Valuations for Estate and Gift Tax Returns: Why You Should Think About a GRAT Today
Executive Summary
A Grantor Retained Annuity Trust (GRAT) is an irrevocable trust funded with a single contribution of assets that shifts future appreciation of assets to beneficiaries at a minimal gift tax cost.
GRATs are uniquely attractive in a volatile market environment where declines in valuations can set investors up for returns in excess of the IRS’s assumed rate of return.
GRATs work best when interest rates are low, which is currently the case due to aggressive monetary policy.
To ensure the GRAT accomplishes its goal, a qualified appraisal of assets is undeniably important; in the absence of a defensible appraisal, the IRS may attempt to redetermine values and assess additional tax years after the gift tax return is filed.
The tax rates in the federal transfer tax system make wealth preservation an important topic for high net-worth individuals. The amounts at stake are of significant consequence. Consider that an estate needs to be larger than $11.58 million at the individual level ($23.16 million for a married couple) to be subject to taxation.
High tax rates combined with large dollar sums warrant a smart tax planning strategy. They also require defensible valuations to rely upon.
One planning strategy that is increasingly popular is the Grantor Retained Annuity Trust (GRAT). A GRAT offers an opportunity for a high net-worth client to transfer appreciating assets to the next generation with little to no gift or estate tax consequences.
The impact of COVID-19 presents many economic challenges in general, but it also presents wealthy families a chance to use GRATs to freeze the value of their estate while transferring any future appreciation to the next generation free of tax.
The nuts and bolts of GRATs
A GRAT is created when a grantor contributes assets with appreciation potential to a fixed-term, irrevocable trust. The grantor then retains the right to receive an annuity stream over the trust’s term. At the end of the term, the assets are distributed to noncharitable beneficiaries — typically, the grantor’s children.
In a GRAT, the grantor receives the right to an annuity stream and not the income of the trust. If the trust does not generate sufficient income, the trustee must invade the principal to make the annuity payment. A taxable gift is calculated by subtracting the value of the grantor’s retained interest from the fair market value of the property transferred into the trust.
The IRS assumes that the trust assets will generate a return of at least the applicable Sec. 7520 interest rate in effect for the month the assets were transferred to the trust. Any appreciation in excess of the Sec. 7520 interest rate passes to the beneficiaries free of gift tax.
As a result, GRATs work best when the Sec. 7520 interest rates are low, which is currently the case due to aggressive monetary policy. As of June 2020, the Sec. 7520 interest rate stands at 0.60%, down from a 2.0% rate as recent as January 2020.
If the assets in the GRAT fail to outperform the Sec. 7520 interest rate, the assets are returned to the grantor. The grantor would have paid little to no gift tax and only have incurred minimal administrative costs to establish and maintain the GRAT. There are no other adverse tax consequences of a substandard-performing GRAT. Therefore, the currently low Sec. 7520 interest rate, coupled with a historically high estate and gift tax exemption, presents a great opportunity to high net-worth individuals preserve their wealth.
Valuation matters
It is critical to understand these structural benefits of a GRAT. However, business owners also need to be cognizant of the importance of valuation. This is often where the rubber meets the road with the IRS.
Any non-publicly traded asset that will be contributed to the GRAT would need to be valued by a valuation specialist. The IRS can – and will – take issue with taxpayers over the “correct” value of the reported assets. Therefore, being able to establish and support the value of these assets is essential. A valuation report that accompanies the tax return needs to be well-written, defensible, and complete to defend against an IRS audit.
A qualified valuation professional is a pre-requisite to ensure this report is thorough given the magnitude of a potential tax liability. Without a qualified appraisal, the IRS may attempt to redetermine values and assess additional tax years after the gift tax return is filed. Redwood’s estate and gift tax valuation services assist high net-worth individuals and business owners in preserving their wealth.
At Redwood, we believe in a team approach which means we collaborate with other professional advisors to assist individuals and families with asset management. By closely working with attorneys, CPAs, private bankers, and financial planners we can proactively construct coherent and effective estate and gift plans for asset management and asset preservation.
Our gift and estate tax valuations are prepared in accordance with Revenue Ruling 59-60 and are provided in a report format satisfying the adequate disclosure rules set forth by the IRS. We can assist with our extensive valuation experience in valuing the following types of business structures:
Family Limited Partnerships (FLPs)
Limited Liability Companies (LLC)
Carried Interests in investment funds
Partial/fractional ownership interests in assets such as real estate
Sub-chapter S and C Corporations
Sole proprietorships
In addition, Redwood’s team of more than a dozen valuation professionals stays on top of the changes in tax law and valuation standards that are pertinent to these types of valuations. To set-up a preliminary conversation with our in-house expert on gift and estate valuations, Hong Yoo, at hong@redwoodvaluation.com.
About the Author: Hong specializes in providing business valuation services to clients of all sizes and diverse purposes, including stock option pricing (409A and ASC 718), purchase price allocation (ASC 805), venture capital funds, complex securities, estate & gift tax planning, merger & acquisition, and litigation purposes. His clients range in size from startups to publicly traded companies with over $750 million in revenues in numerous industries, including construction, restaurant, software, semiconductor, biotech, and many others.