Archive for March, 2018

Minimizing Gift Taxes on Your Estate Through a GRAT

Posted by Sean T. Perkins, CFP®

How the Grantor Retained Annuity Trust (GRAT) Helps High Net Worth Investors Transfer Assets

Gifting wealth to the next generation is a wonderful way to leave your legacy and know you’re helping secure the futures of those you love. But even better is transferring that wealth in such a way that it helps minimize the impact of estate and or gift taxes of high net worth individuals and families.


What is a GRAT?

To understand how a GRAT can benefit you, it’s important to first understand some key points. A grantor is the person who creates and funds a trust. Trusts can be revocable, which means the trusts provisions may be changed during the life of the grantor, or irrevocable, which generally means the provisions may not be changed. If the grantor retains the power to control or direct the trust’s income or assets, that trust is considered also to be a grantor trust. So, by definition, all revocable trusts are grantor trusts, but only some irrevocable trusts may be grantor trusts.

Why is this significant? Grantor trusts are treated the same as the grantor for income tax purposes, so transfers between the grantor and trust are not taxable events, and any income earned by a grantor trust is reported on the tax return of the grantor.

A GRAT is an irrevocable trust, but it is also a grantor trust. It allows a grantor to potentially pass a significant amount of wealth to beneficiaries with no gift tax consequences. At a high level, the way GRATs are generally structured is that the grantor transfers an asset to the GRAT and retains the right to an annuity stream over a set term. The annuity amount is determined by the initial funding value, an interest rate set by the IRS (IRS 7520 rate or “hurdle rate”) that is in place at the time of funding, and the term of the GRAT. The idea is that the grantor will transfer an asset to the GRAT, which has the potential to appreciate more than the interest rate such that after the annuity payments plus interest are paid back to the grantor, there is a remaining balance that is left to the beneficiaries (typically heirs of the grantor or a trust for the benefit of the heirs).

For gift tax purposes, the amount of the taxable gift to the grantor is the fair market value of the property transferred to the GRAT less the value of the grantor’s retained annuity interest, which includes the interest rate mentioned above. If the grantor dies during the GRAT term, the value of the trust assets is included in the grantor’s taxable estate.

A popular approach these days is the “zeroed-out” GRAT. In such a scenario, the grantor sets the retained annuity interest equal to the value of the assets contributed to the GRAT, reducing the taxable value of the grantor’s gift to $0. The appreciation shifts to the beneficiaries without eating into the grantor’s gift and estate tax exemption.


Betting on the Market

On its face, a GRAT may seem like a strange option for a trust, since you’d be setting it up for your heirs, but getting all your assets back as an annuity.

Heightened market volatility can be unsettling for investors, but it is times like these that can present the best estate planning opportunities. Coupled with low interest rates (with a low hurdle rate a grantor doesn’t need much appreciation to generate tax savings), undervalued or potentially highly appreciating assets are ideal for GRATs. Any appreciation during the term of the GRAT is not included in the grantor’s gross taxable estate and, in effect, passes to the beneficiaries free of estate tax (GST tax may apply if the beneficiaries are skip persons).

Of course, investors understand the market can be risky. Relying on market outperformance over the full term of a GRAT may seem like too much risk. However, because a GRAT is a grantor trust that allows for the substitution of assets, there are options that allow you to preserve or lock-in the benefits of investment gains, or call it quits on a GRAT that has failed.

One tactic is to swap the shares in the GRAT with something that is less volatile such as bonds or cash (if the grantor has them to swap). In cases where bonds or cash may not be available, there has recently been some discussion by estate practitioners that a grantor could swap the interest for a promissory note from the grantor with a face amount equal to the fair market value of the substituted shares, earning a fair market rate of interest (this should be discussed with the estate attorney as it is more complex than using cash or bonds and may have different tax considerations if the remainder beneficiary is not a grantor trust of the grantor). In effect, the swap (whether for bonds, cash or promissory note) will “freeze” the value of the GRAT shares based on the price (fmv) of the stock at that time of the swap. The GRAT then becomes the owner of the cash, bonds or promissory note.

