The down equity market brought on by the COVID-19 pandemic plus rock-bottom interest rates have combined to make grantor retained annuity trusts (GRATs) a very attractive way that wealthy clients can save on federal estate and gift taxes.
“There are a lot of planning discussions going on because of the market volatility, but also because clients are concerned about the economy and their overall health,” said Carin L. Pai, CFA, executive vice president and head of portfolio management and equity strategy for Fiduciary Trust International, which is owned by Franklin Templeton.
Wealthy clients tend to be older. Because the COVID-19 virus has more severe consequences for older people, especially those with pre-existing conditions, such clients have become even more aware of having their estate plans in order and making sure they reflect their goals, Pai observed in a recent interview.
A big advantage of a GRAT is that the appreciation of investments moved into them are no longer subject to federal estate and gift taxes. “Estates with assets exceeding the federal estate tax exemption are subject to a 40% tax rate, so GRATs can be attractive to wealthy people who want to reduce the amount of assets that would be subject to it,” Pai said. In 2020, an individual’s estate is subject to federal estate tax to the extent it exceeds $11.58 million, or about $23 million per couple.
Low-basis stock or concentrated positions are often good investments to consider for a GRAT. The grantor receives annuity payments during the GRAT’s term that are based on an included asset’s original cost basis plus the IRS Section 7520 rate, often referred to as the applicable federal rate (AFR), which was 0.8% in May. The beneficiaries receive any appreciation on the assets, net of the AFR, estate and gift tax free.
In down markets when interest rates are low, the annuity that grantors must take during the GRAT’s term will be smaller. “Any appreciation in excess of that interest rate determined by the IRS – we call it the hurdle rate – can be passed on to children or grandchildren or whomever the beneficiaries are. So that’s a really attractive tool that we are talking to clients about,” Pai said.
“With the AFR so low, it makes it almost possible to use any type of security to fund a GRAT,” she said. “In the past, when the AFR was much higher, say 3% or so, you pretty much had to put in a growth stock or something with high growth potential to make the GRAT successful. You still want to do that because you want to maximize appreciation, but because the AFR is so low you could put in a security without much appreciation potential. Maybe it has a dividend rate of 3% and you could still have a successful GRAT even if the security doesn’t appreciate because you still have the dividend that’s in excess of the AFR that you can pass on.”
Recently, with the market down so much, Pai’s team has been recommending to some clients that they consider putting beaten-up oil and gas stocks that they wouldn’t otherwise sell due to the low cost basis, into GRATs in hopes they will appreciate in the next couple of years.
“Those are good examples of securities that we can use to fund a GRAT because they're down in price, and they’ve depreciated so much in value. Some of our clients have costs that are below $1 a share, and some of these oil stocks are still paying a dividend, so they’ll have an increased chance of success with a short-term GRAT. What we've seen is that through history when oil stocks go through a period of significant decline like this, we know that the oil price is not sustainable at this level. There’s a good chance that oil prices will be higher a year or two from now.”
Another approach is to consider putting into GRATs stocks that could be secular winners, like some technology companies, she added. “If you own a technology company that still has a lot of runway in terms of growth potential, if it still has a lot of market share to gain, you could still fund it with a tech stock.”
One risk, though, with GRATs is the possibility of a grantor dying before a GRAT’s term is up. In that case, the assets go back into the estate without any of the appreciation being transferred, and any associated legal costs are usually lost. Grantors should also consider their liquidity needs before putting an investment in a GRAT. For example, Pai said, a person relying on dividend payments from a stock and put the investment in a GRAT might be entitled to less of that cash through GRAT annuity payments.
Pai noted her team has generally been recommending shorter-term GRATs. “A GRAT that might terminate in two or three years is more attractive than a GRAT that has a longer time to its expiration date,” Pai said. “The longer the term of the GRAT, the more of a chance the grantor may not survive the term.”
One strategy that may be attractive to grantors is to plan to get shares of their underlying investment back as part of their annuity, and swap cash into the GRAT for future beneficiaries to “lock in” the appreciation. The number of shares they would get back would be equivalent to the investment’s original cost plus the interest, Pai said. “They would get the equivalent value in shares back, so they don’t have to sell… But if circumstances change, and we decide that we’re better off selling some of the security, we have the flexibility to do that as well.”
Meanwhile, the appreciation can be transferred to the beneficiary in shares or in cash at the end of a GRAT term. But in most cases, it would be better to do the transfer in shares rather than cash, Pai said, because GRATs do not eliminate capital gains taxes. “Whatever is put into the GRAT, that is still considered the grantor’s asset. So if we were to sell the shares and there’s a capital gains tax, the grantor would still have to pay the capital gains tax,” she said.
However, if the beneficiary held on to those shares and sold them years later, she would pay capital gains taxes based on the investment’s original cost basis, Pai added.
While GRATs usually benefit clients who have large estates exceeding federal estate-tax exemptions, they may help less wealthy clients with concentrated assets that aren’t being actively traded. The client may not want to give the children the assets, but may want them to have the appreciation through the GRAT structure during their lifetime, Pai said.
GRATs may also make sense for certain clients who are concerned about estate taxes rising in the future and believe their holdings could be subject to them, she added. “You have to keep in mind that when a client passes, the exemption amounts may not be $23 million per couple,” she said.
Dorothy Hinchcliff is editor of Advisor Perspectives.
Read more articles by Dorothy Hinchcliff
The down equity market brought on by the COVID-19 pandemic plus rock-bottom interest rates have combined to make grantor retained annuity trusts (GRATs) a very attractive way that wealthy clients can save on federal estate and gift taxes.
