Low Rates and Market Volatility Present Tax-Free Gifting Opportunities

05.13.2020 - Bryan Kirk, Director of Estate and Financial Planning and Trust Counsel

Today’s record-low interest rates and volatile stock prices could mean a rare tax-free gifting opportunity for investors. That’s because this combination works in favor of Grantor Retained Annuity Trusts (GRATs), which allow you to pass future appreciation on your investments to family members and other beneficiaries free of taxes.

Why This Environment Favors GRATs

In order to provide tax-free gifts, the GRAT’s assets must appreciate more than the “hurdle” rate set by the IRS each month, based on prevailing interest rates. So, for a GRAT funded in May of 2020, any appreciation above the record-low hurdle rate of just 0.8% could ultimately pass to the trust’s beneficiaries without incurring gift taxes or using any of the grantor’s estate tax exemption amount. In addition, depressed stock prices are providing investors with opportunities to fund their GRATs with assets that could have significant appreciation over the next several years.

The Basics: How GRATs Work

The first step is to fund your GRAT with assets that you expect to appreciate over a fixed period, typically two or three years. You will receive your original investment back through a series of annuity payments from the trust over the course of its life, and all assets remaining in the GRAT at the end of its life can transfer to your beneficiaries tax free.

7 Steps to a Successful GRAT

One of the key drivers for any successful GRAT is active administration by a skilled trustee, starting from the moment it is funded right through to its termination.

  1. Strategically Funding Your GRAT

The most important day in the life of any GRAT is the day it’s funded—its anniversary date. The hurdle rate and the value of the assets transferred to the trust on that day determine the dollar amount of your annual annuity payments and, ultimately, the amount that will pass to your beneficiaries.

When markets are fluctuating, even a single day’s difference in values can influence the success of your GRAT. So, it is important to be clear on exactly when the assets are considered officially transferred into your GRAT. This can be as simple as the date of an assignment document. For assets such as stocks and bonds and other marketable investments, keep in mind that it can take several days after signing the trust document to establish an account in the name of the GRAT's trustee and transfer securities into the new account.

In many cases, the catalyst for funding a GRAT is a specific event, such as a market pullback, expectations of a positive earnings report or when the IRS lowers its hurdle rate. Therefore, if you are funding your GRAT with marketable securities, it’s essential to work with an experienced portfolio manager who understands the markets and is aware of upcoming events that might affect values.

  1. Defining the Value of GRAT Assets

The next step is for the trustee to obtain an appraisal of the GRAT’s assets on the day it was funded. When marketable securities are transferred into a GRAT, their value is the average of the high and low trading prices on the date of funding. But an appraisal will help ensure you have the correct values because price discrepancies can occur when securities are traded on multiple exchanges. Also, prices obtained online may reflect composite valuations, which conflicts with IRS rules requiring prices to be obtained directly from “principal” stock exchanges,typically the NYSE or Nasdaq for U.S. securities.

  1. Monitoring the GRAT’s Performance

It’s important to keep track of the GRAT’s appreciation versus its hurdle rate, assets needed to make annuity payments and the amount you anticipate passing to your beneficiaries. In most cases, we also recommend that you include the GRAT’s assets on your personal balance sheet and keep them in mind when making financial planning and investing decisions, for several reasons:

  • The bulk of the GRAT assets typically will be returned to you via annuity payments.
  • If you die before the GRAT terminates, assets will be included in your estate for tax purposes.
  • As the trust’s grantor, you will usually be responsible for paying taxes on its income.
  • GRATs add a new dimension to these assets but generally do not remove the normal considerations around risk, return and asset allocation.
  • Growth within the GRAT might trigger the need to rebalance portfolio allocations.

Addressing these issues effectively requires close collaboration between you, your portfolio manager and the GRAT’s trustee, if you are not serving in that role yourself.

