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 low 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 BBH 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 transfers $1 million in Stock X to a two-year GRAT this month, the hurdle rate will be 1.2%, and the two annuity payments, due on the first and second anniversaries of the funding of the GRAT, will be $462,984 and $555,581, respectively. Assuming Stock X generates a total return of 8% per year, the remaining assets will be worth $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 be $477,168 and $572,601, with the first payment due in March 2020. 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 currently low valuation (for example, in a market rebound following a precipitous decline), she may want to contribute those assets to a new GRAT with a low hurdle rate. 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 most assets are devalued.
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.
Opinions, forecasts, and discussions about investment strategies represent the author’s views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations. Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2020. All rights reserved PB-03489-2020-04-09
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, available at irs.gov.