In the case of a successful GRAT, swapping provides a great opportunity to hedge against any future market declines by locking in gains now. The possible downside to locking-in early is that the shares may continue to appreciate to some degree, but if the grantor believes that will be the case, he/she can always transfer them to a new GRAT.

You may be wondering what happens if the market does poorly and the value of the assets in the GRAT declines more than the remaining annuity payments due to the grantor. GRATs do fail from time to time, but the important thing to remember is that the grantor will receive the original assets back regardless. If the grantor had held them personally during that time, they would still have gone down in value, so they are no worse off other than the legal and accounting fees they paid to draft and execute the GRAT document. Further, swapping assets with a GRAT that has failed also can be helpful. In the case of a failed GRAT, swapping can be a way of pulling back the volatile assets, which will allow the grantor to contribute them to a new GRAT and start over. Doing so allows the annuity payments to be reset at a lower value given the decline in value of the assets, and hopefully means that there is plenty of room for appreciation in the new GRAT.


Is a GRAT right for you when it comes to planning your estate?

If your estate attorney or tax advisor recommends a GRAT for transferring assets, the grantor should take several items into consideration.

  1. Asset type.
    1. Assets that have the potential for greatest gain should be considered. Collaboration among estate attorneys, accountants, wealth advisors and investment managers is critical when making a decision. The move should be highly considerate of market performance and volatility. Marketable securities are ideal due to their liquidity and the flexibility they provide relative to annuity payments, but grantors can also consider placing non-marketable assets, such as a family business or private stock, which can result in a valuation discount at funding due to lack of marketability (this can be optimized if the business produces cash flow, which can then be used to make the annuity payments with no discount or subsequent valuation requirement).
    2. Depending on which asset is selected, it will also be important to consider the basis of the asset and whether further planning should be done (such as swapping prior to the end of the term to retain low basis assets within the estate for a potential basis step-up).
  1. GRAT term and personal health. If the grantor does not live to the end of the term of the GRAT, the assets will be transferred back into his/her taxable estate. To reduce this mortality risk, consider shorter-term GRATs for elderly individuals or those families who have health concerns.
  2. Personal needs. Grantors should be certain their wealth planning is such that they can afford to live without the appreciation of the specific asset they contribute and don’t need it to offset personal spending now or down the road. They should also consider the impact on their overall portfolio allocation and that of the beneficiaries to understand how contributing the selected asset to a GRAT will impact the risk/return of the portfolio.
  3. Tax exclusions. Under the recently-passed Tax Cut and Jobs Act, there is a lifetime exclusion for estate and gift taxes of $11.18 million per individual as of 2018. In light of such a high exclusion amount, GRATs may seem unnecessary to all but the wealthiest of clients. However, historically low interest rates make GRATs compelling. That said, GRATs are typically not the best strategy to use when the grantor wants to make the most out of their Generation Skipping Exemption since you cannot allocate GST exemption at time of funding, but rather only on the backend when the remainder interest value is determined (at full value).
  4. Political climate. Another item to consider is tax policy. Although the current administration recently made sweeping changes to our tax laws, there is no guarantee Congress will not revise or repeal some of the laws if a new administration takes office in 2020. Nothing is static; any long-term planning should take potential changes into consideration especially as the rules for GRATs have been up for discussion over the last few years. It’s possible they may be subject to changes or limitations in the future.

If you think a GRAT is a sensible idea for transferring your wealth, your estate attorney, accountant and financial advisor will be able to help you decide whether it’s the right move. Working together, they can develop a plan to efficiently transfer wealth to your heirs, grow your assets, and minimize taxes.

Infrastructure Investment Opportunities Existed Before Trump’s Plan

Posted by Joseph W. Chase, CFA®

A Rationale for Adding Infrastructure Exposure to Your Investment Portfolio

The White House recently announced the “Legislative Outline for Rebuilding Infrastructure in America”, a 53-page plan to stimulate $1.5 trillion of investment in infrastructure in the US. While there are valid points to both the pro and con arguments for the plan, we’d like to share our insights into our process and rationale for obtaining infrastructure exposure in an investment portfolio.