  1. Locking in the GRAT’s Gains

In some cases, it can make sense to diversify or sell a GRAT’s holdings before the end of its term. For example, if the value of the GRAT’s holdings increases significantly, you might lock in gains by withdrawing them and replacing them with more stable value assets, such as a diversified set of holdings or cash. This flexibility can be a powerful lever to maximize the benefits of the GRAT.

Alternatively, if the value of the GRAT’s assets has fallen. you can essentially start over, or “Re-GRAT.” This process involves withdrawing the GRAT’s assets, substituting them with other assets of equal value and moving the original GRAT’s assets into a new GRAT, which will have a lower valuation and new starting point. This can be most effective when there’s still time for the assets to appreciate. But the timing of this strategy is critical and asset values need to be calculated with precision.

  1. Making Annuity Payments

Under IRS rules, GRATs can make annuity payments at any time within the 105-day period following their anniversary date each year. Ideally, annuity payments will be made when the trust’s value reaches a high point because your required annuity payment is a fixed dollar amount. So, as the GRAT’s assets grow, your annuity payment represents a smaller portion of its total value.

This is why it is essential for your trustee to focus on valuations and market activity when the GRAT’s anniversary date approaches. The goal is not to perfectly time the market or valuations, which is impossible. Instead, the trustee should be aware of any events that might affect asset prices.

For example, if a stock’s price is under pressure due to general market conditions and the company is approaching what could be a favorable earnings report, the trustee might decide to delay the annuity payment until after the earnings report is released. Conversely, if a stock’s price is trending upward, it could make sense to take the annuity payment sooner. Both decisions carry risks. But the trustee is responsible for managing these risks by analyzing all relevant information and making active decisions.

  1. Avoiding Gifts with Tax Liabilities

The power to substitute GRAT assets can also offer advantages near the end of its term. If assets left in the GRAT have a high tax basis (i.e. they have not appreciated significantly), your beneficiaries may be able to sell those assets and pay only a modest amount of capital gains taxes. On the other hand, if those assets have a low tax basis (they appreciated considerably) your gift could result in a capital gains tax bill of more than 30% for beneficiaries in some states when they sell those assets.

Therefore, as the end of your GRAT’s term approaches, careful consideration should be paid to the assets used to make the final annuity payment and assets that will pass to your beneficiaries. If you prefer to give your beneficiaries GRAT assets that do not carry a capital gains liability, the freedom to substitute assets can be a powerful tool to further manage taxes.

For example, if the GRAT is holding securities with a low income tax basis and you expect $100,000 to pass to beneficiaries, you could replace $100,000 worth of securities with $100,000 in cash. Then you could use the securities that remain in the GRAT for the final annuity payment and leave the $100,000 cash to your beneficiaries.

  1. Maximizing the Benefits of Your Gift

Like all annuity payments, the final annuity installment from your GRAT must be distributed within a 105-day period following the GRAT’s anniversary date. If you haven’t already touched base with your beneficiaries, this would be a good time to ask them what they intend to do with the assets they receive. This conversation could help your beneficiaries incorporate the assets into their financial plans, consider their possible tax implications of their gifts, and diversify concentrated positions if necessary.

Ideally, these discussions will take place long before the GRAT terminates. But if the GRAT’s final results are uncertain late in the game, it might be necessary to have the discussions later in the trust’s term.

Finally, if the beneficiary of the GRAT is another trust, you’ll want to make sure that trust is established and ready to receive assets before the GRAT terminates. And in rare cases when a GRAT is used to fund a trust that is exempt from generation-skipping transfer (GST) tax, keep in mind that it is necessary to file a federal gift and GST tax return, IRS Form 709.

Trust Experience You Can Count On

GRATs are not set-it-and-forget-it strategies, especially when funded with stocks and other publicly traded securities. The experienced trust professionals at Fiduciary Trust can help you to determine if a GRAT is right for you and your family, manage your GRAT for maximum benefits, and help your beneficiaries make the most of your gift.

For details, please contact your Fiduciary Trust representative or call us at 877-384-1111.

This communication is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.

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