Grantor Retained Annuity Trusts In 2020

I was glancing over selected IRS interest rates and one caught my attention.

The Section 7520 rate for June, 2020 is 0.6%.

There are certain tax tools that work well in times of low interest rates. One is a grantor retained annuity trust, commonly referred to as a “GRAT.” One associates them with the fancy-pants rich, but I am thinking they can have broader appeal when the triggering interest rate is 0.6%.

Let’s talk about it. We will keep the discussion general as otherwise we would be going into a math class. Our purpose today is to understand what makes this tax tool work and why 2020 – with low interest rates and declining stock prices – are a perfect setup for a GRAT.

First, a GRAT is an irrevocable trust. Irrevocable means no take-backs.

A trust generally has three main players:

(a)  The settlor; that is, the moneybags who funds the trust. Let’s say that is me (CTG)

(b)  The trustee. That will be you.

(c)  The beneficiaries., There are two types:

a.    Income. For now, that will be me (CTG) as I receive the annuity.

b.    Remainder. That will be my grandkids (mini-CTGs), because they receive what is left over.

This trust will be taxed to me personally rather than pay taxes on its own. The nerd term for this is “grantor’ trust.

I fund the trust. Say that I put in $50 grand.

The trust will then pay me a certain amount of money for a period of time. Let’s say the amount is $10,000, and the trust will pay me for two years. I am retaining an annuity from the trust.

COMMENT: Truthfully, I think it would take at least 2 years to even qualify as an “annuity.” One payment does not an annuity make.

When the trust runs its course (two years in our example), whatever is left in the trust goes to the mini-CTGs.

If you sweep aside the details, you can see that I am making a gift to my grandkids. The GRAT is just a vehicle to get there.

Why bother?

Say that I just give $50 grand to my grandkids or to a trust on their behalf.

I made a gift.

Granted, I am not worried about gift tax on $50 grand given the current lifetime gift tax exemption of $11.5 million, but if someone moves enough money there can be gift tax.

Let’s say you can move enough money.

Congrats, by the way.

Is there a way for you to gift and also minimize the amount of gift tax?

Yep. One way is the GRAT.

Here is how the magic happens:

(1)  The tax Code backs into the amount of the gift. It does this by placing a value on the annuity. It then subtracts that value from the amount transferred into the trust ($50 grand in our example). The difference is the gift.

(2)  How can I maximize the value of the annuity?

a.    I want $10 grand. If I could get 5% interest, I would need $200,000 grand to generate that $10 grand.

b.    But I cannot get 5% in today’s economy. I might get lucky and get 1.5%. To get $10 grand, I would have to put in $666,667, which is a whole lot more than $200,000.

c.    This example is far from perfect, as I what I am describing is closer to an endowment than to an annuity. The takeaway however is valid: I have to put more money into an annuity as interest rates go down if I want to keep the payment steady.  

(3)  How does this affect the gift?

a.    Had I created the GRAT in June, 2018, I would have used a Section 7520 rate of 3.4%.

b.    It would require less money in 2018 to fund a $10,000 payment, as the money would be earning 3.4% rather than 0.6%.

c.    Flipping (b), it would require more money in 2020 to fund a $10,000 payment at 0.6% rather than 3.4%.

d.    As the value of the annuity goes up, the value of the gift goes down.

Let’s express this as a formula:

Gift = initial funding – value of annuity

e.    As the value of the annuity increased in 2020, the gift correspondingly decreased.

f.     That is how low interest rates power the GRAT as a gifting technique.

How do declining stock prices play into this?

Let’s look at Boeing stock.

Around March 1^st Boeing was trading at approximately $275.

As I write this Boeing trades around $120.

Now, I do not want to get into Boeing’s story, other than this: let’s say you believe that Boeing will bounce back and bounce much sooner than eternity. If you believe that, you could fund the GRAT with Boeing stock. The mathematics will be driven-off that $120 stock price and Section 7520 rate of 0.6%.

What happens if you are right and the stock returns to $275?

Your annuity is unchanged, your gift is unchanged, but the value of Boeing stock just skyrocketed. Your beneficiaries will do very well, and there was ZERO added gift tax to you.

Another way to say this is that you want to fund that GRAT with assets appreciating at more than 0.6%.

