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The Bankers Club of Miami, One Biscayne Tower, 2 South Biscayne Blvd., 14 th Floor, Miami, Florida
“6 CREATIVE GRAT STRATEGIES!”
April 18, 2013
Mark R. Parthemer, Esq. AEPBessemer TrustManaging DirectorSenior Fiduciary Counsel, Southeast Region HeadPalm Beach, FL(561) [email protected]
Estate Planning Councilof Greater Miami
Copyright © 2013 by Bessemer Trust Company, N.A. All rights reserved.
Thoughts on Tax Law
“The only difference between death and taxes is that death doesn't get worse every time Congress meets.”- Will Rogers
“I like to pay taxes. It is purchasing civilization.” - Oliver Wendell Holmes
“I am proud to be paying taxes in the United States. The only thing is I could be just as proud for half of the money.”- Arthur Godfrey
“The way taxes are, you might as well marry for love.” - Joe E. Lewis
“There’s nothing wrong with the younger generation that becoming taxpayers won’t cure.”- Dan Bennett
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Administration’s Budget
Released April 10, 2013. Include:
1. Exemptions and rates to 2009 system...$3.5M and 45%.
2. Cap on short-term GRATs plus cap of length at life expectancy + 10 years; no declining annuities.
3. 90 duration of GST exemption.
4. Eliminate HEET trusts by only permitting GST exemption for payment of health and education expenses from individuals.
5. Grantor trust redux. Here again for the second time, but narrowed to focus on installment sales to grantor trust.
6. Basis consistency.
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* Assumes §7520 rate of 2.00 %. ** Assumes trust assets grow at 8%. *** Assumes 20% increase in annuity annually.
Nearly zeroed-out Grantor Retained Annuity Trust
Step 1
Remainder after 2 years: $197,798(no gift tax)
Step 3Annuity***Step 2
Year 1: $937,295Year 2: $1,124,754
Returned to Grantor$2,062,049
(Grantor) Trust for Children$197,798
Initial GRAT Funding
$2,000,000
Amount transferred $2,000,000Value of annuity $1,999,999 *Value of remainder (Gift) $1
Three Keys to Advanced GRAT Planning
• Fundamental Determination: Optimal Term
• Probability Analytics: Annuity
• Free flip of the transfer coin: “Heads I Win; Tails I Get My Money Back”
– Freeze technique, but
– Advisors should “Wait” on GRATs…like a table server at a busy fine dining establishment!
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Understanding GRATs as a Freeze Technique
All value returns to grantor
3%4%
Return to Grantor**
* The hypothetical examples included in this presentation are for illustration only and are not projections of future returns, tax rates or exemption amounts.** The hypothetical examples included in this presentation assume an Internal Revenue Code §7520 rate of 4.0%.
“Hypothetical” One-year 4% GRAT with 3% Return*
Often, Focus Is Only on Return
6%
4%
Return To Grantor
Transfer To Next Generation
4%
10%
* The hypothetical examples included in this presentation are for illustration only and are not projections of future returns, tax rates or exemption amounts.** The hypothetical examples included in this presentation assume an Internal Revenue Code §7520 rate of 4.0%.
“Hypothetical” One-year 4%* GRAT with 10% Return**
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Three sample growth patterns of $1,000,000 investments
Portfolio GRAT: Flat versus Increasing Annuity — Impact of Path Dependency
0
25
50
75
100
125
150
175
Day 1 Year 2 Year 3 Year 4 Year 5 End Yr 5
Steady-Eddy (10%) Beta One (20, 20, 4, 4, 4) Beta Two (-20, -20, 36, 36, 36)
$1,610,000
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Path Dependency: Increasing Annuity Creates Benefit
5 year GRAT Results
1. Leveraged Mixed Asset GRATs
• Fund GRAT with discounted asset, hard-to-value asset or alternative assets. Add fixed income portfolio.
• Use fixed income to fund annuity first.• Gives time for other assets to percolate.• Creates arbitrage between annuity based on partial discount yet
paid in non-discounted assets.
• To ease timing on funding and ease on transfer throughout, drop hard-to-transfer assets (e.g., private equity) into an LLC.
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LLC
GRAT
• Contribute LLC units and fixed income into GRAT.
• GRAT trustee first uses fixed income to satisfy annuity payments.
Fixed Income
Step 2
Leveraged Mixed Asset GRAT
Assets With Growth Potential
LLC Units
Step 1Create Family Entity
and Trust
Annuity Payments
• GRAT Remainder into Grantor Trust.
• GRAT Remainder into Grantor Trust.
