Round One: GRAT--Battle of the Acronyms
In my last column I introduced this battle and gave an overview of whether this is a contest in which you should consider placing a bet. I promised to give you some deep insights into the contestants to help you determine which one has the best chance of winning for you. I introduced the frontrunner GRAT. My objective this month is to describe some of GRAT's less understood attributes that are critical to understanding his fighting ability.
GRAT's economics are most easily understood by the most frequently used version affectionately known as a zero-out GRAT. GRAT starts the fight with a taxable gift usually a teeny one. Suppose you give $1 million worth of family business stock (or other assets) to GRAT. You reduce the gift by the discounted value of the annuity. So, assume you retain the right to a payment of $542,387 each year for two years. Based on IRS interest rates (5.6 percent at the time of writing), the present value of the annuity is $999,999.47. That means the net taxable gift essentially is almost zeroed out at about 53 cents. You easily can offset it with your $1 million gift exemption and pay no gift tax.
If the stock generates total income and appreciation exactly equal to the 5.6 percent discount rate, the trust will have 53 cents left after two years. That's what the kids get. However, if the stock's income and appreciation exceeds 5.6 precent, the kids get all of that excess return, with no further gift consequences. So, for example, if the stock generates 10 percent per year, there will be about $71,000 left for the kids with no gift tax. Conversely, if GRAT's investment performance is less than 5.6 percent, there will be nothing left for the kids.
You could view this as nothing ventured, nothing gained, since you incurred a nominal cost to create the zero-out GRAT. Well, that's not entirely true. Your accountant and lawyer will profit regardless of the trust's investment performance. In other words, you have given them (I mean your kids) the potential upside, with modest downside cost. Perhaps for both of these reasons, the zero-out GRAT is the most popular contender.
GRAT is accepted (unless aggressively structured) by the law. We know how it works so that the referee's (IRS) tax law interpretations can be a non-issue. That's extremely important for those who have trouble sleeping and makes GRAT a real winner in the minds of many advisors.
Perhaps GRAT's most charming quality is that the rule book specifically permits you to include a valuation adjustment clause in the trust instrument. Suppose the IRS asserts that the value of the stock (or other hard-to-value property) contributed to GRAT was really worth $1.5 million. You'd have a taxable gift of $500,000 at inception.
The adjustment clause allows the annuity to be stated as a percentage of the starting value as finally determined for gift tax purposes. When the IRS increases the initial stock value the clause automatically and retroactively increases the annuity. The larger annuity has a greater discounted value which offset the increased stock value. Presto - no gift tax and the IRS agent heads home! This secret weapon is highly praised by fans. Unfortunately, the resulting higher annuity payments leave less in the GRAT for the kids . You win the round, but arguably lose the fight.
GRAT is a grantor trust for income tax purposes. The grantor, rather the trust or the kids, is taxed on all trust income and capital gains. Sounds bad, but it does not mean that GRAT creates income; rather, the older generation pays the tax leaving more in the trust for the younger generation. (However, the income tax may be larger if the older generation is in a higher tax bracket than the trust or the kids.
All is not perfect with GRAT. After all, Congress and the IRS intentionally allow it enter the fight. To really understand GRAT, you must follow the money trail. GRAT is inflexible. The problem with my two-year annuity example is that GRAT has to pay such a large chunk out at the end of the first year, so there's not as much left in the trust to appreciate for the kids.
A short-term GRAT can be great if you expect very rapid appreciation, like if you expect to strike oil. It also works great if you plan to go public or sell the business. You apply minority and marketability discounts to value the stock when you contribute it to GRAT. Those discounts can disappear upon a sale, meaning that there can be a substantial value increase at that time. That increase might pass to the kids via GRAT.
You could use a longer-term GRAT, say 10 to 20 years, to reduce the size of the annuity and still zero out the taxable gift. But, the grantor must outlive the annuity term for GRAT to win the fight. The reason for this is that death before the end of the annuity causes the entire GRAT to be included in the grantor's estate, potentially subject to estate tax. At least one advisor has said, You have nothing to lose if you die prematurely, because the GRAT unwinds. You're treated as if you had not created it in the first place. Small consolation!
The larger payout makes GRAT particularly subject to volatility. Most advisors assume a nice steady increase in the asset's value. Unfortunately, that rarely happens in the real world. Suppose that the $1 million asset doubles in value to $2 million over two years. If that appreciation occurs ratably over two years, the kids get $894,000 at the end.
On the other hand, suppose the asset declines 50 percent to $500,000 by the end of year one, and then performs spectacularly in year two, reaching the same $2 million at that point. Unfortunately, to pay the first annuity installment of $542,387, the trustee must distribute the entire asset (worth only $500,000), so nothing is left in the trust to perform spectacularly the next year. You really need to understand this dynamic to have any clue whether GRAT will work for the specific assets you want to transfer.
GRAT and GST
GRAT doesn't avoid the generation skipping tax, so it can only transfer the excess investment return to the next generation, not to grandchildren or later generations. Therefore, while GRAT might successfully transfer wealth to the kids, they then have to figure out a way to transfer it to their children.
If you funded GRAT with a hard-to-value asset, like family business stock, GRAT will have to make annuity payments in kind, meaning with stock rather than cash. As a result, you may need to incur appraisal costs every year to determine how many shares to pay out.
Finally, you have to disclose the GRAT on a gift tax return. So, GRAT starts the fight by yelling epithets at the referee. I'm doing something here to beat the system, come check it out! If you use an adjustment clause, the IRS gets no gift tax. Instead, the referee increases the payback to you, thereby setting you up for a higher future estate tax.
The Bads seem to outnumber the Goods, but, I'm not suggesting that GRAT will loose the fight; rather, GRAT must fight with one hand tied behind his back.
Please keep this scorecard handy as we continue the analysis next month with a behind-the-scenes examination of the contender PDT.
Ross Nager is Senior Managing Director,
Sentinel Trust Company of Houston, Texas