The Strategist
1st Quarter Supplement 1995 - Volume 2 Issue 2
In past issues, we have strived to educate
our readers about the advantages of making gifts during lifetime. To briefly
review, gifts that are made during lifetime generally are not subject to estate
taxes at your death. Any appreciation in the gift, once made, accrues to the
recipient of the gift, not the donor. Estate taxes can be as high as 55% of the
total estate meaning that the IRS, in many cases, is the largest beneficiary of
your estate. Gift taxes can also be as high as 55%. However, gift taxes are
calculated on the amount received by the donee. Mathematically, it is almost
always more efficient to make gifts, even taxable gifts, than to leave assets
by will.
To illustrate the advantages, assume parents
are worth $10,000,000 and are in the 55% estate and gift tax bracket. When the
parents die, $5,500,000 in estate taxes will be due the IRS, leaving the
children only $4,500,000. On the other hand, if the parents gave away
$4,500,000 today, a gift tax of 55% of $4,500,000 or $2,475,000 is due the IRS.
This still leaves the parents with $3,025,000 after gift taxes in personal
assets that will be subject to estate taxes ($1,663,750) at their death. The children
would inherit $1,361,250 after estate taxes plus have $4,500,000 from the gift
for a total of $5,861,250. This is 30% more than under the straight inheritance
method.
If it is apparent that gifting assets away
during lifetime is at least 30% more cash efficient, why is that more people do
not make gifts? The answer can generally be summed up in two words. CASH FLOW!
Most people are unwilling to part with the income (cash flow) from the assets
they would normally consider gifting.
What if you could gift assets out of your
estate while keeping the income for a specific period of time? What if you
could also deduct the income that you decided to keep from the value of the
gift? Does this sound too good to be true? It can be done with certain limitations!
The method I am referring to is called a Grantor Retained Annuity Trust or GRAT
for short.
In order to create a GRAT, the client
transfers cash or other property to an irrevocable trust (the GRAT) and retains
the right to receive an annuity from the GRAT for a term of years with the GRAT
property thereafter passing to (or continuing in trust for) others such as the
client's children. When a GRAT is created, the client is deemed to have made a
gift to the other persons (e.g., the client's children) who have an interest in
it. The value of that gift is determined by subtracting the value of the
client's retained annuity from the value of the property transferred to the
GRAT. Therefore, if the value of the client's retained annuity represents a
relatively large part of the total value of the property transferred to the
GRAT, the amount of the gift to the other beneficiaries will be small.
If the client dies during the retained
annuity term, all or a portion of the GRAT property will be included in the
client's estate. However, if the grantor survives the annuity term, the
property should pass to or for the benefit of the other trust beneficiaries
(e.g., the client's children) without payment of any additional gift tax or
estate tax.
The amount of the gift deemed made upon
creation of a GRAT is calculated by subtracting the value of the client's
retained annuity interest from the value of the property transferred to the
GRAT. The value of the retained annuity interest usually will depend on (1) the
value of the property transferred to the GRAT, (2) the interest rate for the
month in which the property is transferred to the GRAT, (3) the amount of each
annuity payment to be made, (4) the period of time for which the annuity is to
be paid, and (5) possibly, the client's age (and perhaps that of the client's
spouse) at the time the GRAT is created. The client's age may be a factor
because, under the IRS regulations, in computing the value of the retained
annuity (and, hence, the amount of the gift) upon creation of a GRAT, it
appears that it may be necessary to take into account the actuarial likelihood
that the grantor will die during the retained annuity term. That means an older
client will need to retain a larger annuity to achieve the same gift tax result
as a younger client over any given annuity term, because there is a greater
actuarial likelihood that the older grantor will die during the annuity term.
Let's look at some specific examples based on a March 1995 gift.
Assume Dad is 65 years old and worth $10,000,000.
Dad creates a 10 year, 14% GRAT funded with $1,000,000. For the next 10 years,
Dad will receive $140,000 per year in income. After the 10 years, the GRAT will
end and the balance will be paid to his children. What gift has Dad made?
