The Journal of Wealth Management for Estate-Planning Professionals Since Global Wealth Management. A unit of AllianceBernstein L.P.

Transcription

1 A Penton Media Publication Trusts&Estates COVER AND ARTICLE EXCERPTED FROM DECEMBER 2008 The Journal of Wealth Management for Estate-Planning Professionals Since 1904 Transfer Wealth Tax-free Rolling short-term GRATs can work better than intentionally paying gift tax By David L. Weinreb & Warren Litman Global Wealth Management A unit of AllianceBernstein L.P.

2 Trusts&Estates The Journal of Wealth Management for Estate-Planning Professionals Since 1904 Feature: Estate Planning & Taxation By David L. Weinreb & Warren Litman Transfer Wealth Tax-free It can make sense to pay gift tax. But if a donor has time and liquidity rolling short-term GRATs are more tax-efficient You might think of the gift tax as the lesser of two evils for transferring wealth, with the other evil being the estate tax. Certainly, it can be cheaper to pay gift tax rather than estate tax, because of the gift tax s tax-exclusive nature. 1 But always remember: There is a third way. A donor can transfer wealth during his lifetime without paying any tax on the transfer. If a donor has liquid assets and at least several years to engage in wealth transfer, a strategy using rolling short-term grantor retained annuity trusts (GRATs) can transfer a substantial amount transfer tax-free. 2 Our research quantifies the trade-offs between paying gift tax and using rolling GRATs. The results show that for a donor with a relatively short time horizon (for example, a donor who s very elderly or ill), intentionally paying gift tax is likely the better choice. But a rolling GRAT strategy for a donor with a somewhat longer horizon is likely to work far better. Let s look at the relative merits of each strategy to determine which would be preferable in various situations. David L. Weinreb, far left, is a director and Warren Litman is a senior quantitative analyst in the Wealth Management Group at Bernstein Global Wealth Management in New York The Trade-offs Given an either/or choice between the gift and estate tax, it usually makes sense to pay the gift tax. Consider a donor with $10 million to transfer (See Sometimes It Pays to Pay Gift Tax, next page). For simplicity s sake, disregard the estate tax exemption, and assume a flat 45 percent gift and estate tax rate. If the donor simply leaves the $10 million to her children upon her death, the children will receive only a little more than half because $4.5 million in estate tax will be due the government. But if she chooses to make a lifetime gift, she can transfer $6.9 million to her children, because she ll owe gift tax only on the amount that the children receive in this case, a tax of $3.1 million on the gift. That makes the effective gift tax rate only 31 percent (that is to say, 31 percent of her $10 million) instead of 45 percent. 3 While the analysis in real life is usually a bit more complex, this example illustrates the potential benefit of intentionally paying gift tax. 4 There are a number of other reasons why a donor may choose to pay gift tax: A time constraint may demand a quick and certain transfer of assets perhaps the donee is buying a home or starting a business. Or the donor may simply want the recipients to enjoy the gift as soon as possible. But some donors make the decision based on faulty logic. For example, a donor may reason that by gifting

