2014 was an incredible year for initial public offerings and valuations in general. Tech companies like GrubHub, Zendesk, Buuteeq, and GoPro saw their hard work payoff. Others found their (rumored) valuation reach the billion dollar mark: Airbnb, Box.com, DocuSign, Eventbrite, Palantir, etc.
How do key employees, executives and founders in large billion dollar companies attempt to minimize the tax impact of highly appreciated stock and protect a portion of their newfound wealth to give to others?
One method is to use a grantor retained annuity trust (GRAT). A GRAT is a type of trust that allows an individual to contribute company stock (private or public) they believe will sell or strongly appreciate in value within a defined period of time. The goal is to pass the appreciation in the assets on to beneficiaries of the trust with minimal gift and estate tax incurred. Depending on the term of the GRAT and the amount of the annuity to be paid to the Grantor, it is common to fund a GRAT with no gift tax cost (called “zeroed out GRATS”). Moreover, owners of pass through tax entities like S corps, partnerships and LLCs are also able to transfer tremendous amounts of wealth through a GRAT since the owners’ annual distributions from the entity can be used to pay the annual annuity.
Many have heard this term from media stories surrounding the Facebook and Twitter IPOs. However, GRATs can be used in a number of situations to effectively minimize future taxes.
- The Grantor funds the trust with assets they believe will substantially appreciate in the future. The Grantor maintains an annuity interest (income stream) from the trust for a stated number of years (the “GRAT term”).
- The value of the taxable gift to a GRAT is determined at inception. Conceptually, this amount results from taking the fair market value of assets transferred and reducing the value by the Grantor’s annuity interest.
- The Grantor’s interest is valued by the present value of the annuity that the Grantor will receive during the stated term (actuarially determined). A specified IRS interest rate is used for the determination.
- The annuity amount is generally based on a fixed percentage of property value at inception and is set for the GRAT term.
- The GRAT can be structured to distribute to the beneficiaries or hold the contributed assets in trust for the beneficiaries once the GRAT term expires.
- GRATs are effective for taxable estates exceeding the applicable federal and/or state exclusion. Any appreciation in the value of the assets above the annuity amounts paid to the Grantor is received by the beneficiaries free of gift or estate tax.
- Asset selection: Income-producing and highly appreciated assets incur the most benefit. Generally, the assets include stock the Grantor owns in his or her company.
- Valuation of assets: Company stock must be appraised to establish the value of the gift. If the GRAT is funded with non-public stock, then a valuation will be needed in any year non-public stock is paid to the Grantor to satisfy the annuity. For tech start-ups, this price may be determined by a 409A valuation.
- Trust term: The longer the trust term, the more time the trust assets have to grow, but the higher the risk that the Grantor dies during the term, resulting in a loss of tax benefits.
- Grantor’s annuity interest: The higher the annuity payments, the greater the discount on the remainder interest passing to beneficiaries.
- Interest rate: This is best in a low interest rate environment. At a lower specified IRS interest rate, the hurdle for obtaining value from this structure increases.
- Maintain control, and a right to distributions for a period of time.
- One of a few types of trusts that can be used to hold S corporation shares.
- Beneficiary protection from creditors.
- GRAT can stipulate assets will be held in trust and professionally managed on behalf of beneficiaries.
- Minimizes gift and estate taxes for applicable individuals with highly appreciating securities. Setting up a GRAT early will maximize the tax-free appreciation applicable.
- Beneficial for startup interests – low nominal value of a startup allows appreciation outside of taxable estate.
- Following the GRAT term, assets are no longer controlled by Grantor.
- Grantors will generally be liable for taxes on income earned by the trust during the term. However, any taxes paid by the Grantor increases the effectiveness of the GRAT as more value passes to the beneficiaries free of estate tax.
- Assets passed to the GRAT will retain the original cost basis of the Grantor and will impact capital gains amounts upon sale.
- If the Grantor dies during the GRAT term, all or a portion of the GRAT will be included in the Grantor’s estate.
- Underperforming investment returns below the stated IRS interest rate will cause no value to be realized from the GRAT structure.
This is a very generic description of a GRAT and the benefits and drawbacks of using it to hold company stock. If you are interested in pursuing this, talk to your estate planning attorney for more information.
As an executive or entrepreneur, you maintain the strategic insight for your company in accomplishing its vision and mission. You hire advisors, a board of directors, and executives with expertise to assist you in making that vision and mission a reality. Consider the benefits of doing the same in your personal life and reach out to us at Merriman.
We provide a complimentary second opinion service for individuals already working with a financial advisor. No matter how certain you are that you are on the right path financially, a second opinion never hurts and may provide valuable insights.
Below is an example kindly provided by Walter Impert of Dorsey & Whitney LLP, an international law firm with offices throughout the United States.
The following example assumes that $10 million of stock is transferred to a 5-year GRAT in a month when the IRS hurdle rate is 2%. GRAT rules permit the annuity payments to be varied by as much 20% per year, and the example takes advantage of this feature. The example assumes the stock roughly doubles in 5 years, which corresponds to a 15% annual increase. The annuity payments back to the Grantor total about $10.6 million over the five year period. However, the bulk of the appreciation, about $6.5 million of stock, passes to beneficiaries free of gift and estate tax after five years (as long as the Grantor survives the five year term).
|Year||Beginning Year Principal||15% Annual Growth||Annuity Payment to Grantor||Ending Year Principle|
Assuming a Grantor has an estate above the federal estate tax exemption, and based on the current 52% net effective Washington and Federal Estate Tax rate, one would need about $13,540,000 total to leave $6,500,000 to beneficiaries, and the tax cost would be about $7,040,000 of estate tax ($13,540,000 times 52%). Based on the stated assumptions, this GRAT would save a total of $7,040,000 of estate tax that would have otherwise been needed to leave $6,500,000 to beneficiaries.