SS 18 - Multiple Asset Location

Was reading SS 18 - Multiple Asset Location and could not comprehend the following things. Please help. GRAT: 1) Do the beneficiaries have to pay estate tax on transfer of the asset? (If yes then the text where they have mentioned that GRATS are tax efficient in relation to the wealth transfer taxes makes sense.) 2) In the same section the book also says “GRATS are inefficient due to estate taxes if the grantor should die.” Once there is a trust in place and even if the grantor dies, how would that change anything? Thanks and Regards, Vishal

I just read about GRATs in SS4. According to that reading, a GRAT is a “tax-efficient wealth transfer vehicle” for 2 reasons. First, because of the provision that can allow the grantor to pay income taxes on the GRAT’s behalf. Second, it can be funded in a way that allows valuation discounts to be applied to the assets held in GRAT (when these assets are held through a corporate or partnership structures given to GRAT). Furthermore, transactions between the grantor and the GRAT are not taxable from an income and capital gains standpoint. However, reading clearly states that a GRAT is not necessarily a tax-efficient vehicle from the GRAT’s own standpoint. There is no provision allowing the GRAT to shelter investment return or defer the taxes associated with investment results, other than by having the grantor pay for them.

The key to tax efficiency of a GRAT is that you can structure it as zeroed out GRAT. The amount the beneficiaries receive from the GRAT equals to the difference between the value of the assets in the GRAT less payments to the grantor over life of the GRAT. In order to estimate the present value of annuity stream to the grantor, you need to use a discount rate, esentially rate of return on assets in the GRAT, and here (thanks to IRS) lies a key feature of GRATs. IRS section 7520 rate gives you a discount rate to value GRATs (I belive its currently 3.6%); its 120% of current fed funds rate. So, if you can structure GRAT in a way that the value beneficiaries receive is $0, you will pay no gift tax at the time the GRAT is created. From standpoint of IRS the gift is $0 and no tax needs to be paid. However, if the rate of return on assets held inside GRAT will be higher than 3.6% (7520 rate), then after grantor will recieve all of his annuity payments, there will be assets left inside the GRAT and the beneficiary will receive them tax free. He/she will have to pay capital gains on it when the assets are sold but will be spared from estate/gift tax; the grantor also has the option to sell the assets himself before GRAT expiration and pay capital gains tax and then cash will be passed over to beneficiaries. So, for instance say you put $10M in a GRAT for 10 years. Using 3.6%, annuity stream of 10 payments at $1.21M will yield 10M. And this is how zeroed out GRAT can be structured. The grantor essentialy drawing down the money he put in into the GRAT gradually over 10 years. From IRS standpoint, this is zeroed out GRAT and no gift tax needs to be paid. Now after 10 years has passed, if average rate of return on assets in the GRAT was lower than 3.6% then GRAT would be drawed down earlier than 10 years and beneficiaries get nothing (no harm, no foul since no gift tax was paid at the outset); but if average rate of return exceeds 3.6% than they get the remainder tax free. For instance, at 6% rate of return, there will be about $2M left in the GRAT and it goes to beneficiaries estate tax free. At 10%, there will be $6.7M. When this strategy is used with GRAT, you want to invest the assets held inside GRAT into higher risk/higher expected return asset classes that are more likely to beat 7520 rate; also the timing of GRAT creation is also a factor, again for this strategy you want to create it when the fed funds rate is low (like now), allowing yourself a better chance to beat 7520 rate. All of this works if a grantor is still alive when the GRAT matures. If the grantor dies prematurely, GRAT assets will be transfered to his estate, and the whole strategy is negated. That is why GRATs are usually mid-term in nature, two to 10 years.