Now may be an opportune time to gift assets out of your estate, particularly through an estate planning technique known as the Grantor Retained Annuity Trust (“GRAT“)—a small silver lining of the alarming pandemic and down economy. As you undoubtedly noticed, the stock market and other economic indicators declined significantly in reaction to the COVID-19 pandemic, and the federal interest rates declined in tandem. The federal interest rates remain exceptionally low and many asset values are still generally depressed despite some gains and volatility in the stock market since its initial downturn. A GRAT is a highly efficient wealth transfer vehicle in low interest rate environments when funded with assets that are expected to appreciate considerably after the gifting date. It uses virtually none of your lifetime gift and estate tax exemption amount (currently $11.58 million per person) and has practically no downside risk, which is key in this volatile environment.
A GRAT is an irrevocable trust that is generally structured with a short term to which you gift property that is expected to appreciate over that term—you may consider contributing a concentrated position or securities in one asset class. The GRAT pays an annuity to you during the trust term equal to 100% of the value of the assets at the time you transfer them into the GRAT plus a small amount of interest. The amount of interest included in the annuity (also known as the “hurdle rate”) is based on the Internal Revenue Code Section 7520 rate, which is tied to the applicable federal rate (“AFR”). The GRAT then transfers all remaining appreciation to your beneficiaries, either outright or often to a continuing irrevocable grantor trust (“IDGT”) at the end of the term. Click here to view a flowchart for a simple example of a GRAT structure.
The current Internal Revenue Code Section 7520 rate is exceptionally low in September (0.4%). Gifting certain stocks or interests in assets currently depressed but expected to rebound will shift that relatively significant appreciation out of your estate while using almost none of your lifetime gift and estate tax exemption. If the gifted assets do not appreciate, then the downside is only lost transaction costs because all assets transferred to the GRAT are ultimately distributed back to you. The beneficiaries or IDGT that receives the GRAT appreciation can mirror the provisions of your existing estate plan or you can provide for additional beneficiaries or changed terms, which we can discuss in more detail.
You can also “roll” these GRATs, meaning that when the annuity is paid to you on the applicable anniversaries of the GRATs, you can fund those annuities into new GRATs and continue the process. Click here to view the flowchart for an example of a rolling GRAT structure.
Further, if the GRATs fail from the start because of an immediate downturn, the GRATs are structured so that you can swap the assets back to yourself in exchange for assets of an equal fair market value and then you can fund new GRATs right away to take advantage of the immediate downturn.
The GRAT and IDGT are “grantor trusts” for income tax purposes. You, as an individual, are taxed on the income and realized gains of the GRAT and IDGT. Instead of the trusts bearing their own tax liabilities at the compressed trust tax rates, your payment of the taxes will be a tax-efficient wealth transfer as it will not utilize any of your lifetime gift and estate tax exemption. Grantor trust status may be switched off for the IDGT at any time, in which case the IDGT will bear its own tax liabilities at all times in the future.
A tradeoff between making the gifts discussed herein and retaining them until your death is that assets held at death receive a full step-up in basis for income tax purposes. The income tax basis of assets transferred to the IDGT generally has a “carryover basis” as your basis attaches to the property when gifted to the GRAT. (Note that in certain circumstances this planning could foreclose recognition of losses on gifted assets.) Once the IDGT receives the assets, you may reacquire the assets by substituting other assets with an equal fair market value at the time of the reacquisition. In particular, you may swap assets of the IDGT for other assets that have a relatively high basis to minimize capital gains consequences upon a sale by the IDGT.
A small “adjusted taxable gift” (e.g., typically less than $100) is made upon the transfer of property to the GRAT. There is no gift tax due in connection with the transfer, assuming you have remaining lifetime exemption from gift and estate tax.
Although there is no gift tax due, you need to file a gift tax return (Form 709) reporting the transfer of property to the GRAT at the same time you file your 2020 income tax return. Either we or your accountant will prepare the gift tax return.
Once the property is transferred from the GRAT to the remainder beneficiaries of the IDGT at the end of the GRAT term, the property is not considered part of your taxable estate and will not be taxed at your death. Your lifetime exemption from gift and estate tax will be reduced by the amount of the “adjusted taxable gift” discussed in Paragraph III above. If you do not survive the GRAT term, however, any remaining GRAT property is includable in your taxable estate and may be subject to estate tax depending on your remaining gift and estate tax exemption just as if you never implemented the GRAT planning.