The immediate potential beneficiaries of infrastructure investment are companies that provide design and construction services for infrastructure projects, as well as the producers of materials needed for such projects.

While there are exchange-traded funds (ETFs) that specialize in these types of companies, we prefer to pick up this exposure through broad equity market index vehicles, as we believe the US equity markets are generally efficient. We also believe that, to the extent infrastructure investments boost GDP, the rising tide will lift all ships, so to speak, and broad equity markets will benefit.

Taking an Informed Approach to Infrastructure Investing

We define infrastructure as essential physical assets required by society to function that generate stable, growing cash flows, which are typically linked to inflation. In our view, the best long-term approach to infrastructure investment is to own the physical assets.

Examples of attractive infrastructure assets for investment can include:

These assets are typically natural monopolies (it doesn’t make sense to have two highways running in parallel, for example), and are government-regulated, allowing for a specified rate of return on investment for the owner. Cash flows generated by these assets typically have low correlation to short-term changes in the economic cycle, but grow over time with long-term population and GDP growth, as cars driving on a toll road increase, for example. The regulated nature of these assets allows for long-term contracts with built-in inflation escalations, meaning cash flows are predictable over long periods of time and increase with inflation, providing an investment portfolio with some insulation from rising costs.

A Global Opportunity

For governments around the world to close the $50 trillion funding gap in infrastructure over the next 15 years, infrastructure spending would need to increase from $2.5T annually to $3.3T, according to McKinsey. For reference, the World Bank reports that approximate total annual government spending was $12.5T globally in 2016.

This funding gap has increased willingness to open the doors to private ownership and operation of infrastructure in some countries, which provides capital to government owners of infrastructure. That capital can in turn be used to relieve the debt burden taken on to build said assets, and can eliminate the need for governments to continue spending to maintain the assets.

Examples of private ownership include the passing of a law in India in June of 2016, allowing for foreign ownership of airports. Additionally, governments in Colombia and Australia have recently sold transportation and power generation assets to private owners.

Here in the US, we aren’t accustomed to privately-owned roads and bridges, but other infrastructure assets, such as electric grids and energy pipelines, are often owned by private enterprises. In other parts of the world, privately-owned roads, bridges, and other infrastructure is common.

The White House’s infrastructure plan provides a few avenues to encourage private ownership of infrastructure assets:

The need for capital is especially acute in rapidly-growing emerging market countries, which account for 60% of the total funding need. This situation creates an opportunity for investors to gain exposure to emerging market countries–emerging market economic and consumer activity in particular–rather than exposure to broad emerging market equities, which includes companies that rely on exports for a significant portion of their revenue.

How to Choose the Right Infrastructure Exposure for Your Investment Portfolio

Exposure to infrastructure investments can be obtained through publicly traded or private investment vehicles, and both types of exposure have the potential to benefit a diversified portfolio. Private funds are structured in a similar manner to private equity funds, in which the investor makes a capital commitment to a fund that is drawn over several years as the fund manager invests in various infrastructure projects. Private funds typically invest in development projects and distressed assets that need a turnaround to achieve peak earnings (referred to as Development Stage and Opportunistic assets).

Public infrastructure vehicles are typically Limited Partnerships or Corporations, and are traded on major stock exchanges such as NYSE, allowing for an investor to buy and sell the investment daily. Compared to private funds, they tend to own lower risk assets that are already in operation, and perhaps in need of minor operational improvements to maximize earnings (known as Core and Core Plus assets).

Public vehicles have the benefit of higher liquidity and less operational/development risk, and typically have a lower expected return than a private fund. Public and private infrastructure investments exhibit relatively low correlation to major asset classes, which helps to diversify portfolios and can reduce overall portfolio volatility.

Owning productive infrastructure assets over the long term can be an attractive addition to an investment portfolio, due to the long-term visibility into cash flows, a natural hedge to inflation, and returns that exhibit low correlation to other major asset classes.