Folks, that is a low bar.

There however be dragons in this area.

You could fund the trust and the assets could go down in value. It happens.

Or you could die when the trust is still in existence. That would pull the trust back into your estate.

Or the trust becomes illiquid and you start pulling back assets rather than cash. That is a problem, as the assets appreciating is part of what powers this thing.

Then there are variations on the payment. One could specify a percentage rather than a dollar amount, that way the dollar amount of the annuity would increase as the assets in the trust increase.

There is a technique where one uses the annuity to fund yet another GRAT. It is called a “rolling” GRAT, and it worked when interest rates were much higher.

BTW, there is a twist on a GRAT, and it involves working the math so that the gift comes out to exactly zero. One might want to do this if one has run out of lifetime exemption, for example. The tax nerds refer to it as a “Walton” GRAT, in honor of Audrey Walton, wife of Wal-Mart cofounder Bud Walton. It took a court case to get there, but the technique has thereafter assumed the family name.

Facebook and Tax Planning With Trusts

You may know that Facebook is going public. This means an IPO, hotly anticipated and all but guaranteed to make the founders incredibly wealthy. You may have read about Eduardo Saverin, who has renounced his U.S. citizenship and intends to become a resident of Singapore. There is discussion about tax motivations for his expatriation. Could be. Singapore has more lenient tax treatment of capital gains than the U.S. To be fair, Saverin only became a U.S. citizen in 1998, so his ties may not be as strong as that of a natural-born citizen.

I intend to blog about on Saverin and his tax implications, but for today I wanted to talk about founder Mark Zuckerberg. Facebook’s prospectus lists eight “annuity trusts” set up by insiders, including Zuckerberg, Dustin Moskovitz, Sean Parker, Sheryl Sandberg, Reid Hoffman and Michelle Yee. These trusts hold approximately 22 million shares, which could be worth around $700 million at IPO.

You can afford a lot of tax planning with $700 million. The insiders have not spoken about this matter, nor should one expect them to. I have been reading tax commentary speculating that these trusts are grantor retained annuity trusts, also called GRATs. I agree. Let’s talk about it.

A GRAT is used to shift wealth from one taxpayer to another. In my experience, it has been from one generation to another.

The GRAT has to pay-out a stream of payments to its settlor (the grantor). The payment stream is called the annuity. There are two more considerations: how much to pay out and for how long. The shortest GRAT I have seen is two years. At the end of the term, the remaining money in the GRAT goes to the beneficiary.

All right, so the settlor gifts the remaining money in the GRAT. There may be gift tax, depending on the amount of money gifted. There is a version of a GRAT where “nothing” passes at the end, so the gift is zero. Why the quotation mark around “nothing?” Ah, there is where tax planners make their money.

You see, “nothing” does not actually mean nothing. In this area of the tax world, “nothing” can be something, and quite a lot of something. The “nothing” is a mathematical calculation and not an actual dollar amount. The key to the calculation is the interest rate. 

Say that I put $1 million into a GRAT. I want payments over ten years. I have to use an interest rate, because payments are being made over time. The IRS publishes minimum interest rates for this purpose. As long as I use their interest rate (or higher), there is no problem. Say that their interest rate is 5% and I am looking to zero-out the GRAT. In year one I would take out $150,000 ($1,000,000 divided by 10 years plus $1,000,000 times 5%). What if the money was invested in something that pays – or appreciates – at more than 5%? That is the key that starts the GRAT engine. Let’s say that the investment actually pays 10%. The GRAT is paying out 5%, or only ½ of its actual earnings. The trust is accumulating, isn’t it? Let it accumulate for 10 years and I can transfer a tidy sum at the end. However, for IRS purposes I am deemed to have transferred zero, zippo, nada, because the IRS allows me to assume that the investment is paying only 5%. According to IRS math, there is no money left over to accumulate. Ten years of zero is zero. There is no gift. There is no gift tax. The IRS cannot be wrong.

Let’s go back to the Facebook insiders. What interest rate do they have to use? Last time I checked it was around 1.6%. Do you think there is an accumulation possibility here with Facebook stock? Yes, I think so.

I am not making this up. I wish I could have been one of the advisors.

Actually, I wish I could have been one of the insiders.