Roll with it – Keep wealth in the family using rolling GRATs

Estate Planner May-June 2006

A grantor retained annuity trust (GRAT) can be a powerful tool for transferring wealth to family members with minimal gift and estate tax consequences. But GRATs also have some disadvantages.

Perhaps the most significant drawback is the “mortality risk.” Generally, the longer a GRAT’s term, the better it performs. But if you, as the grantor, fail to survive the term, the GRAT’s benefits are lost. Thus, designing a GRAT involves striking a balance between maximizing performance and minimizing mortality risk. One technique that may offer the best of both worlds (maximizing the GRAT’s term while minimizing the risk of dying during its term) is the use of rolling GRATs.

How a GRAT works

To take advantage of a GRAT’s benefits, you make a one-time contribution of assets to an irrevocable trust. In return for your contribution, the trust pays you an annuity for a specified term, and at the term’s end, any remaining assets are transferred tax-free to the trust’s beneficiaries. The annuity payments are either a fixed percentage of your initial contribution’s value or a fixed percentage of the trust’s assets recalculated on a periodic – generally annual – basis. A GRAT is considered a “grantor trust,” so you pay any income taxes on the trust’s earnings.

A GRAT can reduce your estate tax exposure because the assets you contribute are removed from your estate – as long as you outlive the trust’s term. When you create a GRAT, however, you make a taxable gift to the trust’s beneficiaries equal to the present value of their remainder interest. The amount of the gift is calculated by subtracting the present value of your annuity payments from the value of the assets you transfer to the trust.

Increasing the GRAT’s term and the size of the annual payments increases your annuity’s present value and, therefore, decreases the size of the taxable gift. If you set the term long enough and the annuity payments large enough, the gift disappears altogether (a so-called zeroed-out GRAT).

GRATifying results

Now here’s the secret to taking advantage of a GRAT: Your annuity’s present value for tax purposes is based on an assumed rate of return – the Section 7520 rate – published monthly by the IRS. The applicable rate is the Sec. 7520 rate in effect during the month you create your GRAT. If you design the GRAT so the present value of your annuity payments is equal to the value of the assets you contribute to the trust, the present value of the remainder interest is zero. Therefore, there’s no taxable gift, but any appreciation of the GRAT assets above the Sec. 7520 rate passes to your beneficiaries gift-tax free.

So, the key to a successful GRAT is for the trust assets to generate returns that exceed the assumed rate of return. The Sec. 7520 rate often is referred to as the “hurdle rate,” because your GRAT’s growth rate (appreciation and earnings) must top that rate to pay off. This is one reason longer-term GRATs tend to perform better. Historically, longer-term investments have yielded higher average returns: the longer your GRAT’s term, the greater your chances of clearing the hurdle rate. GRATs also typically do well in a low-interest-rate environment because you can lock in a low hurdle rate, increasing your chances of success.

GRATs on a roll

As interest rates continue to increase, GRATs become riskier. After dropping to a historical low of 3% in July 2003, the Sec. 7520 rate has inched back up to the 5% to 6% range. Although you can improve your chances of outperforming the hurdle rate by choosing a long trust term, this increases your mortality risk.

Rolling GRATs are an alternative to traditional GRATs that may allow you to enhance performance without increasing the mortality risk. The technique involves creating a series of short-term GRATs (typically two or three years) with each successive GRAT funded by annuity payments from the previous ones. By using short trust terms, you can minimize the mortality risk. But over the longer term, rolling GRATs stand a good chance of successfully transferring wealth, and in many cases outperform single, longer-term GRATs.

Improving your odds

With a single, longer-term GRAT, poor market performance in the early years can make it difficult for the trust to recover. Rolling GRATs, on the other hand, thrive on volatility. And unlike the success of a single, longer-term GRAT, which usually performs better when interest rates are low at inception, the success of a series of rolling GRATs is less dependent on a lower initial interest rate.

Rolling GRATs offer other advantages as well. They may allow you to transfer wealth to your beneficiaries sooner. And you can stop creating GRATs if your assets’ growth rates drop too low, you feel you’ve transferred enough wealth or you need the income from the trust assets.

Rolling out a strategy

Like most investments, rolling GRATs offer no guarantees of success. But under the right circumstances, they can greatly improve your chances. And remember, when a GRAT “fails” – either because you don’t outlive the trust or because the trust doesn’t outperform the hurdle rate – the money isn’t lost. It simply goes back into your estate and you’re no worse off than if you hadn’t created the GRAT in the first place.

Sidebar: Rolling GRATs in a volatile market
Rolling GRATs can be effective because of their ability to capture the upside of a volatile market. To illustrate this concept, consider the period from 1965 to 1974. The S&P 500’s compound return for that 10-year period was about 1.2%. And though the IRS didn’t establish the Sec. 7520 rate until 1989, analysts have estimated that the hurdle rate at the beginning of 1965, based on IRS methodology, would have been 5.2%.

According to a 2005 study by Bernstein Investment Research and Management, if you’d created a 10-year GRAT in 1965 funded with $5 million and invested in a diversified portfolio of U.S. equity securities, at the end of the term nothing would have been transferred to your beneficiaries.

If, on the other hand, you’d used that $5 million to create a series of two-year rolling GRATs, about $1.5 million would have been transferred to your beneficiaries gift-tax free. Why? Because, despite the stock market’s dismal overall performance between 1965 and 1974, there were a couple of very good years. Although most of the two-year GRATs would have failed – that is, not transferred wealth to your beneficiaries – strong performance by the GRATs established in 1967 and 1971 would have been enough to produce a windfall transfer.