3 Feature: Estate Planning & Taxation now, she will achieve an overall tax savings because the gifted assets will grow outside of her estate. But, assuming tax rates stay the same, this reasoning is erroneous: For example, assume that the gift of $6.9 million in our hypothetical grows at an 8 percent annualized rate. It will be worth $14.9 million in 10 years. Had the donor retained the same $10 million for 10 years before gifting it, and it grew at the same rate, she would have $21.6 million. Assuming the same 31 percent effective tax rate, she could move $14.9 million to her children (that is to say, $21.6 million less a tax of $6.7 million). The children would wind up with exactly the same amount as they would have had the donor gifted the assets sooner rather than later. But what if the donor has time to implement a slightly longer-term wealth transfer strategy? Our prior research has shown that a program of rolling short- Sometimes It Pays To Pay Gift Tax Gift tax is computed only on the amount received by the donee, while estate tax is due on an entire estate If a donor leaves $10 million at death, the heirs receive slightly more than half, with $4.5 million in estate tax due to the government. Using the same $10 million during life, a donor could give $6.9 million to beneficiaries, with a tax bill of just $3.1 million. $4.5 in estate tax Gift at Death ($ millions) $5.5 to heirs $10 Million in Initial Assets Lifetime Gift ($ millions) $3.1 in gift tax For Illustrative Purposes Only $6.9 to beneficiaries AllianceBernstein term GRATs funded with publicly traded stocks is a highly effective way to transfer wealth gift tax-free. 5 Applying our firm s wealth forecasting model to simulate 10,000 market scenarios across a wide range of asset classes, inflation and Internal Revenue Code Section 7520 rates, we can compare and quantify the costs and benefits of a rolling GRAT strategy versus intentionally paying gift tax. 6 Consider the donor in our hypothetical scenario who wants to use $10 million for wealth transfer to her children. We compared two strategies: (1) giving $6.9 million directly to her children and paying $3.1 million of gift tax, versus (2) committing the full $10 million to a program of rolling GRATs. 7 In the first strategy, we assume that children invest the gift in a globally diversified portfolio of equities. 8 In the second, we assume that the remaining property in any successful GRAT passes to an intentionally defective grantor trust (IDGT) 9 for the children (which is also invested in a globally diversified portfolio of equities). We also assume that the income taxes on both the GRATs and the IDGT are paid by the grantor out of each annuity payment from each GRAT, with only the balance of each annuity payment rolling forward into a new GRAT. We compared the range of wealth in the hands of the children after imposing estate taxes on all assets committed to the rolling GRAT strategy not transferred to the IDGT for the donor s children at the donor s assumed death. In the median case, paying the gift tax is likely to be more effective only if the donor dies in years four through six after inception. (Paying gift tax is likely to be less effective before the end of the third year because the donor must live for at least three years after the gift for it to achieve any tax savings.) 10 But this window of opportunity closes at the end of year six, when our projections show that using the rolling GRAT strategy is likely to move about the same total wealth to the children as paying gift tax. And for each subsequent year that the rolling GRAT strategy is in effect, it becomes increasingly likely to produce better results than intentionally paying gift tax. For example, if the rolling GRAT strategy is in

4 Feature: Estate Planning & Taxation It's About Time With time, rolling GRATs are likely to transfer more money than paying gift tax Paying gift tax is likely to be more effective than a rolling GRAT strategy only if the donor dies in years four through six. After year six, in the median case, the rolling GRAT strategy is likely to transfer more total wealth to beneficiaries. 100% Odds a rolling GRAT strategy outperforms paying gift tax end of year Assumptions: All accounts are invested in 100 percent globally diversified equities. Based on Bernstein estimates of the range of returns for the applicable capital markets over the duration of the analysis. Data does not represent past performance and is not a promise of future results. AllianceBernstein paying gift tax in all market scenarios, particularly in strong ones. Choices There are a number of reasons why a donor may wish to make a gift that results in a gift tax liability. Some are better than others. If the donee needs the money quickly and without the possibility of delay, a gift may be desirable. Or if the donor has a short time because of age or illness (but is not at death s door, because of the three-year look back with respect to the gift tax), the time required for a rolling GRAT strategy to be highly likely to achieve an overall tax savings may make it the less desirable choice. But in the majority of cases, a donor wishing to transfer substantial liquid assets will likely find the rolling GRAT strategy a superior way to save taxes compared to purposely paying gift tax. Te place for 10 years, it beats paying gift tax about 80 percent of the time. With 15 or more years to work, the rolling GRAT strategy will virtually always be superior. (See It s About Time, this page.) Bottom line: our analysis shows that paying gift taxes is preferable economically only during a brief three-year window (that is to say, in years four, five and six). Moreover, the benefits are skewed in favor of the rolling GRAT strategy. The reason is that the benefit of paying gift tax is limited to the difference between paying tax at the effective and statutory tax rates (that is to say, 31 percent and 45 percent). In contrast, wealth is transferred by the rolling GRAT strategy transfer tax-free. For example, at the end of year six, in the worst 10 percent of cases in our modeling, paying gift tax beats the rolling GRAT strategy by about $900,000. But in the best 10 percent of cases, the rolling GRAT strategy beats paying gift tax by a much greater margin: about $2.1 million (See The Advantage Widens, next page) And the longer the rolling GRAT strategy can be sustained, the greater is its advantage over Bernstein Global Wealth Management, a unit of AllianceBernstein L.P., does not offer tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions. Endnotes 1. The gift tax is tax-exclusive because it s based on the value of the asset being transferred. By contrast, the estate tax is tax-inclusive because it s based on the entire estate, including the assets that will be used to pay the estate tax. (See infra note 3.) 2. A grantor retained annuity trust (GRAT) refers to a trust in which the grantor retains a qualified annuity interest within the meaning of Treasury Regulations Section For purposes of this article, all GRATs are assumed to be zeroed out, which means that the value of the annuity payments, as determined under Internal Revenue Code Section 7520, equals the value of the property that the grantor transfers to the GRAT. In addition, the annuity payments increase by 20 percent each year. See Treas. Regs. Section (b)(ii). Rolling GRATs refers to a strategy in which a client uses the annuity payment he receives each year from a GRAT to fund a new GRAT. 3. The example assumes that the donor lives for more than three years

