Undoubtedly, the last several months have been exceedingly difficult. We hope that you and your family are staying safe and sound during this challenging period.
And while this pandemic has been unprecedented in many ways, it has also brought about estate planning opportunities that we’ve seen during past periods of market unrest. Like the dot com bubble and the 2008 financial crisis, these opportunities are the result of two market factors coming together:
- Depressed asset values following a market correction
- Low interest rates, as the result of the Fed’s response
In this article, we’ll discuss two especially attractive trust strategies for the current economic landscape. If you have questions about what is covered or would like a custom consultation, we invite you to connect with our team.
Grantor Retained Annuity Trust (GRAT)
A Grantor Retained Annuity Trust (or “GRAT”) is a type of trust often used to minimize taxes on large financial gifts to family members. The grantor must first establish a fixed-term irrevocable trust in order to set up a GRAT. As the name implies, the grantor retains the right to receive the original value of the assets contributed, plus a rate of return set by the IRS. This rate of return is commonly known as a Section 7520 rate or “hurdle rate”; as of June 2020, the hurdle rate is just 0.6% per year.¹
The hurdle rate determines the amount of annuity payments needed to “zero out” the GRAT. Any excess appreciation above the hurdle rate will pass to your beneficiaries without using any of your estate or gift tax exemption. The lower the hurdle rate, therefore, the better the odds that the GRAT’s assets will grow at a greater rate, meaning more funds for beneficiaries without any tax implications.
For example, here’s the breakdown for a 3-year zeroed-out GRAT with $3 million worth of investments returning 8% annually:
| Initial GRAT funding | $ 3,000,000 |
| Gift to GRAT | $ 0 |
| Annual Annuity Payments Paid Back | $ 3,036,028 |
| Remainder of GRAT to Beneficiaries | $ 743,108 |
Even if the assets in the GRAT do not appreciate in value and clear the hurdle rate, the assets are simply returned to the individual who created the GRAT with no exemption having been utilized.
GRATs have historically been a popular option for transferring wealth; however, there are two significant downsides. The first is the lack of asset protection: if the person who establishes the GRAT dies before the term is up, the assets will be included in their estate. The second is the possibility that a GRAT could yield no tax benefits at all if the underlying assets do not appreciate during the term.
As a result, individuals increasingly favor another type of trust: Intentionally Defective Grantor Trusts, or IDGTs.
Intentionally Defective Grantor Trusts (IDGTs)
Like GRATs, IDGTs are used to transfer assets to beneficiaries while minimizing the tax burden. Setting up an IDGT requires an individual to “sell” assets to a Grantor Trust and receive a promissory note in return. The duration on these promissory notes is typically 10 to 15 years, and—as with GRATs—the interest rate on the promissory note must be above the IRS’ hurdle rate.
There are some key differences that make IDGTs more attractive to many. The first is that IDGTs use the “applicable federal rate” (AFR) as a minimum interest rate. Depending on the term of the trust, the AFR can be even lower than the GRAT hurdle rate—the current AFR for a three- to nine-year loan is 0.52%. ²
When the owner of the IDGT passes away, the beneficiaries of the trust receive the underlying assets that have been allowed to grow tax-free. In this sense, an IDGT represents the best of both worlds: the assets are out of the estate for estate tax purposes, but in the estate for income tax purposes.
IDGTs also offer greater payment flexibility. While GRATs require an annuity payment, IDGTs also offer the option of paying interest only on the loan balance for the term of the loan, followed by a lump-sum payment. Retaining more of the principal allows more room for the assets in an IDGT to grow before the final lump sum payment is due. When compared side-by-side, most individuals prefer the additional flexibility offered by IDGTs to the simplicity of GRATs.
How We Can help
Periods of great unrest are generally the time to re-evaluate your estate plan from top to bottom. If that would be beneficial for you, your family, and your estate, we invite you to connect with our team. Working in tandem with your attorney, we can help you maximize inheritance to loved ones while minimizing their tax burden.
ABOUT THE AUTHOR: JEFFREY FOSSELMAN, CFP®, CPA/PFS, JD
As Senior Wealth Advisor for Relative Value Partners, Jeff provides comprehensive advisory services in estate planning, income tax planning, cash flows, asset allocation and other financial planning areas. With more than a decade of experience in the industry, Jeff is instrumental in delivering financial planning strategies and counsel to high-net-worth individuals.
Jeff is also an attorney and has provided basic legal services in the areas of business consultation, formation of legal entities and drafting of estate planning documents.
Graduating with a Bachelor of Science from the University of Illinois in 2000, Jeff continued his studies and earned his Juris Doctor from the University of Illinois College of Law in 2003, and a Master of Science in Taxation from DePaul University’s Charles H. Kellstadt Graduate School of Business in 2010. He is also a member of the American Institute of CPAs – Personal Financial Planning Section and holds a CPA license with a Personal Financial Specialist designation. Further, Jeff is a CERTIFIED FINANCIAL PLANNER™.
¹IRS, Section 7520 Interest Rates. (Link)
²IRS, Applicable Federal Rates (AFR) for June 2020. (Link)
Disclosure
Information contained in this article is obtained from a variety of sources which are believed though not guaranteed to be accurate. Past performance does not indicate future performance. This article does not represent a specific investment recommendation.
No client or prospective client should assume that the above information serves as the receipt of, or a substitute for, personalized individual advice from Relative Value Partners, LLC which can only be provided through a formal advisory relationship. Clients of the firm who have specific questions should contact their Relative Value Partners counselor. All other inquiries, including a potential advisory relationship with Relative Value Partners, can be directed here.
Relative Value Partners merged with Kovitz Investment Group Partners, LLC as of August 2024. All Insights are opinions of the author as of the posting date. Any graphs, data, or information in this publication are considered reliably sourced, but no representation is made that it is accurate or complete, and should not be relied upon as such. This information is subject to change without notice at any time, based on market and other conditions. Past performance is not indicative of future results, which may vary.