans ignored. Loans between a grantor and a grantor trust do not give rise to taxable income

Grantor’s substitution of assets is ignored. The grantor’s reacquisition of appreciated trust assets and in exchange for higher basis assets can be achieved tax-free. The ability to reacquire and substitute assets without triggering gain has many benefits. For example, a grantor may reacquire assets tax-free to make his estate eligible for a § 6166 election to defer payment of estate tax attributable to closely held business interests. Also, the reacquired assets will obtain a basis adjustment under § 1014 if held by the grantor at the time of his death

Enhanced GRAT return. If the grantor pays income tax on income accruing to the GRAT, it increases the probability that the yield on the assets held in the GRAT will exceed the § 7520 rate used to value the gift to the remainder beneficiaries, so that the arrangement will generate the intended gift tax advantages. Following the expiration of the annuity, the grantor’s payment of income tax continues to increase the trust’s yield on its investments

38

Income Tax (Cont.)Grantor trust triggers A GRAT is a grantor trust under § 677(a)(1) because the grantor has retained the right

to an annuity payable from income or principal. PLRs 9451056 (9/26/94); 9449013 (9/9/94); 9449012 (9/9/94); 9448018 (8/30/94); 9504021 (10/28/94).

However, if §677 is the only basis for grantor trust classification, the IRS could treat the grantor as the owner of only a portion of the trust. For example, if the annuity amount is less than the §7520 amount, the IRS could treat the grantor as the owner of only the income portion and not the principal portion of the trust. Therefore, for the reasons stated above, it is a good idea to include another provision to make the trust a grantor trust as to the entire trust. In the context of a GRAT, some of the more common ways to achieve wholly grantor trust status include (i) a §675(4)(C) power in the grantor to reacquire the trust assets by substituting other assets of equivalent value, (ii) a §675(2) power in the grantor or nonadverse person to borrow from the trust without adequate security, (iii) a §677(a) power to make distributions to the spouse as a beneficiary in a continuing trust after the retained term, and (iv) if the grantor’s contingent reversionary interest (the reversion to the grantor’s estate if the grantor dies during the term of the annuity) is worth more than 5% of the value of the trust, the grantor will be treated under §673 as the owner of both ordinary income and corpus

New CLT forms – Power of substitution See Harrison, Planning with Grantor Trusts, 40th Annual Advanced ALI-ABA

Summer Program, University of Wisconsin Law School, Madison (June 21, 2004)

39

Income Tax (Cont.)Revenue Ruling 2004-64 (July 6, 2004) This Revenue Ruling addresses the gift tax consequences of a grantor trust when the

grantor pays the income tax on the trust’s income. It also addresses the estate tax consequences if, pursuant to the governing instrument or applicable local law, the grantor may or must be reimbursed by the trust for that income tax

No right of reimbursement rule: Assuming that neither the trust instrument nor local law requires or permits reimbursement for such taxes, the ruling held that (i) when the grantor pays the income taxes it is not considered a gift to the beneficiaries, but rather a legal obligation of the grantor under Sect. 671; and (ii) no estate tax inclusion results under § 2036, because the grantor will not have retained the right to have trust property expended in discharge of the grantor’s legal obligation

Right of reimbursement rule: If the trust instrument or applicable state law requires the trust to reimburse the grantor for taxes paid, the ruling held that there is no gift tax implication to either the grantor’s payment of the tax or the trust’s reimbursement to the grantor for the taxes. However, the full value of the trust's assets is includible in the grantor's gross estate under §2036(a)(1), since the grantor has retained the right to have the trust pay his or her obligations

40

Income Tax (Cont.)Revenue Ruling 2004-64, July 6, 2004 (Cont.)

Discretionary reimbursement rule: If reimbursement is at the discretion of the trustee, the ruling held that there is no gift tax implication to either the grantor’s payment of the tax or the trust’s reimbursement to the grantor for the taxes. Furthermore, the value of the trust’s assets is not necessarily included in the grantor’s estate. To avoid inclusion, the discretionary reimbursement clause must be drafted in a manner that ensures it is discretionary, and there must be no evidence of an implied agreement to reimburse

Effective date. This ruling states that the Service will not adversely apply the estate tax holding under the Right of Reimbursement Rule (situation #2 in the ruling) if the trust is created before Oct. 4, 2004. Otherwise, the ruling does not provide effective date rules

41

Income Tax (Cont.)