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Initial 1 2 3 4 5 $-
$200,000
$400,000
$600,000
$800,000
$1,000,000
$1,200,000
$1,400,000
$1,600,000
$1,800,000
$2,000,000
Private Equity*
5 Year GRAT with 50% Private Equity and 50% Fixed Income
April 2013 7520 Rate 1.40%
Fixed Income/Yield $ 1,000,000 3.00%
Private Equity/Growth $ 1,000,000* 20.00%
Fixed Income
* For illustrations purposes, assumes no valuation discount.
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LLC
GRAT
• Contribute LLC units and fixed income into GRAT.
• GRAT trustee first uses fixed income to satisfy annuity payments.
Fixed Income
Step 2
Bonus: Leveraged Mixed Asset GRAT with Loan from GST Exempt Trust
Assets With Growth Potential
LLC Units
Step 1Create Family Entity
and Trust
Annuity Payments
Loan
• GRAT Remainder into Grantor Trust.
• Grantor Trust repays loan with LLC units.
• GRAT Remainder into Grantor Trust.
• Grantor Trust repays loan with LLC units.
GST ExemptTrust
2. Portfolio GRATs: Separate GRATs for Correlated or Concentrated Positions
Diversification:• Prudent (Imperative) under Modern Portfolio Theory,
but• Anathema to a Portfolio GRAT!
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Portfolio GRAT: Asset Selection Not Enough
Return Ending Value
1,000,000 @ $50 Company A +20% $60 $6,000,000
1,000,000 @ $50 Company B -20% $40 $4,000,000
$10,000,000
Minimum annuity to grantor* $10,140,000
Amount transferred to next generation – 0 –
* Assumes a 1.4% §7520 rate and for illustration and emphasis purposes only, a fictitious one year GRAT term.
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Split Uncorrelated Assets into Separate GRATs
GRAT 1:
Company A +20% $60 $6,000,000
Minimum annuity to grantor* $5,070,000
Amount transferred $930,000
GRAT 2:
Company B -20% $40 $4,000,000
Minimum annuity to grantor* $5,070,000
Amount transferred – 0 –
Total Transferred $930,000* Assumes a 1.4% §7520 rate and for illustration and emphasis purposes only, a fictitious one year GRAT term.
3. Portfolio GRATs: Use Substitution Power to Manage Performance
Resulting Raw Volatility Creates Likelihood of Greater Swings
Focus on Swings; Not Just Return over Term
Tactically Deploy Substitution Power to:• Lock-in Winners• Re-GRAT Losers
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Portfolio GRAT:Active Management via Substitution Power
8%
Time Maturity
Capture intermediate appreciation
Expected Volatility
Swap Zone!
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Portfolio GRAT: Active Management via Substitution Power
Why waste reversion to mean?
Swap Zone!
Expected Volatility
Time Maturity
8%
Case Study: $2,500,000 Portfolio GRAT
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GRAT #1 - $380,000
GRAT #2 – Failed
GRAT #3 - $610,000
Total - $980,000
If still original GRAT - Failed
4. “Shelf” GRATs
Four Risks to a Rolling GRAT Program:
1. Donor dies.
2. Assets decline in value.
3. 7520 rises dramatically.
4. Law change prohibits new short term GRATs.
Shelf GRATS can mitigate risks #3 and 4.
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4. “Shelf” GRATs
Step One: Create inventory of mid through longer GRATs.
Step Two: Fund currently with low volatile assets.
Step Three: Set on “Shelf” (but pay annuities).
Step Four (when needed): Swap in volatile assets to activate.
• Article April/May edition of Probate & Property.
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Impact of Minimum 10 Year Term
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First 5 years:
31.54%
7520 Rate 1.40%
Annuity Growth 20%
10 9 8 7 6 5 4 3 2
1 4.24% 5.24% 6.53% 8.26% 10.65% 14.08% 19.35% 28.29% 46.44%
2 5.09% 6.28% 7.84% 9.92% 12.78% 16.89% 23.22% 33.95% 55.73%
3 6.10% 7.54% 9.41% 11.90% 15.33% 20.27% 27.86% 40.74%
4 7.32% 9.05% 11.29% 14.28% 18.40% 24.33% 33.43%
5 8.79% 10.86% 13.55% 17.13% 22.08% 29.19%
6 10.55% 13.03% 16.26% 20.56% 26.49%
7 12.66% 15.63% 19.51% 24.67%
8 15.19% 18.76% 23.41%
9 18.23% 22.51%
10 21.87%
Why Prohibit “Front-Loading” of Annuity
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First 3 years:
