ESTATEPLANNINGPLANNINGLeveraging Liquid Wealthto Transfer Illiquid Assets

Francis W. Dubreuil Jon Ruff

February 2009

Illiquid assets, such as real estateor closely held business interests,present attractive lifetime wealthtransfer planning opportunities,

but they pose challenges as well.Strategies used to transfer liquidassets can also work well with illiq-uid ones—for example, direct gifts,intentionally defective grantortrusts (“IDGTs”),1 and grantorretained annuity trusts (“GRATs”).2

And because the value of illiquidassets that are gifted or sold can bediscounted, it’s possible to lever-age the amount of property trans-ferred. Often, however, sizabletransfers of illiquid assets are con-strained because the gift tax exclu-sions available are insufficient todirectly shelter them from taxationor to facilitate other planning.

An installment sale of illiquidassets to an IDGT3 is a classic exam-ple of the constraints that can beencountered. Such a sale is madein exchange for a promissory notethat obligates the trust to pay theprincipal amount plus interest to

the grantor. The wealth transferpayoff comes if the assets sold tothe IDGT produce an investmentreturn that exceeds the interestpayable under the note—in whichcase the excess return is capturedby the trust without gift tax con-sequences. To ensure that the strat-egy is respected for tax purposes,most planners recommend thatprior to the transaction the trustalready hold assets whose valueequals at least 10% of the assets tobe purchased.4 If sufficient prop-erty isn’t already held in the trust,the grantor will usually make aninitial “seed” gift to support a lever-aged purchase of assets by the trust.

The grantor’s ability to shelterthe seed gift from gift tax is limit-ed by the grantor’s (and possiblyhis spouse’s) available lifetime gifttax exclusion.5 As a consequence,installment sale planning is often“capped” at $20 million (or less)of illiquid assets (ten times the max-imum $2 million seed gift to thetrust that can be sheltered from gifttax by the grantor and his spouse’scombined lifetime gift tax exclu-sions). A donor wishing to even-tually make larger sales could usesome portion of his liquid assets tofund a “rolling” GRAT strategy,couple that strategy with an IDGT(new or existing), and thus set thestage for effective future transfersof illiquid assets for the benefit ofyounger generations. Such a hybridtransfer strategy—leveraging liq-uid wealth to transfer illiquidassets—can provide an elegant,flexible, and effective solution thatfamilies with substantial illiquidholdings may want to consider.

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Leveraging Liquid Wealthto Transfer Illiquid Assets

Roll ing grantor retained annuity trusts and intentionally defective grantor trusts provide a powerful synergy that either alone or in combination with installment sales can

leverage l iquid wealth to achieve a family’s i l l iquid asset transfer goals.

FRANCIS W. DUBREUIL AND JON RUFF

FRANCIS W. DUBREUIL is a National Managing Direc-tor, and JON RUFF is a Director, of the Wealth Man-agement Group, at Bernstein Global Wealth Man-agement. The authors are resident in the firm’s SanFrancisco office. Bernstein Global Wealth Manage-ment (“Bernstein”), a unit of AllianceBernstein L.P.,does not provide tax, legal, or accounting advice. Inconsidering this material, you should discuss yourindividual circumstances with professionals in thoseareas before making any decisions.

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Combining roll ing short-term GRATs and IDGTs“Rolling” short-term GRATs fund-ed with marketable securities canadd significant power to any multi-generational wealth transfer plan.In a basic GRAT, the grantor trans-fers assets to the GRAT and retainsthe right to a specified annuity pay-ment from the GRAT each year dur-ing its term. If the grantor struc-tures the GRAT so that it is“zeroed-out” (in other words, theannuity payments are calibrated sothat their present value when theGRAT is funded—discounted by theSection 7520 rate—is equal to thevalue of the assets contributed tothe GRAT), any growth in the valueof GRAT assets beyond the totalamount required to fund the annu-ity payments will be transferred tothe GRAT remainder beneficiariesfree of gift tax.

In a rolling GRAT strategy, thegrantor creates a short-term GRAT(say, one with a two-year term),funds the GRAT with marketablesecurities, and uses each year’s annu-ity payment to fund a new GRAT.The grantor can keep doing this foras many years as he wants, but let’ssay he continues the process for

ten years. During this time, he willhave created nine two-year GRATs(the final one expires in year 10).

