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Final Round: GRAT vs. PDT

Let's review the action in the first two rounds:

Round 1: GRAT, which is the recognized darling of the tax authorities, landed a devastating blow with its ability to avoid gift tax, even if the referee challenges the initial contribution's value.

Round 2: PDT scored with a series of punches demonstrating its remarkable agility in paying back the grantor and its ability to skip generations. Plus, unlike GRAT, you can die whenever you want without knocking PDT out of the fight.

Now is the time you have all been awaiting. This month, the two contenders will face off for the grand finale.

Compare the Economics

Both techniques use a form of leverage to transfer wealth to a trust. GRAT's leverage is an annuity payable to the grantor. The present value of the annuity offsets the value of the transferred property to minimize the taxable gift. PDT's leverage is a note payable to the grantor, which offsets the value of property sold to the trust.

That leverage works only if the property generates income and appreciation in excess of the repayment of the leverage. The longer you can leave property in the trust, and the less you take out, the better the chances of generating and maximizing this excess return.

PDT wins on the leverage contest for three reasons:

 

  • PDT's note can be structured with more lenient payment terms (e.g., low annual principal payments with a balloon payment at maturity) than GRAT's fixed annual annuity.
  • If you die during GRAT's annuity term, its assets are subject to estate tax, so you would tend to hedge your bets by choosing a shorter payment term with a higher annual annuity amount. There is no such mortality risk for PDT, so you can use a much longer term with lower principal payments.
  • PDT s required interest rate typically is lower than GRAT's annuity discount rate. For example, if the fight began in May 2006, PDT's interest rate was 5 percent or less compared to GRAT's 5.8 percent. A lower rate means more stays in the trust.

The money trail is compelling, but there are numerous other similarities and differences to consider. The table presents a blow-by-blow comparison of other characteristics and issues associated with these two techniques. The best punch is highlighted in bold.

 

 

Characteristic/Issue GRAT PDT
Fees and administration costs to create and operate the structure Relatively low More complex structure results in somewhat higher costs
IRS accepts the technique Yes, unless aggressively structured Uncertain--can be designed within statutory rules, but IRS has not specifically sanctioned all aspects of the structure
Flexibility in payment terms Annuity payments must be equal and paid annually (Regulations permit a 20% per year increase in annuity amount) Great flexibility, which allows more to stay in the trust longer for the benefit of your descendents
Required interest rate 120% of the mid-term AFT discount rate in valuing the annuity Short, mid or long-term AFR interest rate, depending upon note term--typically a lower rate than the GRAT
Gift tax (or use of gift exemption) at inception Nominal, if structured as zero-out GRAT Seed capital gift likely is required (perhaps 10% of total value of the assets to be sold to the trust)
Gift tax risk at inception Minimal with adjustment clause that is permitted by regulations, although trade-off is a larger annuity paid back to the grantor Potentially significant if the property sold to the trust is undervalued. Adjustment clause is not likely to be accepted by the IRS
Reporting to the IRS Required, although if IRS examines the transaction, the adjustment clause would increase the annuity and not result in gift tax Seed capital gift must be reported. Sale transaction is not required to be disclosed unless taxpayer wants to start statute of limitations
Generation skipping potential Cannot skip generations there will be generation skipping tax on any amounts passing to the grandchildren Can skip multiple generations if GST exemption is allocated to the seed capital gift
Income tax treatment Grantor trust grantor pays tax on trust income Grantor trust grantor pays tax on trust income; sale to trust and interest on note are ignored for income tax purposes
Addional transfers to the trust Not permitted--must create a new GRAT for each additional transfer Additional gifts are allowed. Additional sales to the trust are permitted, especially as its net worth increases
Estate tax risks associated with grantor's death Death during annuity term causes entire trust to be included in the grantor's taxable estate, thereby eliminating any benefit from the GRAT Trust excluded from grantor's estate, although IRS may assert otherwise if aggressively structured
Capital gains tax risk if grantor dies while leverage outstanding None IRS might assert gains tax on trust s debt in excess of basis in its assets at time of grantor's death
Consequences if assets decline in value Assuming a zero-out GRAT, everything goes back to the grantor and you accomplish nothing; only cost is fees to create and administer the GRAT Seed capital gift (along with the asset sold) is returned to grantor, thereby wasting gift and GST exemptions; not to mention the fees to create and administer the trust

 

Which technique will win the battle? Not surprisingly, the answer is, It depends. Your decision must be based upon the nature of your assets and expectations for their future investment returns; your objectives; your risk tolerance, age and health status; and your perspective of each of the issues addressed in the table. It might well make sense to hedge your risk and place bets on both contenders!

Ross Nager is Senior Managing
Director of Sentinel Trust Company of
Houston, Texas

 

 

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