90.02%
7520 Rate 1.40%
Annuity Growth -50%
10 9 8 7 6 5 4 3 2
1 51.44% 51.49% 51.58% 51.77% 52.15% 52.94% 54.63% 58.40% 67.91%
2 25.72% 25.74% 25.79% 25.88% 26.07% 26.47% 27.31% 29.20% 33.96%
3 12.86% 12.87% 12.90% 12.94% 13.04% 13.24% 13.66% 14.60%
4 6.43% 6.44% 6.45% 6.47% 6.52% 6.62% 6.83%
5 3.22% 3.22% 3.22% 3.24% 3.26% 3.31%
6 1.61% 1.61% 1.61% 1.62% 1.63%
7 0.80% 0.80% 0.81% 0.81%
8 0.40% 0.40% 0.40%
9 0.20% 0.20%
10 0.10%
5. Leveraged GRAT Combined with Sale Transaction.
Concept: Client with investment FLP sells and contributes LP units and other assets (e.g., fixed income) to an LLC; (Discounted) Sale price paid with a Note; Note contributed into a GRAT.• Leveraged GRAT (Strategy #1) effective, plus may serve as
revaluation buffer.• Extraordinary leverage if Note interest can fully fund GRAT
annuity payments.• Consider SCIN.
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FLP
GRAT
• Client contributes and sells LP units plus other assets to LLC.
GRAT annuity funded with Note interest.
Step 2
Leveraged GRAT with Sale
Assets With Growth Potential
LP UnitsStep 1
Create Investment FLP.
LLC• LLC pays with a Note.• Could be a SCIN.
Step 3
Fund GRAT with Note.
• GRAT Remainder into Grantor Trust.
• GRAT Remainder into Grantor Trust.
6. Derivatives with GRATs
Some contribute derivatives into GRATs.
There also is an ability to have the GRAT use them.
All entail friction costs and must be justified by whatever enhancement may result to the probability of transferring more value (or cap ultimate transfer).
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Public versus Private
Private hedge transactions may minimize costs.
Use of grantor’s spouse may avoid reciprocal trust issues and income taxation:• Sales between spouses tax free under section 1041.• Sales between grantor trust and grantor’s spouse tax free. PLR
8644012; PLR 20012007.
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One of Two Counter-party Options
Grantor’s spouse (or other party) purchases from the GRAT an out-of-the-money - call option with a strike price that is higher than the market price.
Option priced via Black-Scholes or other binomial model. Rev. Proc. 98-34.
Example: Assume that for a $10 Stock, a $12.50 option sells for $3.29.
Result:
1. Success: Stock rises above $12.50, remainder beneficiaries receive benefit of 25% return ($12.50/share) plus 32.9% option return ($3.29/share), less §7520. Balance of upside reverts to grantor’s spouse.
2. Success: Stock does not exceed $12.50, remainder beneficiaries receive actual growth plus option return of $3.29, less §7520.
3. Success: Stock remains at $10, GRAT has $13.29/share and remainder beneficiaries receive $3.29, less §7520.
4. Success or Failure: Stock drops below $10, remainder beneficiaries receive excess, if any, of reduced value plus $3.29, less $10 and less §7520. (If 7520 were 0%, stock could drop to $6.72 and GRAT still would be (barely) successfully.)
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Derivative Example #1: Sell an Out-of-the- Money Option.
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GRAT purchases at-the-money call option (option's strike price is identical to the price of the underlying security). This provides GRAT right to future growth, if any.
Example: GRAT owns 100 shares trading at $100 per share. Trust purchases option on 100 shares at $100.
Result:Success: Remainder beneficiaries receive double on growth, if any, less cost of option
and less §7520.
Failure: GRAT will fail if stock price goes down, remains flat or is up negligible amount (not enough to offset cost of option plus §7520).
Derivative Example #2: Purchase an At-the-Money Option.
Derivative Example #3: Covered-call Combination.
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GRAT:
• Purchases an at-the-money option, and• Sells an out-of-the-money call option.
Use strike price or limit number of shares so net no cost to GRAT.
Example: GRAT owns 100 shares trading at $100 per share. Trust purchases option on 100 shares at $100 (same as Example #2). Further, GRAT sells option on 200 shares at $120 per share.
Result: Success: Assuming cost of options net to zero, remainder beneficiaries receive double on growth from $100 to $120, but nothing on growth above $120, less §7520.
Failure: GRAT will fail if stock price goes down, remains flat or growth on 200 shares is less than §7520.
Potential to double gain on modest growth stocks, with little to zero net cash cost. Achieved by giving up excess growth.
Share PriceLower
Share PriceHigher
StockPrice
GRAT Fails
GRAT Succeeds
Simplified GRAT Payoff Chart (7520 @ 0%)
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Funding Value
Share PriceLower
Share PriceHigher
StockPrice
Receive Premium forAgreeing to cap return
Impact of selling a “Covered Call” Strategy
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Share PriceLower
Share PriceHigher
StockPrice
Return is capped
Payoff Chart of GRAT with “Covered Call”
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One More Thought on Tax Law
“Why does a slight tax increase cost you two hundred dollars and a substantial tax cut save you thirty cents?” - Peg Bracken
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