A grantor retained annuity trust (GRAT) is a financial

Transcription

1 Daily Tax Report Reproduced with permission from Daily Tax Report, 238 DTR J-1, 12/11/2014. Copyright 2014 by The Bureau of National Affairs, Inc. ( ) Trusts John D. Finnerty and Rachael W. Park of AlixPartners LLP outline an alternative option pricing model for valuing grantor retained annuity trust interests. The conventional method of valuing GRAT components ignores the optionality in the GRAT residual interest and the downside risk the grantor faces, so the beneficiaries residual interest is typically undervalued and the grantor s receivable is typically overvalued, they write. Applying an option-based approach is appropriate because of the contingent nature of the ultimate payoff to the GRAT beneficiaries. Gifting a Grantor Retained Annuity Trust: A Valuable Option BY JOHN D. FINNERTY AND RACHAEL W. PARK A grantor retained annuity trust (GRAT) is a financial instrument that can be used to make a large gift to a family member without incurring gift tax or using any gift tax unified credit. It is generally employed as an estate freeze technique to transfer wealth between generations in a tax efficient manner. 1 The tax benefit is generally greater when the price of the asset is more volatile because there is generally a 1 The beneficiaries are generally prohibited from being named as beneficiaries of a grantor retained income trust, which is another estate freeze device. John D. Finnerty is managing director at Alix- Partners LLP and a professor of finance at Fordham University. Rachael W. Park is a vice president at AlixPartners LLP. The opinions expressed are those of the authors and do not necessarily reflect the views of AlixPartners LLP, its affiliates, or any of its or their respective other professionals or clients. The information provided in this article is for informational purposes only and is not intended to be legal or tax advice. The reader should consult with an attorney and/or tax professional before acting in reliance on any such information. greater opportunity to transfer value with more volatile assets. Gifting a GRAT residual interest can convey substantial value to the GRAT beneficiaries because of the often highly contingent nature of the residual payment when the GRAT terminates. The value of a GRAT can be a contentious issue in a matrimonial or other dispute. The grantor (husband or wife) retains a portion of the original asset value (the GRAT receivable ), and the GRAT beneficiaries get the rest (the GRAT residual interest ) at the end of the GRAT term, which is gifted to them out of the marital property. 2 But how much of the initial asset value is transferred to the beneficiaries depends on the value of the future contingent payment the beneficiaries will receive. This article describes how to value this contingent payment and explains how this contingent value affects the values of the GRAT receivable and the GRAT residual interest. How a GRAT Works The asset owner, as grantor, establishes a GRAT by setting up an irrevocable trust and funding it by donating assets to the trust. The GRAT agreement provides 2 The GRAT receivable represents the value to the grantor as of the establishment date of the GRAT, and the GRAT residual interest represents the value to the beneficiaries determined at the expiration of the GRAT term. COPYRIGHT 2014 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN

2 2 that the grantor will receive periodic annuity payments (the GRAT annuity payments ) from the trust for a fixed period of time, which defines the term of the trust. At the expiration of the GRAT term, any assets remaining in the trust, the GRAT residual interest, are passed on as a tax-free gift to the trust beneficiaries, who are typically close family members of the donor. The term of a GRAT can be any length of time subject to a minimum of two years. The GRAT annuity payments must be paid to the grantor at least annually. 3 They must comply with Internal Revenue Service regulations, which permit either fixed dollar amounts or fixed percentages of the assets in the GRAT at the inception of the trust. 4 When the GRAT term expires, the beneficiaries receive the GRAT residual interest. Therefore, any appreciation in the value of the assets in the GRAT above what is required to pay the annuity to the grantor is passed on to the GRAT beneficiaries. Since the worst that can happen to GRAT beneficiaries is that they receive nothing at the end of the GRAT term, the GRAT residual interest has a contingent payoff profile like that of a call option. 5 A GRAT has an important weakness. If the donor dies during the GRAT term, the GRAT assets must be included in the donor s estate, which eliminates the potential gift tax benefit. 6 This risk effectively places an upper limit on the desirable term of the GRAT. Conventional Methodology For Valuing Interests in a GRAT When the GRAT is set up, the donor gifts the residual interest in the GRAT (the GRAT gift ) to specified GRAT beneficiaries. 7 The IRS has published regulations governing how the value of the GRAT gift is calculated when the GRAT is set up and how the remaining value is taxed when the GRAT term expires or the donor dies before the end of the term. 8 The IRS formula ignores the value of the GRAT residual interest, which makes it inappropriate for valuing the GRAT components in connection with a marital or other dispute. The value of the GRAT gift is calculated for gift tax purposes as the fair market value of the assets initially 3 Treas. Reg. Section (b). 4 Treas. Reg. Section (b). 5 A call option conveys the right, without an obligation, to buy an asset at a stated strike price before the option expires. If the asset price is below the strike price, the option holder will let the option expire worthless. If the asset price exceeds the strike price, the option holder will exercise it and pocket the difference between the asset price and the strike price. The greater this difference, the higher the call option holder s payoff. 6 I.R.C. Section The GRAT gift represents the value to the beneficiaries calculated as of the establishment date of the GRAT. 8 Treas. Reg. Section (e). contributed to the GRAT plus the theoretical amount of interest calculated at a rate of interest determined by IRS regulations (in effect for the month the GRAT is established), 9 which is applied to the principal in the GRAT, minus the amount of the GRAT annuity payments that will be paid to the grantor during the GRAT term. The theoretical rate of interest (the Section 7520 interest rate ) is adjusted monthly and is equal to 120 percent of the applicable federal midterm interest rate for the month the GRAT is established. 10 Gift tax may be avoided by making the value of the GRAT gift zero under the IRS gift tax formula. 11 This is accomplished by making the present value of the GRAT annuity payments equal to the fair market value of the GRAT assets. The intuition underlying this calculation is that the amount that will be returned to the donor through the GRAT annuity payments will be equal to the value of the assets the grantor donated to the GRAT plus the amount of theoretical interest adjusted for present value. However, this formula ignores the value of the GRAT residual interest, which makes it inappropriate for valuing the GRAT components in connection with a marital or other dispute. When the GRAT is funded with common stock or another type of asset with a highly volatile price, the total investment return realized on the GRAT assets can greatly exceed the amount of theoretical interest. The GRAT beneficiaries will get the lion s share of the investment return tax-free in that case. Importantly, the value of the assets remaining in the GRAT at termination may be quite large notwithstanding the zero value initially placed on the GRAT gift under the IRS formula. Example Table 1 illustrates the valuation of the GRAT components according to the IRS formula. A grantor contributes $1 million of a non-dividend-paying stock to a 10- year GRAT. The grantor will receive $120,000 each year during the 10-year term. The stock is expected to appreciate 10 percent each year during the 10-year term. Assume the Section 7520 interest rate is 4 percent. The present value of the GRAT annuity payments to be distributed to the grantor is $973,307. Therefore, the value of the GRAT gift, calculated as of the inception date, is equal to the difference between the initial contribution amount ($1 million) and the present value of the GRAT annuity payments ($973,307), or $26, This difference is treated as a gift for gift tax purposes. With the assumed 10 percent annual rate of stock price appreciation, the stock in the trust is expected to be worth $681,252 at the end of the GRAT term, which will be distributed to the trust beneficiaries tax-free (but subject to capital gains tax upon a potential sale of the stock). However, the donor is liable for gift tax only on the (initial) $26,693 value of the GRAT gift even though 9 Treas. Reg. Section (b) and (d). 10 I.R.C. Section 7520 specifies the interest rate that must be used to value certain charitable interests in trusts. It is published monthly by the IRS. 11 Walton v. Commissioner, 115 T.C. 589 (2000), acq. Notice , IRB , Oct. 15, 2003, established the method the IRS currently uses to calculate the value of the GRAT gift for gift tax purposes. 12 For the sake of simplicity, no discounts have been applied to the value of the stock in this example COPYRIGHT 2014 BY THE BUREAU OF NATIONAL AFFAIRS, INC. DTR ISSN

3 3 the value of the (ultimate) gift the GRAT beneficiaries will receive at the end of the GRAT term is $681,252. As this example illustrates, any appreciation in the value of the GRAT assets in excess of the Section 7520 interest rate benefits the beneficiaries of the GRAT, who receive the entire GRAT residual interest. Criticism of the Conventional GRAT Appraisal Methodology The value of the GRAT gift should be equal to the present value of the GRAT residual interest, which is the residual payment, if any, the GRAT beneficiaries will receive when the GRAT terminates. But appraisers conventionally apply the IRS formula illustrated in Table 1, or a similar method of calculation, when there is a marital or other dispute regarding the value of the GRAT. They calculate the value of the beneficiaries interest in the GRAT, including the value of the GRAT gift at inception, as the difference between the current fair market value of the GRAT assets and the present value of the (remaining) GRAT annuity payments. 13 They typically use the Section 7520 interest rate as the discount rate to value the stream of GRAT annuity payments. The choice of interest rate is important because the higher the discount rate, the smaller the present value of the stream of GRAT annuity payments and the greater the value of the GRAT gift. By discounting at the Section 7520 interest rate to value the grantor s GRAT receivable, the conventional GRAT appraisal methodology usually fails to adjust properly for the specific risk of loss the grantor faces under the GRAT structure. If the value of the GRAT assets falls to zero during the GRAT term, the GRAT annuity payments to the grantor will cease. The grantor bears this risk of loss of value. The fair market value of the GRAT receivable at the inception date could be less, perhaps even far less, than the present value of the GRAT annuity payments calculated by discounting at 13 Treas. Reg. Section (b). the Section 7520 interest rate, depending on how the risky asset s value might change during the term of the GRAT. The discount rate used to value the GRAT receivable should be chosen so as to reflect properly the grantor s risk of loss. The GRAT beneficiaries are shielded from this loss; although they might not receive anything at the end of the GRAT term, that is the worst that can happen to them. Therefore, the present value of the GRAT annuity payments discounted at the Section 7520 interest rate generally represents the maximum value of the grantor s GRAT receivable. Consequently, the conventional approach to valuing the GRAT receivable will usually overstate the fair market value of the grantor s interest in the GRAT. Similarly, calculating the value of the GRAT gift as the fair market value of the GRAT assets minus the present value of the GRAT annuity payments would generally understate the value of the GRAT gift. The valuation will be accurate only if the riskadjusted discount rate is chosen correctly. Option-Based Methodology For Valuing the GRAT Components The conventional appraisal methodology for valuing the grantor s GRAT receivable and the beneficiaries GRAT gift also fails to recognize the option value that is effectively transferred from the grantor to the beneficiaries at the end of the GRAT term. An appraiser can quantify the amount of value transferred by applying an option pricing model to value the GRAT gift. Chart 1 illustrates the difference between the conventional approach and our recommended option-based approach to valuing the GRAT components. Under our recommended methodology, the value of the grantor s GRAT receivable is reduced by the amount transferred to the GRAT beneficiaries. As shown in Chart 1, a portion of the value of the GRAT annuity payments is effectively transferred to the Chart 1 Distribution of the Value of the GRAT Assets between the Grantor and the Beneficiaries Based on the Conventional GRAT Appraisal Methodology and the Option-Based Methodology Conventional GRAT Appraisal Methodology Option-Based Methodology Initial Value of the Asset Contributed to the GRAT Value of the GRAT Receivable as Measured by the Present Value of the GRAT Annuity Payments (Value of the Grantor's Interest) (Value of the Beneficiaries' Interest) Value of the GRAT Receivable (Value of the Grantor's Interest) (Value Transferred to the Beneficiaries) As Measured by the Value of a Call Option (Value of the Beneficiaries' Interest) DAILY TAX REPORT ISSN BNA

4 4 Table 1 Calculation of the Present Value of the GRAT Annuity Payments and the GRAT Gift Based on the Conventional GRAT Appraisal Methodology Assumptions Initial Contribution (in stock) $ 1,000,000 Term of Trust (years) 10 Annuity Payment to the Grantor $ 120, Interest Rate 4% Annual Growth Rate of Stock Value 10% Calculation of the Components of the GRAT Present Value of GRAT Annuity Payments (Value of the Grantor s Interest in the GRAT) $ 973,307 [1] (Value of the Beneficiaries Interest in the GRAT) $ 26,693 [2] The Remaining Value in the GRAT Notes: [1] [2] Year Year-End Asset Value Annuity Payment Ending Balance 1 $ 1,100,000 $ 120,000 $ 980, ,078, , , ,053, , , ,027, , , , , , , , , , , , , , , , , , , , ,252 Present value is calculated by discounting at the 7520 interest rate. The value of the GRAT gift is calculated as the initial contribution amount less the present value of the GRAT annuity payments. beneficiaries who receive the GRAT residual interest. The value so transferred can be calculated by recognizing that the GRAT residual interest has a contingent payoff profile like that of a call option. A call option on an asset is a financial instrument that gives the option holder