Grats are great grab, but clock is ticking
Lisa Shidler, Investment News, August 18, 2008Time may be running out for financial advisers to use a strategy that can allow clients to pass on hundreds of thousands of dollars to relatives while avoiding gift taxes.
The strategy, which involves using short-term grantor retained annuity trusts, is currently appealing because interest rates are low and the stock market is off from recent highs.
“Clients like [GRATs] because they’re not giving up a dollar of their wealth. All they are sharing is their upside, and they get the first 4%,” said John D. Schuman, an attorney, certified public accountant and adviser with Budros Ruhlin & Roe Inc. in Columbus, Ohio, which manages about $1.4 billion in assets.
“They only give if their assets appreciate more than 4%,” he said. “For little old ladies who think they never have enough, they love it.”
A GRAT is an irrevocable trust. Among clients with assets that are likely to increase in value, it is popular because the appreciation can be passed on tax-free to beneficiaries.
If an individual creates a GRAT with $1 million, they will receive $1 million in annuity payments over the length of the GRAT, which is generally several years. They also will receive interest on that $1 million at a rate — currently 4.2% — set by the Internal Revenue Service.
Any appreciation above 4.2% would go to beneficiaries free of gift tax. A rising market could result in a significant gift.
Clients who start GRATs in the current down market could see considerable asset growth, advisers said. However, if interest rates rise, GRATs make less sense because assets in the trust must appreciate by more than the prevailing rate of interest, advisers said.
Starting GRATS when a bull market is at its peak makes it difficult for the assets to appreciate, advisers said.
Among the pitfalls in this strategy is timing. If a person dies before the term of the GRAT is up, the GRAT is returned to the estate — and will be taxed.
It is also important to choose investment options that will increase in value. If there is no appreciation, the strategy is useless.
Taxwise, GRATs are complex products, and advisers must work with attorneys to assure their success, said Maggie Mitchell, vice president of advanced sales for ING Security Life of Denver, which is part of Amsterdam, Netherlands-based ING Groep NV.
Now is the time to act — before interest rates rise, she said.
“The rates are lower now, and you need to do this now,” Ms. Mitchell said. “I’m not surprised that advisers are acting now; it’s the perfect time.”
One downside to the strategy is that a GRAT may appreciate so much that clients end up gifting much more than they intended, Mr. Schuman said. Given that the trust is irrevocable, the gain must be passed on nonetheless.
One client’s GRAT, started when the market had dropped in 2002 and dipped again at the end of 2004, later appreciated by nearly $1 million.
“To be honest with you, the bigger downside is the GRAT can outperform by more than what the clients had intended,” Mr. Schuman said. In this case, he switched the assets in the GRAT, withdrawing stocks that had appreciated while putting in a vacation home.
This allowed the client to transfer to his children the vacation home, which was worth the same as the appreciated GRAT.
Mr. Schuman said that he is replacing depreciated stocks with bonds in GRATs that were set up last year but have underperformed, while also creating new GRATs.
“The GRATs we set up late last year — the portfolio is down, and they had a higher interest rate — they have no shot of winning,” Mr. Schuman said.
If assets don’t appreciate, the strategy is frustrating to clients, said John Koehler, vice president of the retirement and wealth strategies group at Jackson National Life Distributors LLC in Denver. But even if the assets don’t appreciate, the clients aren’t out any money, he said.
“The strategy has limited downside with an unlimited upside potential. The IRS isn’t giving away something for free,” Mr. Koehler said.
“There has to be some risk by the grantor,” he said. “A GRAT is really driven by interest rates, and low interest rates make the strategy more attractive.”
The GRAT works especially well for clients who have family businesses, said Seamus Smith, an estate-planning attorney with Vold & Morris LLC in Leawood, Kan. Annuity payments can be made in company stock, and any appreciation will go gift tax free to relatives.
For family businesses, this is a popular estate-planning tool, said Samuel R. Scott, a certified financial planner with Sunrise Advisors Inc. in Leawood, who has worked with Mr. Smith to create GRATs. Mr. Scott’s firm manages $130 million.
“We’re seeing demographics changing,” he said. “People are thinking of what they are going to do when they’re winding down their business.”
Even if the GRAT doesn’t appreciate more than the interest rate, investors don’t lose anything, said Susan Elser, a certified financial planner with Indianapolis-based Elser Financial Planning Inc. It just means that no gifts go to children or family members.
“I’ve also seen GRATs where the asset did not grow … so the children did not benefit from it,” Ms. Elser wrote in an e-mail. “But incurring the legal fee to establish the GRAT, and possibly a valuation expense, are the only downside in that case.”