5 Feature: Estate Planning & Taxation $ millions The Advantage Widens Looking beyond year six and across a range of potential market scenarios, the benefit of a rolling GRAT strategy grows in comparison to paying gift tax Advantage/Disadvantage of rolling GRAT strategy vs. intentionally paying gift tax ($6.9 million gift with tax vs. $10 million GRATs) $16 Superior Markets 14 All accounts are invested in 100 percent globally diversified equities. Poor Markets Typical Markets -2 }When Taxable Gifts Are Advantageous years Note: Based on Bernstein estimates of the range of returns for the applicable capital markets over the duration of the analysis. Data does not represent past performance and is not a promise of future results. AllianceBernstein }When Rolling GRATs Are Advantageous after the gift. If the donor fails to live for more than three years, the gift tax will be includible in the donor s gross estate. IRC Section 2035(b). 4. Potential issues that may diminish the benefit of paying gift tax include: (1) the donor s state of residence imposes a state gift tax; (2) the donor must sell appreciated property to pay the gift tax, resulting in an otherwise avoidable tax on the capital gain; (3) by the time the donor dies, her estate would not have been subject to estate tax even if she had not made the gift, because the estate tax has been repealed or because the unified credit has increased; and/or (4) gift and estate tax rates decrease between the date on which the gift is made and the donor s date of death. This last possibility can be particularly detrimental if the donor does not survive for more than three years after the gift, because it can make the donor worse off than if she had not made the gift at all. The reason is that, although IRC Section 2001(b)(2) provides a credit against the estate tax for gift tax paid, the credit is based on only the amount of gift tax that would have been payable had the gift and estate tax rate schedule in effect at the decedent s death been applicable at the time of the gift. 5. See David L. Weinreb and Gregory D. Singer, Rolling Short-term GRATs Are (Almost) Always Best, Trusts & Estates, August 2008 at p See IRC Section Our analyses use a Monte Carlo model that simulates 10,000 plausible future paths of returns for each asset class and inflation and produces a probability distribution of outcomes. (Our model also simulates 10,000 plausible paths for the Section 7520 rate.) But the model does not randomly draw from a set of historical returns to produce estimates for the future. Instead, our forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of an analysis; and (4) factor in a reasonable degree of randomness and unpredictability. 7. For the sake of simplicity, we assume in both cases that the donor has no remaining gift or estate tax exemption and that the gift and estate tax is imposed at a flat 45 percent rate. 8. Specifically, the children invest the gift 35 percent in U.S. value stocks, 35 percent in U.S. growth stocks, 25 percent in developed international stocks and 5 percent in emerging markets stocks. 9. A grantor trust refers to a trust that, under the provisions of IRC Section 671 is ignored for income tax purposes and treated as if the grantor owned the trust assets. Specifically, the grantor must include all items of income, deduction, and credit attributable to the trust in computing his taxable income. 10. See supra note 3. Copyright 2008 by Penton Media, Inc.

6 Global Wealth Management A unit of AllianceBernstein L.P.