Issues with Revenue Ruling 2004-64

One concern arising from this ruling is the potential of the grantor’s creditors accessing the trust’s assets, when the grantor has a right of reimbursement or there is a discretionary right of reimbursement

One potential solution is to include a provision allowing for a discretionary payment of taxes, rather than a discretionary reimbursement of taxes paid, thereby exposing the trust’s assets only to the tax service

Another way to avoid this issue is to avoid the entire reimbursement provision by making the grantor’s spouse a discretionary beneficiary. Doing so would allow a distribution to be made to the spouse and used to pay the taxes. However, this course of action would not be beneficial in all cases, and the benefit would be lost if the spouse were to pre-decease the grantor

42

Income Tax (Cont.)

Issues with Revenue Ruling 2004-64 (Cont.)

Clients should further be advised that as a consequence of this ruling, there is an increased likelihood of auditing, as the Service may look for “implied agreements” to pay the taxes when there are discretionary provisions in an attempt to include the trust’s assets in the grantor’s estate

The IRS has previously said that it will not issue a favorable ruling on a GRAT unless the trust requires that the grantor be reimbursed for income tax attributable to trust income. PLR 9709001 (2/28/97). Given the holding in Rev. Rul. 2004-64, it would seem questionable for the IRS to continue this ruling position

43

Income Tax (Cont.)Planning considerations with Revenue Ruling 2004-64 Given the holding in Rev. Rul. 2004-64, if a GRAT is not required to

reimburse the grantor for income taxes, there should be no risk that the IRS will view the trust as permitting constructive additions that could disqualify the GRAT

In the context of a GRAT, including a discretionary right of reimbursement seems unwarranted in most cases. Where the annuity percentage is high, as for a short-term GRAT, the tax reimbursement clause is not likely to have any practical effect. he trust is not likely to have income in excess of the annuity amount. If the trust would continue beyond the term as a grantor trust, perhaps consider including the ability to turn off grantor trust status

As noted above, the tax-free growth of the GRAT’s assets afforded by the grantor’s payment of tax is generally an intended consequence. In some cases, however, it is a good idea to permit reimbursement of the grantor for taxes on trust income, in case the tax burden of paying taxes on income accruing to the trust becomes too great. This is more likely where the trust owns an interest in an S corporation, partnership or LLC

Strategies for maximizing benefits

Mark R. Parthemer, Esq., Bessemer Trust

[email protected]

GRATs And Gruts: Evaluating Estate Planning Options Webinar

Oct. 7, 2009

2

Strategies For Maximizing Benefits

1. Portfolio GRATs: Structure and manage to capture volatility

2. Use to repay family loans

3. Add bonds or publicly traded stocks if GRAT includes hard-to-value or illiquid assets

4. Lengthen the term for high-income-producing assets.

5. Derivatives for added horsepower

3

Understand What Traditionally Makes The Portfolio GRAT Technique Effective

All value returns to grantor

3%4%

Return to grantor**

* The hypothetical examples included in this presentation are for illustration only and are not projections of future returns, tax rates or exemption amounts.** The hypothetical examples included in this presentation assume an Internal Revenue Code §7520 rate of 4.0%.

“Hypothetical” one-year, 4% GRAT with 3% return*

4

We Focused On Return

6%

4%

Return To Grantor

Transfer to next generation

4%

10%


“Hypothetical” one-year, 4%* GRAT with 10% return**

5

Integrating Estate Planning With Investment Strategies

The secret to portfolio GRATs: Capture volatility, not return

How?

1. Portfolio GRAT architecture• Term – Optimal maturity• Annuity – Flat vs. increasing

2. Portfolio GRAT engineering• Asset selection – Diversification anathema• Substitution power – Lock-in or bailout

6

Portfolio GRAT Architecture 101 - Optimal Maturity

Value Shifted after 10 Years

0%

5%

10%

15%

20%

25%

30%

35%

40%

$-

$2,00

0,000

$4

,000,0

00

$6,00

0,000

$8

,000,0

00

$10,0

00,00

0 $1

2,000

,000

$14,0

00,00

0 $1

6,000

,000

$18,0

00,00

0 $2

0,000

,000

$25,0

00,00

0 $1

00,00

0,000

10 Year GRAT Rolling 2 Year GRATs

Return = 8%, Volatility = 20%, 7520 rate = 3.6%

7

Portfolio GRAT Architecture 201 – Flat Vs. Increasing Annuity* – Impact Of Path Dependency

Value transferred if portfolio return 4%$0

Value transferred if portfolio return 10% $2,391,390

Year

BeginningPortfolio Value

IRS AssumedReturn**

Required % Annuity

Required $Annuity

Portfolio Value

1 $10,000,000 $400,000 22.46% $2,246,271 $8,153,729

2 $8,153,729 $326,149 22.46% $2,246,271 $6,233,607

3 $6,233,607 $249,344 22.46% $2,246,271 $4,236,680

4 $4,236,680 $169,467 22.46% $2,246,271 $2,159,876

5 $2,159,876 $86,395 22.46% $2,246,271 $0


8

Portfolio GRAT Architecture 201 – Flat Vs. Increasing Annuity* – Impact Of Path Dependency

(Cont.)

