Have a GRAT? You may want to “freeze” it and start over. Don’t have a GRAT? You may want to create one.
Market turmoil, though unsettling for investors, can present estate planning opportunities. Right now, the most appealing estate planning techniques are those that take advantage of declining asset prices and relatively low (but rapidly rising) interest rates. One such technique is a grantor retained annuity trust, also known as a GRAT. Creating or “freezing” a GRAT during times of market stress can be a very tax-efficient way to transfer wealth.
As described in detail in a recent article, 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 is 1.2% for GRATs funded this month.1 Any appreciation experienced by the transferred assets in excess of the hurdle rate will pass to the beneficiaries designated by the grantor without the imposition of any transfer 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).
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 $462,984 and $555,581, respectively. Assuming Stock X generated a total return of 8% per year, the remaining assets in April 2022 would have been $110,796. If the appreciation was instead 20%, the remaining assets would be worth $328,836.
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, we recommend “freezing” the GRAT and starting over with an asset 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 $477,168 and $572,601, 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).
Although it depends on the type of asset in the GRAT, it usually makes sense to freeze these “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 GRATs allowing 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. If the grantor believes that those assets are likely to appreciate in the future despite their current low price (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? Instead, “freeze” that failing GRAT where it is, and start a new GRAT. You can still hope for that statistically unlikely return, but even if you get a small fraction of it, as long as the new GRAT beats that small hurdle, you have success.
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 price of many assets has declined.
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.
