the bankers club of miami, one biscayne tower, 2 south biscayne blvd., 14 th floor, miami, florida...

The Bankers Club of Miami, One Biscayne Tower, 2 South Biscayne Blvd., 14 th Floor, Miami, Florida

 “6 CREATIVE GRAT STRATEGIES!”

April 18, 2013

Mark R. Parthemer, Esq. AEPBessemer TrustManaging DirectorSenior Fiduciary Counsel, Southeast Region HeadPalm Beach, FL(561) 655-4030parthemer@bessemer.com

Estate Planning Councilof Greater Miami

Copyright © 2013 by Bessemer Trust Company, N.A. All rights reserved.

Thoughts on Tax Law

“The only difference between death and taxes is that death doesn't get worse every time Congress meets.”- Will Rogers

“I like to pay taxes. It is purchasing civilization.” - Oliver Wendell Holmes

“I am proud to be paying taxes in the United States. The only thing is I could be just as proud for half of the money.”- Arthur Godfrey

“The way taxes are, you might as well marry for love.” - Joe E. Lewis

“There’s nothing wrong with the younger generation that becoming taxpayers won’t cure.”- Dan Bennett

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Administration’s Budget

Released April 10, 2013. Include:

1. Exemptions and rates to 2009 system...$3.5M and 45%.

2. Cap on short-term GRATs plus cap of length at life expectancy + 10 years; no declining annuities.

3. 90 duration of GST exemption.

4. Eliminate HEET trusts by only permitting GST exemption for payment of health and education expenses from individuals.

5. Grantor trust redux. Here again for the second time, but narrowed to focus on installment sales to grantor trust.

6. Basis consistency.

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* Assumes §7520 rate of 2.00 %. ** Assumes trust assets grow at 8%. *** Assumes 20% increase in annuity annually.

Nearly zeroed-out Grantor Retained Annuity Trust

Step 1

Remainder after 2 years: $197,798(no gift tax)

Step 3Annuity***Step 2

Year 1: $937,295Year 2: $1,124,754

Returned to Grantor$2,062,049

(Grantor) Trust for Children$197,798

Initial GRAT Funding

$2,000,000

Amount transferred $2,000,000Value of annuity $1,999,999 *Value of remainder (Gift) $1

Three Keys to Advanced GRAT Planning

• Fundamental Determination: Optimal Term

• Probability Analytics: Annuity

• Free flip of the transfer coin: “Heads I Win; Tails I Get My Money Back”

– Freeze technique, but

– Advisors should “Wait” on GRATs…like a table server at a busy fine dining establishment!

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Understanding GRATs as a Freeze Technique

All value returns to grantor

3%4%

Return to Grantor**

* The hypothetical examples included in this presentation are for illustration only and are not projections of future returns, tax rates or exemption amounts.** The hypothetical examples included in this presentation assume an Internal Revenue Code §7520 rate of 4.0%.

“Hypothetical” One-year 4% GRAT with 3% Return*

Often, Focus Is Only on Return

6%

4%

Return To Grantor

Transfer To Next Generation

4%

10%

* The hypothetical examples included in this presentation are for illustration only and are not projections of future returns, tax rates or exemption amounts.** The hypothetical examples included in this presentation assume an Internal Revenue Code §7520 rate of 4.0%.

“Hypothetical” One-year 4%* GRAT with 10% Return**

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Three sample growth patterns of $1,000,000 investments

Portfolio GRAT: Flat versus Increasing Annuity — Impact of Path Dependency

0

25

50

75

100

125

150

175

Day 1 Year 2 Year 3 Year 4 Year 5 End Yr 5

Steady-Eddy (10%) Beta One (20, 20, 4, 4, 4) Beta Two (-20, -20, 36, 36, 36)

$1,610,000

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Path Dependency: Increasing Annuity Creates Benefit

5 year GRAT Results

1. Leveraged Mixed Asset GRATs

• Fund GRAT with discounted asset, hard-to-value asset or alternative assets. Add fixed income portfolio.

• Use fixed income to fund annuity first.• Gives time for other assets to percolate.• Creates arbitrage between annuity based on partial discount yet

paid in non-discounted assets.

• To ease timing on funding and ease on transfer throughout, drop hard-to-transfer assets (e.g., private equity) into an LLC.

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LLC

GRAT

• Contribute LLC units and fixed income into GRAT.

• GRAT trustee first uses fixed income to satisfy annuity payments.

Fixed Income

Step 2

Leveraged Mixed Asset GRAT

Assets With Growth Potential

LLC Units

Step 1Create Family Entity

and Trust

Annuity Payments

• GRAT Remainder into Grantor Trust.

• GRAT Remainder into Grantor Trust.