Value transferred if portfolio return 4%$0

Value transferred if portfolio return 10% $2,667,746

An additional transfer of over $275,000, or 11.6%!

Year

BeginningPortfolio Value

IRS AssumedReturn**

Required % Annuity

Required $Annuity

Portfolio Value

1 $10,000,000 $400,000 15.31% $1,530,782 $8,869,218

2 $8,869,218 $354,769 18.37% $1,836,938 $7,387,049

3 $7,387,049 $295,482 22.04% $2,204,326 $5,478,206

4 $5,478,206 $219,128 26.45% $2,645,191 $3,052,143

5 $3,052,143 $122,086 31.74% $3,174,229 $0


9

Three sample growth patterns of $1,000,000 investments

Portfolio GRAT Architecture 201 — Flat Vs. Increasing Annuity — Impact Of Path Dependency (Cont.)

0

25

50

75

100

125

150

175

Day 1 Year 2 Year 3 Year 4 Year 5 End Yr 5

Steady-Eddy (10%) Beta One (20, 20, 4, 4, 4) Beta Two (-20, -20, 36, 36, 36)

$1,610,000

10

Portfolio GRAT Architecture 201 — Flat Vs. Increasing Annuity — Impact Of Path Dependency

(Cont.)

Final results

$293,481 $298,098

$0

$163,601$183,077

$71,172

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

Flat Annuity 20% Increasing

11

Portfolio GRAT Engineering 101 – Asset Selection*

Let’s consider a two-stock portfolio

Let’s recall that our IRS hurdle rate is 4%**

Company A – 10,000 shares – $50 – $5,000,000

Company B – 10,000 shares – $50 – $5,000,000

$10,000,000


12

Portfolio GRAT Engineering 101 —Assets Selection* (Cont.)

Return Ending ValueCompany A – +20% $60 6,000,000Company B – -20% $40 4,000,000

10,000,000

Minimum annuity to grantor** 10,400,000Amount transferred to next generation – 0 –


13

Portfolio GRAT Engineering 101

GRAT 1:

Company A +20% $60 6,000,000

Minimum annuity to grantor 5,200,000

Amount transferred** 800,000

GRAT 2:

Company B -20% $40 4,000,000

Minimum annuity to grantor 5,200,000

Amount transferred** – 0 –

Total Transferred 800,000


Splitting “volatile” assets Into multiple GRATs*

14

Portfolio GRAT Engineering 101 - Comparison Of Combined Vs. Separate GRATs, One Two-Year And One Three-Year

(Including 10% Growth)

$0$100,000$200,000$300,000$400,000$500,000$600,000$700,000$800,000$900,000

$1,000,000$1,100,000$1,200,000$1,300,000

Combined Separate

TransferredWealth

$1,224,577

$607,311

15

Portfolio GRAT Engineer 201 —Active Management Via Substitution Power

Lock in gains, cut losses and bet on the future• When assets in GRAT appreciate significantly and sooner than expected, or

depreciate materially, anticipate reversion To mean

– Grantor exercise substitution right; invest replacement assets to keep pace with §7520 rate

– Grantor re-GRAT’s substituted assets to transfer future appreciation

• Time to swap?

– February 2009: Lowest 7520 rate and many GRATs created

– Since March 6, S&P 500 is up about 60%

16

Portfolio GRAT Engineer 201 —Active Management Via Substitution Power (Cont.)

8%

Time Maturity

Capture intermediate appreciation

Expected volatility

Swap zone!

17

Portfolio GRAT Engineer 201 —Active Management Via Substitution Power (Cont.)

Why waste reversion to mean growth?Swap zone!

Expected volatility

Time Maturity

8%

18

Portfolio GRAT Engineer 201 – Active Management Via Substitution Power (Cont.)

