Market turmoil, though unsettling for investors, can present estate planning opportunities. One estate planning technique that is particularly appealing during periods of declining asset values and/or relatively low interest rates is a grantor retained annuity trust (GRAT). Creating or “freezing” a GRAT during times of market stress can be a tax-efficient way to transfer wealth free of gift or estate tax.
What is a GRAT?
A GRAT is a type of irrevocable trust to which the creator of the trust (the grantor) transfers specific assets and retains the right to receive an annual annuity payment for a designated number of years. The total of the annuity payments is equal to the value of the assets transferred to the GRAT plus interest calculated at a rate determined by the IRS for the month of the transfer (the hurdle rate). The hurdle rate (or 7520 rate) is 5% for GRATs funded this month.1
Any appreciation of the transferred assets in excess of the hurdle rate will pass to the beneficiaries designated by the grantor without the imposition of any gift tax (assuming the grantor survives the term of the GRAT). Therefore, the best assets with which to fund a GRAT are those that are likely to appreciate significantly over the trust’s term (often two years).
GRAT examples
For example, if Olivia transferred $1 million in Stock X to a two-year GRAT in April 2020, the hurdle rate would have been 1.2%, and the two annuity payments, due on the first and second anniversaries of the funding of the GRAT, were $462,995 and $555,593, respectively. Assuming Stock X generated a total return of 8% per year, the remaining trust assets in April 2022 would have been $110,772. If the appreciation was instead 20%, the remaining assets would be worth $328,813.
However, when the markets are volatile and the assets in the GRAT lose value or do not appreciate more than the hurdle rate, the GRAT is unlikely to recover. In these instances, it may be beneficial to “freeze” the GRAT and start over with an asset that you expect to grow significantly over the next couple years.
As an example, assume that instead of funding the GRAT in April 2020, Olivia funded it in March 2019 when the hurdle rate was 3.2%. The annuity payments would have been $477,161 and $572,594, with the first payment due in March 2020, when markets dropped precipitously due to uncertainty regarding COVID-19. If the assets in the GRAT have decreased in value even slightly at the time the first annuity payment is due, it is unlikely that the GRAT will be successful (where success is defined as having assets remaining to pass to Olivia’s beneficiaries).
When to freeze a GRAT
Although it depends on the type of asset in the GRAT, it usually makes sense to freeze “underwater” GRATs around the time of the first annuity payment and re-GRAT those assets if you believe they will appreciate moving forward.
What does it mean to “freeze” a GRAT? It means that the grantor utilizes a provision found in most GRAT agreements that allows the grantor to substitute or swap assets of equivalent value in and out of the trust. Typically, the grantor will swap cash or a similarly stable asset (some attorneys even suggest a promissory note) into the GRAT in exchange for the remaining GRAT assets. Since a GRAT is structured as a “grantor trust” for income tax purposes, there are no income tax consequences to exchanging assets between the grantor and the GRAT. If the grantor believes that those assets are likely to appreciate in the future despite their current low value (for example, in a market rebound following a steep decline), she may want to contribute those assets to a new GRAT. That new GRAT would have a higher statistical likelihood of success.
In other words, if you have a GRAT that is already failing, especially if it has made an annuity payment back to you, why cross your fingers and hope for a statistically anomalous return in the second year just to break even or pass a small amount of appreciation to your intended beneficiaries? If you instead proactively “freeze” your failing GRAT and start a new one, you are more likely to be successful in transferring assets to your beneficiaries.
The two key takeaways are:
- If you currently have a GRAT, you should check the value of the assets in the GRAT and work with your investment advisor to evaluate the likelihood of success.
- If you don’t have a GRAT or have determined that your existing GRAT is likely to fail, you should consider creating one while the value of many assets are depressed.
If you wish to discuss this technique in further detail or to review your investments, we encourage you to reach out to your BBH relationship team.
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1 To find the current rate, see the latest monthly IRS revenue ruling with the applicable federal rate tables (see Table 5 of the revenue ruling), or consult the IRS's “Section 7520 Interest Rates” webpage.
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