According to the IRS, Dad has made a gift
equal to the original $1,000,000 less the present value of Dad's retained
income over the next 10 years. Dad has kept $140,000 of income for 10 years or
a total of $1,400,000. The present value of this retained income stream,
according to the IRS tables, is $793,128. Therefore, Dad has made a gift
calculated as follows: $1,000,000 minus $793,128 equals a $206,872 gift. Dad
would be required to pay gift taxes on this gift. If Dad has not used his
Unified Credit, he could apply the Unified Credit to the gift tax and pay
nothing. If Dad is in the 55% gift tax bracket, Dad will owe $113,780 in gift
taxes.
If Dad makes the term of the GRAT 11 years
instead of 10 years, the value of the gift has decreased to $169,352. The longer
the term of the GRAT, the smaller the gift. Suppose the annuity rate Dad
selected was 16% for 10 years. The value of Dad's retained interest would
increase to $906,432 and the resulting gift for tax purposes has decreased to
$93,568.
What if the GRAT does not generate the
required annuity return necessary to pay Dad his annuity payment? The GRAT has
several options. First, the GRAT could distribute to Dad the shortfall in
principal. This would reduce the principal available to the eventual beneficiaries.
The principal distributed to Dad to make up any shortfall would not be subject
to income taxes since it is a return of principal.
The second option is for the GRAT to issue
Dad an interest bearing note. Many tax attorneys feel as though this is the same
as a principal distribution and therefore, Dad would not be subject to income
taxes on the note but taxes would be due on interest actually paid.
What if the GRAT earns more than the
required payment obligation to Dad? Under the Grantor Trust rules that a GRAT
must follow, all of the income would be taxable to Dad.
The annuity rates illustrated thus far may
seem high. However, this may not necessarily be the case. Assume that Dad owns
all of the stock in a subchapter S corporation that is worth $5,000,000. Also
assume that the sub S corporation has income equal to $500,000 or 10%. It may
be possible for Dad to gift a 20% interest or $1,000,000 of stock to a 10 year
GRAT and claim a discount for gift tax purposes due to a minority interest and
a lack of marketability of the stock. If these discounts work out to be a 33%
discount, Dad has made a gift of stock equal to $666,666. However, the GRAT
will receive $100,000 per year in sub S distributions (20% of $500,000 in sub S
earnings) are payable to Dad. The $100,000 in earnings divided by a $666,666
gift of stock equals a 15% income rate to support a 15% annuity rate payable to
Dad. At the March 1995 rates, this works out to be only a $100,147 gift. No
principal invasion would be required. At the end of the 10 year GRAT, the
children would own stock worth $1,000,000.
Interest rates look like they may have
peaked and are possibly on the way down. Just 16 months ago (November 1993) the
interest rate used to determine the value of a GRAT gift was 5.91%. The March
1995 rate is 9.4%. This is an increase of almost 60%. If the interest rate used
for calculating these types of gifts decreases to 6.6%, the previously
described sub S GRAT would generate a taxable gift of only $27,727.
Individuals should also consider creating
multiple GRATs which are sometimes referred to as staggered GRATs. In other
words, instead of establishing a $1,000,000 ten year GRAT, consider
establishing four $250,000 GRATs with different maturities (e.g., 5 years, 6
years, 7 years, and 8 years). If the donor survives 6 and 1/2 years, the 5 and
6 year GRATs are excluded from his estate while a portion, if not all, of the 7
and 8 year GRATs are included in his estate for estate tax purposes.
We have the ability to calculate the optimum
use of GRATs for you.
To learn more about GRATs, give your
attorney, accountant, or us a call.
The
Wealth Transfer Group, Inc. is not engaged in the practice of law or accounting
nor are any of its employees, representatives, or agents. Tax and legal advice should
be obtained from qualified personnel.
(c) 1995 The Wealth Transfer
Group, Inc.
283 Cranes Roost Boulevard, Suite 145, Altamonte Springs, Florida, 32701 (407)
339-5787
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