Cut the losses, bet on the future

• Substitution methods we have seen:

– Grantor exercises substitution right with outside assets, typically with bonds and/or cash

– Fund a new GRAT with annuity from existing “under water” GRAT

– Exchange assets for note (new or existing, such as from a sale to grantor trust)

19

Example – GRATs And Family Loans

Facts:

Parent wishes to make $2.0M asset available to child

Parent sells asset to grantor trust f/b/o child; trust pays withinterest only, balloon 9-year term note

Parent dedicates $10.0M stock portfolio to a series of rolling two-year GRATs; distributions from GRATs used to repay note

Result: Assuming 8% average return on stocks, loan repaid in five years – but, we can be more scientific than assuming straight-line growth

20

10,000,000$ 4.20%2008

28.00%0.00%

20.00%48.42837%

Beginning Interest @ EndingLoan Balance 3.55% Payments Balance

2008 1 2,000,000$ 71,000$ -$ 2,071,000$ 2009 2 2,071,000$ 73,521$ (810,423)$ 1,334,098$ 2010 4 1,334,098$ 47,360$ (393,819)$ 987,640$ 2011 5 987,640$ 35,061$ (714,399)$ 308,302$ 2012 6 308,302$ 10,945$ (319,247)$ -$ 2013 7 -$ -$ -$ -$ 2014 8 -$ -$ -$ -$ 2015 9 -$ -$ -$ -$ 2016 10 -$ -$ -$ -$ 2017 11 -$ -$ -$ -$

Year

Annuity IncreaseBeneficiary Growth

Funding

Initial YearTerm

GRAT Growth

7520 Rate

Annuity Factor

Two-Year Rolling GRATs To Repay $2.0M Loan

21

Two-Year Rolling GRATs To Repay $2.0M Loan

But, we can be more scientific than assuming straight-line growth

Can use Monte Carlo and solve for desired time, funding amount or transfer

• Client: Transfer to ex-wife a set sum within five years, not as part of divorce

22

20.00%Annuity Increase

7.50%Beneficiary Growth

7.50%GRAT Growth

2Term

$833,2522008Initial Year

Benefit to Beneficiary in Year 20183.40%7520 Rate

Single Trial Simulation$ 3,000,000 Funding

US Large Cap / ST Cash

2008 Through 2018

Annually Rolling 2 Year GRATs

Multiple Year Analysis

Client Example

23

Chart Of Benefits To Remainderman

24

Monte Carlo Analysis

Annually Rolling 2 Year GRATs Simulated Transfer

$ -

$ 500, 000

$ 1, 000, 000

$ 1, 500, 000

$ 2, 000, 000

$ 2, 500, 000

$ 3, 000, 000

$ 3, 500, 000

$ 4, 000, 000

$ 4, 500, 000

$ 5, 000, 000

2 3 4 5 6 7 8 9 10 11

Ye a r

10th pe r c e nt i l e Me dia n 90th pe r c e nt i l e

25

* Assumes February 2008 §7520 rate of 4.2%. ** Assumes trust assets grow at 6% net per year, with 1% net income. Remainder value is not discounted value.*** Assumes 20% increase in annuity annually and all annuity payments with undiscounted assets.

Family Sample – LLC/Grantor Retained Annuity Trust

Assets $4M + $9M LLC (undiscounted value)Step 1

Remainder after 3 years: $3.99M (no gift tax)

Step 3Annuity***Step 2

Year 1: $3.08MYear 2: $3.70MYear 3: $4.43M

Mom

Trust for Children

GRAT trust value $10,300,000

Amount transferred $13.0MDiscount ($2.7M)Value of annuity ($10.3M) *Value of remainder (Gift) $1

26

Longer-Term GRATs For Income-Producing Assets

– Flat, high-income producing assets may still benefit from longer term as income can be used to fund annuity

• Example: Tthe case of the “horse GRAT”

• But, these situations are atypical, and other strategies may be better

Unless, law change …

27

Integrating Estate Planning With Investment Strategies – Pending Legislative Change?

24.96%10

25.32%20.80%9

25.97%21.10%17.33%8

27.01%21.64%17.58%14.44%7

28.62%22.50%18.03%14.65%12.04%6

31.14%23.85%18.75%15.03%12.21%10.03%5

35.24%25.95%19.88%15.63%12.52%10.18%8.36%4

42.45%29.37%21.63%16.56%13.02%10.44%8.48%6.96%3

57.43%35.38%24.47%18.02%13.80%10.85%8.70%7.07%5.80%2

47.86%29.48%20.39%15.02%11.50%9.04%7.25%5.89%4.84%1

2345678910

20%Annuity Growth

3.40%7520 Rate

28

Integrating Estate Planning With Investment Strategies – Pending Legislative Change? (Cont.)

