For years, family limited partnerships and intentionally defective grantor trusts were the "sexy" estate planning ideas for family offices and high-net-worth individuals.
Grantor retained annuity trusts (GRATs), meanwhile, were considered too boring unless you had a concentrated position or an asset that lent itself to a heavily discounted valuation. But even then, GRATs have been largely left unused in the advisor's tool kit because of the complexity involved in them. They require frequent appraisals of illiquid, hard-to-value assets as well as appraisals for discount valuations on what could turn out to be little (or no) tax savings. Many estate-planning attorneys don't realize how averse some clients are to complexity and costs.
Historically, GRATs have also been underutilized because many estate planning attorneys have opted for more aggressive strategies or waited for the ideal asset-often either a privately owned business or an illiquid piece of real estate that could be discounted based on its lack of marketability or some other issue.
Yet very simple, GRATs with low (or no) tax risk made up of marketable equity securities-even diversified stock portfolios-can be very effective estate planning tools. When you use an existing portfolio of (easy-to-value) marketable equities securities, the client's concerns can be alleviated.
First, the basics. On October 8, 1990, Section 2702 of Chapter 14 of the Internal Revenue Code gave taxpayers and their advisors a blueprint for the use of GRATs. If done correctly, these trusts are statutory in nature, and unlike family limited partnerships and sales to defective trusts, which are not statutory, GRATs do not involve tax risk.
The taxpayer creates a trust for a term of at least two years and takes back an annual annuity. Annuity payments are based on the section 7520 rates (which change monthly). If the assets appreciate faster than the Section 7520 interest rate (which is currently the October 2009 rate of 3.20%), then any appreciation in excess of that amount can pass to a taxpayer's descendents-or more likely, to a trust for those descendents-without it being considered a gift.
If the assets don't appreciate at a rate that exceeds the 7520 rate, then all of the assets revert to the grantor as if nothing ever happened. In short, heads you win, tails you tie. But you can't lose.
Two-year rolling GRATs are easy to draft, relatively inexpensive and, if funded with marketable securities, don't require expensive appraisals. The idea of "rolling" GRATs means that after the first year, approximately half of the GRAT proceeds are required to be paid back to the grantor, and they are immediately deposited into a second GRAT. If the term of the first GRAT is years zero to two, the second GRAT would be years one to three, and the third GRAT would be from years two to four, funded with the second distribution from GRAT No. 1 and the first distribution from GRAT No. 2. Essentially, the two-year GRATs overlap.
The beauty of the two-year rolling GRAT is that it is primarily a bet on volatility-the volatility of the stock market is far more important than long-term stock market returns or the absolute level (high or low) of the 7520 interest rate (the hurdle rate).
To illustrate this point, we have gone back to January 1, 1991, when GRATs were first made statutory, and started with $10 million in marketable securities. We began rolling two-year GRATs forward to the end of 2008. Over those 18 years, we would have succeeded in removing more than $25 million from the taxpayer's estate (and far more if we included earnings on the funds removed). This calculation uses actual 7520 rates that were in place each January and does not assume that the $10 million is "trued up," using additional assets in years in which the equity values declined. (See the attached table.)