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Initial 1 2 3 4 5 $-

$200,000

$400,000

$600,000

$800,000

$1,000,000

$1,200,000

$1,400,000

$1,600,000

$1,800,000

$2,000,000

Private Equity*

5 Year GRAT with 50% Private Equity and 50% Fixed Income

April 2013 7520 Rate 1.40%

Fixed Income/Yield $ 1,000,000 3.00%

Private Equity/Growth $ 1,000,000* 20.00%

Fixed Income

* For illustrations purposes, assumes no valuation discount.

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LLC

GRAT

• Contribute LLC units and fixed income into GRAT.

• GRAT trustee first uses fixed income to satisfy annuity payments.

Fixed Income

Step 2

Bonus: Leveraged Mixed Asset GRAT with Loan from GST Exempt Trust

Assets With Growth Potential

LLC Units

Step 1Create Family Entity

and Trust

Annuity Payments

Loan

• GRAT Remainder into Grantor Trust.

• Grantor Trust repays loan with LLC units.

• GRAT Remainder into Grantor Trust.

• Grantor Trust repays loan with LLC units.

GST ExemptTrust

2. Portfolio GRATs: Separate GRATs for Correlated or Concentrated Positions

Diversification:• Prudent (Imperative) under Modern Portfolio Theory,

but• Anathema to a Portfolio GRAT!

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Portfolio GRAT: Asset Selection Not Enough

Return Ending Value

1,000,000 @ $50 Company A +20% $60 $6,000,000

1,000,000 @ $50 Company B -20% $40 $4,000,000

$10,000,000

Minimum annuity to grantor* $10,140,000

Amount transferred to next generation – 0 –

* Assumes a 1.4% §7520 rate and for illustration and emphasis purposes only, a fictitious one year GRAT term.

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Split Uncorrelated Assets into Separate GRATs

GRAT 1:

Company A +20% $60 $6,000,000

Minimum annuity to grantor* $5,070,000

Amount transferred $930,000

GRAT 2:

Company B -20% $40 $4,000,000

Minimum annuity to grantor* $5,070,000

Amount transferred – 0 –

Total Transferred $930,000* Assumes a 1.4% §7520 rate and for illustration and emphasis purposes only, a fictitious one year GRAT term.

3. Portfolio GRATs: Use Substitution Power to Manage Performance

Resulting Raw Volatility Creates Likelihood of Greater Swings

Focus on Swings; Not Just Return over Term

Tactically Deploy Substitution Power to:• Lock-in Winners• Re-GRAT Losers

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Portfolio GRAT:Active Management via Substitution Power

8%

Time Maturity

Capture intermediate appreciation

Expected Volatility

Swap Zone!

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Portfolio GRAT: Active Management via Substitution Power

Why waste reversion to mean?

Swap Zone!

Expected Volatility

Time Maturity

8%

Case Study: $2,500,000 Portfolio GRAT

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GRAT #1 - $380,000

GRAT #2 – Failed

GRAT #3 - $610,000

Total - $980,000

If still original GRAT - Failed

4. “Shelf” GRATs

Four Risks to a Rolling GRAT Program:

1. Donor dies.

2. Assets decline in value.

3. 7520 rises dramatically.

4. Law change prohibits new short term GRATs.

Shelf GRATS can mitigate risks #3 and 4.

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4. “Shelf” GRATs

Step One: Create inventory of mid through longer GRATs.

Step Two: Fund currently with low volatile assets.

Step Three: Set on “Shelf” (but pay annuities).

Step Four (when needed): Swap in volatile assets to activate.

• Article April/May edition of Probate & Property.

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Impact of Minimum 10 Year Term

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First 5 years:

31.54%

7520 Rate 1.40%

Annuity Growth 20%

10 9 8 7 6 5 4 3 2

1 4.24% 5.24% 6.53% 8.26% 10.65% 14.08% 19.35% 28.29% 46.44%

2 5.09% 6.28% 7.84% 9.92% 12.78% 16.89% 23.22% 33.95% 55.73%

3 6.10% 7.54% 9.41% 11.90% 15.33% 20.27% 27.86% 40.74%

4 7.32% 9.05% 11.29% 14.28% 18.40% 24.33% 33.43%

5 8.79% 10.86% 13.55% 17.13% 22.08% 29.19%

6 10.55% 13.03% 16.26% 20.56% 26.49%

7 12.66% 15.63% 19.51% 24.67%

8 15.19% 18.76% 23.41%

9 18.23% 22.51%

10 21.87%

Why Prohibit “Front-Loading” of Annuity

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First 3 years:

90.02%

7520 Rate 1.40%

Annuity Growth -50%

10 9 8 7 6 5 4 3 2

1 51.44% 51.49% 51.58% 51.77% 52.15% 52.94% 54.63% 58.40% 67.91%

2 25.72% 25.74% 25.79% 25.88% 26.07% 26.47% 27.31% 29.20% 33.96%

3 12.86% 12.87% 12.90% 12.94% 13.04% 13.24% 13.66% 14.60%

4 6.43% 6.44% 6.45% 6.47% 6.52% 6.62% 6.83%

5 3.22% 3.22% 3.22% 3.24% 3.26% 3.31%

6 1.61% 1.61% 1.61% 1.62% 1.63%

7 0.80% 0.80% 0.81% 0.81%

8 0.40% 0.40% 0.40%

9 0.20% 0.20%

10 0.10%

5. Leveraged GRAT Combined with Sale Transaction.

Concept: Client with investment FLP sells and contributes LP units and other assets (e.g., fixed income) to an LLC; (Discounted) Sale price paid with a Note; Note contributed into a GRAT.• Leveraged GRAT (Strategy #1) effective, plus may serve as

revaluation buffer.• Extraordinary leverage if Note interest can fully fund GRAT

annuity payments.• Consider SCIN.

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FLP

GRAT

• Client contributes and sells LP units plus other assets to LLC.

GRAT annuity funded with Note interest.

Step 2

Leveraged GRAT with Sale

Assets With Growth Potential

LP UnitsStep 1

Create Investment FLP.

LLC• LLC pays with a Note.• Could be a SCIN.

Step 3

Fund GRAT with Note.

• GRAT Remainder into Grantor Trust.

• GRAT Remainder into Grantor Trust.

6. Derivatives with GRATs

Some contribute derivatives into GRATs.

There also is an ability to have the GRAT use them.

All entail friction costs and must be justified by whatever enhancement may result to the probability of transferring more value (or cap ultimate transfer).

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Public versus Private

Private hedge transactions may minimize costs.

Use of grantor’s spouse may avoid reciprocal trust issues and income taxation:• Sales between spouses tax free under section 1041.• Sales between grantor trust and grantor’s spouse tax free. PLR

8644012; PLR 20012007.

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One of Two Counter-party Options

Grantor’s spouse (or other party) purchases from the GRAT an out-of-the-money - call option with a strike price that is higher than the market price.

Option priced via Black-Scholes or other binomial model. Rev. Proc. 98-34.

Example: Assume that for a $10 Stock, a $12.50 option sells for $3.29.

Result:

1. Success: Stock rises above $12.50, remainder beneficiaries receive benefit of 25% return ($12.50/share) plus 32.9% option return ($3.29/share), less §7520. Balance of upside reverts to grantor’s spouse.

2. Success: Stock does not exceed $12.50, remainder beneficiaries receive actual growth plus option return of $3.29, less §7520.

3. Success: Stock remains at $10, GRAT has $13.29/share and remainder beneficiaries receive $3.29, less §7520.

4. Success or Failure: Stock drops below $10, remainder beneficiaries receive excess, if any, of reduced value plus $3.29, less $10 and less §7520. (If 7520 were 0%, stock could drop to $6.72 and GRAT still would be (barely) successfully.)

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Derivative Example #1: Sell an Out-of-the- Money Option.

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GRAT purchases at-the-money call option (option's strike price is identical to the price of the underlying security). This provides GRAT right to future growth, if any.

Example: GRAT owns 100 shares trading at $100 per share. Trust purchases option on 100 shares at $100.

Result:Success: Remainder beneficiaries receive double on growth, if any, less cost of option

and less §7520.

Failure: GRAT will fail if stock price goes down, remains flat or is up negligible amount (not enough to offset cost of option plus §7520).

Derivative Example #2: Purchase an At-the-Money Option.

Derivative Example #3: Covered-call Combination.

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GRAT:

• Purchases an at-the-money option, and• Sells an out-of-the-money call option.

Use strike price or limit number of shares so net no cost to GRAT.

Example: GRAT owns 100 shares trading at $100 per share. Trust purchases option on 100 shares at $100 (same as Example #2). Further, GRAT sells option on 200 shares at $120 per share.

Result: Success: Assuming cost of options net to zero, remainder beneficiaries receive double on growth from $100 to $120, but nothing on growth above $120, less §7520.

Failure: GRAT will fail if stock price goes down, remains flat or growth on 200 shares is less than §7520.

Potential to double gain on modest growth stocks, with little to zero net cash cost. Achieved by giving up excess growth.

Share PriceLower

Share PriceHigher

StockPrice

GRAT Fails

GRAT Succeeds

Simplified GRAT Payoff Chart (7520 @ 0%)

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Funding Value

Share PriceLower

Share PriceHigher

StockPrice

Receive Premium forAgreeing to cap return

Impact of selling a “Covered Call” Strategy

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Share PriceLower

Share PriceHigher

StockPrice

Return is capped

Payoff Chart of GRAT with “Covered Call”

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One More Thought on Tax Law

“Why does a slight tax increase cost you two hundred dollars and a substantial tax cut save you thirty cents?” - Peg Bracken

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