24.96%10

25.32%20.80%9

25.97%21.10%17.33%8

27.01%21.64%17.58%14.44%7

28.62%22.50%18.03%14.65%12.04%6

31.14%23.85%18.75%15.03%12.21%10.03%5

35.24%25.95%19.88%15.63%12.52%10.18%8.36%4

42.45%29.37%21.63%16.56%13.02%10.44%8.48%6.96%3

57.43%35.38%24.47%18.02%13.80%10.85%8.70%7.07%5.80%2

47.86%29.48%20.39%15.02%11.50%9.04%7.25%5.89%4.84%1

2345678910

20%Annuity Growth

3.40%7520 Rate

First 5 years: 35.99%

29

Integrating Estate Planning With Investment Strategies – Legislative Change? (Cont.)

0.80%10

1.24%1.24%9

1.93%1.91%1.90%8

3.01%2.97%2.94%2.92%7

4.75%4.64%4.57%4.52%4.50%6

7.60%7.31%7.13%7.03%6.96%6.92%5

12.50%11.69%11.24%10.97%10.81%10.71%10.65%4

21.59%19.23%17.99%17.29%16.88%16.63%16.48%16.38%3

41.27%33.21%29.58%27.68%26.60%25.97%25.58%25.35%25.20%2

63.49%51.09%45.51%42.58%40.93%39.95%39.36%39.00%38.77%1

2345678910

-35%Annuity Growth

3.40%7520 Rate

30

Integrating Estate Planning With Investment Strategies – Legislative Change? (Cont.)

0.80%10

1.24%1.24%9

1.93%1.91%1.90%8

3.01%2.97%2.94%2.92%7

4.75%4.64%4.57%4.52%4.50%6

7.60%7.31%7.13%7.03%6.96%6.92%5

12.50%11.69%11.24%10.97%10.81%10.71%10.65%4

21.59%19.23%17.99%17.29%16.88%16.63%16.48%16.38%3

41.27%33.21%29.58%27.68%26.60%25.97%25.58%25.35%25.20%2

63.49%51.09%45.51%42.58%40.93%39.95%39.36%39.00%38.77%1

2345678910

-35%Annuity Growth

3.40%7520 Rate

First 3 years: 80.35%

31

Portfolio GRAT Engineering Grad School - Derivatives

Generally, more effective with larger standard deviation (more volatile) assets due to friction costs and probability of adding value

Public vs. private

• Consider private hedge transactions to minimize costs

• When appropriate, use grantor’s spouse to avoid reciprocal trust issues and income taxation (Sect. 1041 sales between spouses tax-free; PLRs 8644012 & 20012007 sales between grantor trust and spouse tax-free)

32

Portfolio GRAT Engineering Grad School – Derivatives (Cont.)

GRAT derivative strategy designed to (1) assure some value will transfer or (2) cap wealth transferred

Grantor’s spouse purchases an out-of-the-money option using Black Scholes approach or other binomial model. Rev. Proc. 98-34 permits private options

Example: If stock worth $10, price of a $12.50 option, depending on volatility, approximately $3.29

• If stock goes above $12.50 at end GRAT term, remainder beneficiaries receive benefit of 25% return plus 32.9% option return, less §7520. Balance of upside reverts to grantor’s spouse

• If stock does not exceed $12.50, remainder beneficiaries receive actual growth plus option purchase, less §7520 (e.g., if stock remains at $10, GRAT has $13.29/share)

33

Portfolio GRAT Engineering Grad School – Derivatives (Cont.)

GRAT derivative strategy designed to double gain up to 20% on assets with modest growth expectations during GRAT term

1. Assume GRAT owns 100 shares trading at $100 per share. GRAT purchases at-the-money call option on 100 shares at $100, providing GRAT right to future appreciation

2. GRAT sells an out-of-the-money call option on 200 shares at $120 per share, assuming cost of purchased call option equals proceeds on sold option. Use strike price or number of shares sonet no cost to GRAT

Result: GRAT receives double on growth from $100 to $120, and nothing on growth above $120

34

Share pricelower

Share pricehigher

Stockprice

GRAT fails

GRAT succeeds

Simplified GRAT Payoff Chart (Assume AFR = 0)

35

Share pricelower

Share pricehigher

Stockprice

Receive premium foragreeing to cap return

Impact Of Selling A “Covered Call” Option

36

Share pricelower

Share priceHigher

Stockprice

Return is capped

Payoff Chart Of GRAT With “Covered Call”

37

Concluding Takeaways For Portfolio GRATs

GRAT “tweaks”• Short-term “rolling” GRATs• Separate GRATs for correlated assets • Monitor GRAT performance: Lock in gains or bailout of losses • Consider derivatives to enhance horsepower• Formula to “cap” amount passing to family; balance is

returned• Pass GRAT remainder into continuing trust

– Spouse could be a potential beneficiary– Qualify trust for grantor income tax status

• Be scientific about amount

grats and gruts: evaluating estate planning...

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