Rising Rates Don’t Spell Doom for GRATs
June 17, 2015
Do higher interest rates really mean the end of the golden years for grantor retained annuity trusts (GRATs)? The Wall Street Journal took this view in an article published on June 15, but we think GRATs can still play a major role in estate planning for wealthy families as rates rise—if they are structured right.
GRATs are widely employed by wealthy families in the US to transfer wealth to younger generations with little to no gift tax implications. The key to not paying gift tax with the strategy is to “zero out” the trust, which means the grantor, most often a member of the wealthy senior generation, contributes assets to the trust and agrees to take back an annuity payment equal to the value of what was contributed, plus a minimum amount of interest set by the IRS. This interest rate, called the Section 7520 rate, is based on midterm Treasury yields, which remain quite low. Any assets remaining in the trust after the final annuity payment is made to the grantor pass to children or other beneficiaries free of any transfer tax.
In other words, the GRAT transfers only the performance of the assets above the interest rate to the next generation. Because the grantor takes back what he contributed plus interest, the initial value of the transfer is said to be zero. Thus, no gift tax is due.
GRATs can be tailored in some ways. For example, the grantor can choose the term of the trust, or choose to increase the annuity payment by 20% each year, which would make the later annuity payments larger and allow the assets to grow inside the trust for longer.
But grantors need to follow some rules. Importantly, the grantor needs to survive the term of the trust for the GRAT to transfer wealth to the next generation free of transfer tax, and the trust must run for a minimum of two years. For more on how GRATs work, see our recent video.
The lower the interest rate at the GRAT’s inception, the more opportunity growth-oriented assets in the GRAT have to succeed by outperforming the interest rate. Historically low interest rates and strong US equity market performance since 2009 have produced an unparalleled environment for GRATs to succeed.
With interest rates expected to lift off later this year and equity returns forecasted to be more modest, can GRATs still work?
We say yes! First, we expect rates to rise slowly from their historic lows, so grantors still have an opportunity to implement a GRAT strategy at relatively low rates.
But the right structure can raise the odds of success. While some practitioners now advocate locking in a low rate with a five- or 10-year GRAT, we often recommend a five- or 10-year series of shorter-term (usually two-year) GRATs. In this “rolling” GRAT structure, the grantor takes an annuity payment each year and restarts a new two-year GRAT with the assets to create the series.
We generally prefer a series of short-term GRATs because they provide the grantor with more times at bat. Any one GRAT can succeed or fail, but there’s a good chance that at least some of the two-year GRATs in a rolling structure will succeed.
Let’s look at the results for GRATs started at a time like the present, when rates were low but about to rise. If a grantor locked in a 3.0% rate for 10 years in July 2003, a $10 million GRAT invested in the S&P 500 would have succeeded in transferring $3.6 million, as the left column in the Display shows. But a series of shorter-term GRATs would have fared even better, transferring over $7.5 million (more than double the long-term trust), even though interest rates doubled by the fourth year before falling again and two of the rolling GRATs failed.
Prevailing interest rates alone do not determine whether a GRAT will succeed in transferring wealth. Structure matters at least as much. Working with wealthy families and their professional advisors, Bernstein can help design a GRAT strategy with a high probability of long-term success in any interest-rate environment.
Bernstein does not provide tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions.