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Estate Planning Techniques:
An Introduction to Grantor Retained Annuity Trusts (GRATs)
By: Joseph Scime, CFA, CFP®
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| The term “estate planning” can be overwhelming. It is a complicated topic, but first, let’s define it so that we can better understand the solutions.
Estate planning exists to help mitigate the amount of tax paid upon an individual’s death and maximize the assets they are able to pass onto heirs. Citing its most basic definition, estate tax is a tax on your right to transfer property at death. The tax was established in 1916 as a backstop to the income tax rules. Prior to the estate tax, any asset that had appreciated in value and not sold could be passed onto heirs tax free.
The Federal Reserve Board cites, as recent as 2009, these unrealized capital gains accounted for almost 55 percent of the largest taxable estates, representing close to $15 billion in annual tax revenue. That amount isn’t going to solve our $20 trillion National Debt anytime soon; however, it is meaningful as it correlates to spending for U.S. federal agencies including the Food and Drug Administration, Centers for Disease Control and Environmental Protection Agency.
The estate tax originated more than 100 years ago to ensure the wealthy paid tax on large transfers to their heirs and that hasn’t changed.
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| The IRS has established a lifetime exemption amount for all individuals that in 2019 excludes the first $11.4 million of assets from estate taxes. This number is up significantly from the 2017 exemption of $5.49 million as a result of the Tax Cuts and Jobs Act (TCJA).
While the TCJA was a boon for individuals and families concerned about estate taxes and how to transfer wealth to the next generation, there are additional techniques and methods above and beyond the traditional estate tax exemption for effective generational wealth transfer.
Even though the top estate tax bracket is 40 percent, the tax is based on the assets in excess of the exemption amount, the average effective tax rate of estates’ owing tax in 2013 was only 16 percent.
In 2011 the IRS passed an exemption, referred to as the portability election, which allows married couples to share exemptions. This means a married couple would have to have a taxable estate in excess of $22.8million before being subject to estate taxes. While the calculation of a gross estate value includes items like securities, real estate and personal property, it is reduced by outstanding debts, charitable gifts, and of course the lifetime exemption, which means that very few estates actually qualify to pay estate taxes. In fact, according to the Joint Committee on Taxation, only 0.2 percent of the American population (or two in every 1,000 people) owed Federal Estate Tax in 2016.
While a relatively small number of taxpayers are subject to the Federal Estate tax, many more are affected by estate taxes imposed by the state. Every state is allowed to determine whether to impose an estate tax and if so, set its own exemption limits. Some states, including Massachusetts and Oregon, have exemptions as low as $1million.
Individuals whose assets exceed the exemption amounts have a number of strategies to employ during their lifetime to transfer wealth, reduce their taxable estate and tax liability.
Of the more commonly used strategies to remove assets from an individual’s taxable estate without electing an estate tax exemption is a Grantor Retained Annuity Trust (GRAT).
The GRAT is an irrevocable trust setup for a donor’s specified beneficiaries and the donor retains the right to an annuity payment during the GRAT’s term. The required annuity payment is based on an IRS mandated Section 7520 interest rate, which is 2.8 percent as of May 2019. GRAT terms can vary but they are commonly found in two, five or 10 year increments.
The goal of the GRAT is to generate capital appreciation in excess of the annuity payment, as any growth above that amount at the end of the GRAT term is passed estate tax free to the beneficiaries while the originally contributed principal is distributed back to the grantor. The graphic below depicts how the GRAT asset transfers work.
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| GRATs come with their unique considerations.
The first is the illiquidity to the grantor during the term of the GRAT. While the grantor is receiving annuity payments based on the 7520 rate, the principal contributed to a GRAT is not accessible to the grantor until the end of the term. This is less of a concern for individuals with a taxable estate large enough to consider this wealth transfer strategy, but it may be a reason to appropriately size the dollar amount of assets contributed to a GRAT.
A second consideration is the potential that the assets in a GRAT do not grow sufficiently to outpace the 7520 rate. The current rate is low by historical standards, but in a market environment that has been extremely favorable to equity investors for almost a decade, a GRAT created today could encounter headwinds during its term.
In that scenario, the downside to a GRAT is fairly minimal since the contributed assets simply revert back to the grantor’s estate because there is no excess wealth to transfer. The only cost to the grantor are the legal fees required to establish the GRAT.
Another consideration when deciding whether to utilize a GRAT is longevity. The grantor must survive to the end of the GRAT term in order to have the capital appreciation of the assets pass estate tax free to the beneficiaries. If the grantor doesn’t outlive the GRAT term, all GRAT assets are included in the calculation of the grantor’s gross estate, including any appreciation above the 7520 rate.
With thoughtful construction and asset placement, GRATs can be a very effective estate planning tool. A short-term GRAT may be more appropriate for older grantors to ensure they survive the term, while a long-term GRAT would provide more opportunity for capital appreciation and larger wealth transfers to the next generation.
Determining which assets to include in a GRAT can also maximize asset transfer. In the current market environment where the S&P 500 is up over 250 percent from its low in 2009, including assets with more attractive valuations, for example: emerging market equities or energy infrastructure master limited partnerships (MLPs), can provide more long-term upside for the GRAT depending on the term.
If you have questions regarding estate taxes, GRATs or any other estate planning topics please reach out to any of the professionals at DiMeo Schneider & Associates, L.L.C. for more information.
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| While this article addresses generally held investment philosophies of DiMeo Schneider & Associates, L.L.C., it does not represent a specific investment recommendation for any individual client or prospective client. Please consult with your advisor, attorney and accountant, as appropriate, regarding specific advice. Information has been obtained from a variety of sources believed to be reliable but not independently verified. Past performance does not indicate future performance.
This report is intended for the exclusive use of clients or prospective clients of DiMeo Schneider & Associates, L.L.C. Content is privileged and confidential. Any dissemination or distribution is strictly prohibited.
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