the right, without the obligation, to purchase the asset for a stated exercise price within a specified period. The option holder will exercise this right if the asset s price exceeds the strike price on the exercise date. Otherwise, the holder will let the call option expire worthless because it doesn t pay to exercise it. The value of the call option derives from the appreciation in the value of the underlying asset above the stated exercise price before the call option expires. The GRAT residual interest has this same call option payment profile. The GRAT beneficiaries effectively have the right, without any obligation, to receive the GRAT residual interest. The option payoff is contingent on what remains in the trust after all the GRAT annuity payments have been made. When the GRAT is established, the value of the underlying asset in the call option model is the value of the assets contributed to the GRAT; the time to expiration is the GRAT term; and the stated exercise price of the call option is the value of the GRAT annuity payments compounded forward to the GRAT expiration date. Compounding these payments forward expresses them as of the date the amount of the GRAT residual interest is determined. As with a typical call option, the GRAT residual interest has a zero payoff when there are insufficient assets in the GRAT to cover the GRAT annuity payments (because the GRAT residual interest is determined at expiration). In that case, the grantor realizes the entire GRAT value, the beneficiaries receive nothing, and the GRAT residual interest is zero. Any asset price appreciation above the value of the GRAT annuity payments before the GRAT terminates is paid to the GRAT beneficiaries. The GRAT gift (consisting of the transferred option value) is under the control of the GRAT trustee and benefits the GRAT beneficiaries, not the grantor. However, as noted, the grantor s interest in the GRAT does face a significant downside risk: If the fair market value of the GRAT assets falls below the value of the GRAT annuity payments at any point during the term of the GRAT and fails to recover, the grantor won t receive the full amount of the expected GRAT annuity payments. As a result, the grantor faces the same risk COPYRIGHT 2014 BY THE BUREAU OF NATIONAL AFFAIRS, INC. DTR ISSN

5 5 Table 2 Valuation of the GRAT Gift and GRAT Receivable Under the Conventional GRAT Appraisal Methodology And the Option-Based Methodology Panel A. Calculation of the Components of the GRAT Based on the Conventional GRAT Appraisal Methodology Assumptions Value Initial Contribution to the GRAT (in Stock) $ 1,000,000 Term of Trust (Years) 10 Annuity Payment to the Grantor (per Year) $ 120, Interest Rate 4.00% [1] Calculation of the Components of the GRAT Value of the GRAT Receivable $ 973,307 (Present Value of GRAT Annuity Payments) $ 26,693 [2] Panel B. Calculation of the Components of the GRAT Based on the Option-Based Methodology Assumptions Component of BSM Value Model Initial Contribution to the GRAT (in Stock) S 0 $ 1,000,000 Risk-Free Rate r f 3.33% [3] Annualized Volatility of the Stock σ 30% GRAT Term T 10 Annuity Payment to the Grantor (per Year) $ 120,000 Future Value of Annuity Payments K (Strike) $ 1,396,972 [4] Calculation of the Components of the GRAT $ 347,905 (Value of a Call Option Based on the BSM Model) Value of the GRAT Receivable $ 652,095 [5] Notes: [1] [2] [3] [4] [5] 7520 interest rate is equal to 120 percent of the applicable federal midterm interest rate for the month the GRAT is established. I.R.C specifies the interest rate that must be used to value certain charitable interests in trusts, which is published monthly by the IRS. The value of the GRAT gift is the fair market value of the GRAT assets less the present value of the GRAT annuity payments. The risk-free rate is equal to the federal midterm interest rate under a standard risk-neutral framework. Strike price represents the value of the GRAT annuity payments compounded forward to the GRAT expiration date at the risk-free interest rate. The value of the GRAT receivable is equal to the fair market value of the GRAT assets less the value of the GRAT gift. return profile as any asset holder who writes a call option on an asset. He forgoes all of the upside potential above the strike price and retains all the downside risk below the strike price. It is appropriate to value the GRAT gift in a manner that recognizes the GRAT residual interest s option value. For example, the popular Black-Scholes-Merton (BSM) option pricing model can be used for this pur- DAILY TAX REPORT ISSN BNA

