Estate Planning Strategies For Wealthy Families During The Covid-19 Crisis
Americans are reeling from the impact of the Covid-19 crisis, but many wealthy Americans are looking at their estate planning to see if there are any unique opportunities.
Many wealthy individuals are considering the Grantor Retained Annuity Trust or a GRAT during the Covid-19 crisis. GRATs are a great technique for passing appreciation to the next generation with little to no gift or estate tax consequences. GRATs have long been a useful tool for the wealthy and they are even more powerful in today’s environment.
Why is now a great time for GRATs? Two reasons: First, asset values are depressed due to COVID-19. Second, the IRS hurdle rate is at a historic low. If, after we are past the pandemic, rates of return come back at even average rates, a GRAT would result in the transfer of a great deal of wealth to its intended beneficiaries.
For a wealthy individual or family considering this technique, it is important to understand the technical aspects of a GRAT as well as the potential risks.
How A GRAT Works
A GRAT is a unique way to pass wealth. In order for it to work, a grantor will transfer assets into an irrevocable trust that is for a fixed period of time. This fixed period of time can range from two to ten years. The assets that fund the GRAT typically have a significant growth potential.
During the life of the trust, on the anniversary date, the grantor takes an annuity. But the annuity calculation is unique.
The amount of the annuity payment that is required to be paid to the grantor during the term of the GRAT is calculated using an interest rate determined monthly by the IRS called the section 7520 rate.
The 7520 rate is what makes a difference in having this strategy work. The IRS releases these rates on a monthly basis for the following month. Currently the May 2020 rate is 0.8%. From a historical perspective, it is incredibly low. A year ago, in May of 2019, the rate was 3.2%. The lower the rate, the more likely the GRAT has a higher chance of success.
You should think of the 7520 rate as a ‘hurdle rate’. If the trustee’s investments in the GRAT outperform the rate, then the beneficiaries benefit from the GRAT. If not, the assets go back to the Grantor.
That is where the current market makes a GRAT even more interesting. During the Covid-19 crisis, the S&P 500 was down over 30% at one point. But Blackrock found that since 1982 the one-year performance of US stocks in a year following a bear market averaged 41.1%. As this strategy allows appreciation to pass to the beneficiaries at the end of the GRAT term, the upside potential of putting a GRAT into work can be quite high.
When the trust ends after the designated number of years, the beneficiaries receive the assets estate and gift tax free. Since GRATs are usually done with assets in the millions, this transfer to the beneficiaries can be a significant number. Further, the technique can be done multiple times to move assets to the next generation.
The Risks Involved
However, wealthy individuals and families need to also be aware of the risks involved. There is no guarantee that a GRAT will work. In fact, it is not uncommon that GRATs fail.
If the GRAT’s stock underperforms the hurdle rate, the grantor client receives back all of the assets of the trust and the other beneficiaries receive nothing. The consequence to the grantor was the cost of preparing the documents.
As a result, to be successful, the grantor needs to make sure they are choosing assets with strong appreciation potential. In the current market, given where stock valuations are, there is a lot of upside in the recovery that is likely to occur in the next two to three years. This short-term potential upside is causing many GRATs for shorter time frames.
Further, wealthy individuals also need to be aware that while the assets are in the GRAT, as the grantor, they will still need to pay any income taxes due on them.
The Perfect Environment
GRATs are a unique way to transfer assets. With a low 7520 hurdle rate and the potential for strong market returns in the next few years, this is an ideal time to undertake this type of estate planning. Although it is not a technique most Americans can employ, for those with significant taxable estates who want to maximize what they can pass assets on to beneficiaries, the GRAT may be an excellent vehicle to consider in these trying times.