Finding Tax-Free Transfer Opportunities in Undervalued Energy Stocks

In the past few weeks, crude oil has extended its biggest price slump since the 2007-2009 global financial crisis, dropping to the lowest levels since 2009 amid signs of softer demand growth from major economies, strong output from the US and steady output from the rest of the world.

The supply and demand dynamics in the oil markets did not change overnight; this shift has been building for over a year. The roughly 45% price drop this year from $107 per barrel to $55 per barrel recently was exacerbated by technical and geopolitical factors. We believe, however, that long-term fundamentals will likely remain in place and the markets should normalize with a higher equilibrium price, although low commodity prices could persist in the near- to medium-term before production slows and supply/demand balances tighten. 

Given the oil price drop, the energy sector appears undervalued, making it more attractive to us. Some companies have been harder hit - but may also be presenting some of the good opportunities, in our view. With prices in the sector generally more attractive and dividend yields of integrated oil companies in the S&P 500 Index now averaging 3.5%, we are taking an active approach to reviewing potential long-term opportunities.

Undervalued Securities Offer a Key Estate Planning Opportunity

Investors who own securities considered to be undervalued, such as energy stocks, may take advantage of the opportunity to transfer the potential future appreciation of these securities to beneficiaries free of estate and gift tax via a Grantor Retained Annuity Trust (GRAT). A GRAT allows you to transfer securities into trust for a predetermined term, usually two to three years. You receive an annual annuity payment over the term totaling the amount you put into the trust, plus interest. The interest rate, often called the "hurdle rate" or the "7520 rate" is issued monthly by the IRS. 

Any appreciation of the securities at the end of the GRAT term that is above the IRS hurdle rate is transferred free of gift and estate tax to your beneficiaries. Given the low interest rate environment, today's hurdle rate is very low - only 2% for December 2014 - theoretically making it easier to beat. 

As an example, assume you transfer depreciated energy securities valued at $1,000,000 to a two-year GRAT in December 2014. With the current IRS hurdle rate at 2%, you would receive an annuity of $515,039 each year for two years, equaling your original principal plus 2% interest. If, for example, the securities were to appreciate by 6% annually over the next two years, $62,619 (the appreciation over the 2% hurdle) would pass to your heirs free of gift and estate tax. 

Additional Potential Capital Gains Tax Benefits 

The unique thing about GRATs is that they are actually sanctioned by the IRS. Moreover, the grantor may swap assets in an out of the trust (such as cash for stock), which allows for investment flexibility and for the grantor to lock in any appreciated gain.

Carin Pai, CFA,, is Executive Vice President, Head of Equity Strategy and Elisa Shevlin Rizzo is Managing Director, Trust Counsel at Fiduciary Trust International, a trusted wealth advisor for individuals, families, endowments and foundations.

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