6 6 pose. 14 According to the BSM model, the premium on a standard stock option is determined by six factors the market price of the stock at the time the option is valued (S 0 ), the time until the option is scheduled to expire (T), the interest rate on riskless (i.e., government) debt with a maturity equal to the option s time to expiration (r f ), the option strike price (K), the stock s dividend yield (D) and the volatility of the stock price (σ). 15 To apply the BSM model to value the GRAT components, treat the fair market value of the GRAT assets on the contribution date as the market price of the stock, the time until the GRAT expiration date as the time to option expiration, the future value of the GRAT annuity payments as of the GRAT termination date as the strike price, and the annualized volatility of the GRAT asset s price as the volatility. The value of the GRAT gift is the call option value of the beneficiaries GRAT residual interest, which is based on the BSM model with these parameters. Value of the GRAT Receivable The value of the GRAT receivable as of the establishment date of the GRAT is the difference between the fair market value of the GRAT assets and the value of the GRAT gift. Table 2 illustrates this calculation. 14 Hull, John C., Options, Futures, and Other Derivatives, 8th ed., Pearson, Boston, 2012, pages Hull, John C., Options, Futures, and Other Derivatives, 8th ed., Pearson, Boston, 2012, pages Example Table 2 compares the calculation of the value of the grantor s GRAT receivable and the value of the beneficiaries GRAT gift using the two valuation methodologies. We valued the GRAT receivable and the GRAT gift in the standard risk-neutral framework, in which the annual growth rate of the GRAT assets is equal to the risk-free interest rate (the federal midterm rate). Panel A of Table 2 values the components of the GRAT under the conventional GRAT appraisal methodology. The value of the grantor s GRAT receivable is calculated by present valuing the GRAT annuity payments at the Section 7520 interest rate, and the value of the beneficiaries GRAT gift is equal to the difference between the fair market value of the GRAT assets and the value of the GRAT receivable. The value of the GRAT receivable is $973,307, and the value of the GRAT gift is $26,693. As noted, the present value of the GRAT annuity payments overstates the value of grantor s interest in the GRAT, because this present value calculation doesn t take into account the downside risk to which the grantor is exposed during the term of the GRAT. Panel B of Table 2 illustrates our recommended option-based valuation of the GRAT components. Panel B assumes the same GRAT features as Panel A. In addition, the risk-free rate is the federal midterm rate, the asset price volatility is 30 percent, and the strike price is the value of the GRAT annuity payments compounded forward to the GRAT expiration date at the risk-free rate. Applying the BSM model, the value of the GRAT gift is $347,905, which represents the expected present value of the beneficiaries GRAT residual interest. The value of the GRAT receivable is $652,095. As illustrated in this example, a significant amount of value, $321,212 (= $973,307 - $652,095), is transferred from the grantor to the GRAT beneficiaries. The value of this wealth transfer becomes clear when an option pricing model is used to value the GRAT components. This transfer of value represents the expected value of the asset appreciation that the grantor gifts to the beneficiaries when the investment return on the GRAT assets exceeds the Section 7520 interest rate. It also corresponds to the grantor s expected loss of value due to the risk that the value of the GRAT assets might decline causing the GRAT annuity payments to be less than initially promised. 16 Conclusion GRAT valuation can become a contentious issue when there is a marital or other dispute and the assets involved include an interest in a GRAT. The conventional method of valuing GRAT components ignores the optionality in the GRAT residual interest and the downside risk the grantor faces, which might interrupt or reduce the flow of GRAT annuity payments. As a result, the beneficiaries GRAT residual interest is typically undervalued, and the grantor s GRAT receivable is typically overvalued, the difference in each case reflecting the miscalculation of the amount of value transferred when the conventional GRAT appraisal methodology is applied. This article describes a method of GRAT valuation that respects the optionality of the GRAT residual interest. It recommends and illustrates using a simple option pricing model to value the beneficiaries GRAT residual interest as a call option where the strike price is the value of the GRAT annuity payments compounded forward to the GRAT expiration date on which the amount of the residual assets in the GRAT trust is determined. Our recommended approach properly accounts for the portion of GRAT asset value the grantor transfers to the beneficiaries. Applying an option-based approach is appropriate because of the contingent nature of the ultimate payoff to the GRAT beneficiaries. 16 The two explanations represent two equivalent ways of characterizing the transfer of value to the GRAT beneficiaries. This equivalence is a direct consequence of what is known as put-call parity. Hull, John C., Options, Futures, and Other Derivatives, 8th ed., Pearson, Boston, 2012, pp A fuller discussion of this point lies beyond the scope of this article COPYRIGHT 2014 BY THE BUREAU OF NATIONAL AFFAIRS, INC. DTR ISSN