Applying Bernstein’s wealth fore-casting model to simulate 10,000market scenarios across a wide rangeof asset classes and likely Section7520 rates, we are able to show howmuch wealth is transferred in themedian case by a rolling GRAT strat-egy that passes the assets remain-ing in any successful GRAT to anIDGT.6 The total wealth reflected byeach bar in Exhibit 1 comprises theaggregate value of the assets receivedby the IDGT from successful GRATs,the subsequent growth of thoseassets, and the portion of that growththat is attributable to the grantor‘spayment of the income taxes on theincome from those assets.7

Assuming a $10 million com-mitment to the rolling GRAT strat-egy (and sufficient other grantorassets from which to pay the incometaxes on the income of the assets inthe GRATs and IDGTs), a grantorcould expect to move $8 million ofinflation-adjusted wealth out of hisestate in ten years’ time in typicalmarkets. The longer the strategy con-tinues, the more powerful it becomes:In two decades, the strategy passes

$22 million to the next generationin typical markets, and in threedecades, a total of $46 million—more than four times the amountcommitted to the strategy.

Rolling GRATs take advantageof the long-term upward trend inthe value of publicly traded stocks,and in effect make market volatil-ity your friend. The key is that overtime, a number of GRATs duringsome periods will likely capturestock price increases for the ben-efit of the GRAT remainder bene-ficiary, free of offsetting stock pricedeclines in other periods. Even if markets are poor and stockreturns are relatively flat (or evendown), over any particular stretchof time there are likely to be sev-eral shorter periods when stockprices move up.

A case in point: The BiltmoresLet’s see how this strategy might beput into practice. Consider a familythat we’ll call the Biltmores, who haveabout $100 million in real estate equi-ty and $30 million in liquid assets.The family is headed by a developerand his spouse, who are both 60 yearsold. The next generation is alsoinvolved in the business.

1 Assets held in an intentionally defectivegrantor trust (“IDGT”) are excluded from thegrantor’s estate for estate tax purposes, butthe income generated by the assets is tax-able to the grantor. Because the grantor islegally responsible for the payment of the tax,that payment is not considered a gift. See Rev.Rul. 2004-64, 2004-2 CB 7. There are a num-ber of interests in, or powers over, a trust thata grantor may have that will cause it to beclassified as an IDGT. One common provisionused by planners is for the IDGT to give thegrantor or a nonadverse person the power,acting in a nonfiduciary capacity, to reacquirethe trust principal by substituting other prop-erty of equivalent value. See Section 675(4).The IRS recently confirmed that the posses-sion of such a power by a grantor will notcause the inclusion of trust assets in thegrantor’s estate under Section 2036 or 2038.Rev. Rul. 2008-22, 2008-16 IRB 796. See Mad-den, Hayes, and Baldino, “Current Tax Devel-opments: Power to Substitute Trust AssetsDoes Not Cause Estate Tax Inclusion, RulesIRS,” 35 ETPL 34 (Sept. 2008).

2 A grantor retained annuity trust (“GRAT”) refersto a trust in which the grantor retains a qual-ified annuity interest within the meaning ofReg. 25.2702-3. Although the Regulationsallow GRAT annuity payments to increase

by 20% each year, the analysis here assumesconstant payments. See Reg. 25.2702-3(b)(ii).

3 Because the assets of an IDGT are treated asowned by the grantor, transactions betweenthe IDGT and the grantor are ignored forincome tax purposes. See Rev. Rul. 85-13,1985-1 CB 184.

4 Under prevailing practice, 10% appears tobe the general rule. However, no tax or legalauthority expressly sanctions 10% as a nec-essary or sufficient amount.

5 In the case of a trust that is not intended to beexempt from generation-skipping transfer(“GST”) tax, additional seed gift tax shelter mightbe obtained by granting Crummey powers totake advantage of the gift tax annual exclusion.See Section 2503(b). A number of recentlyissued private letter rulings concluded that theoriginal grantor continued to be treated as the“owner” of all the trust under the grantor trust rules despite the existence of a Crummeypower under the trust. Ltr. Ruls. 200729005,200729007, 200729008, 200729009, 200729010,200729011, 200729013, 200729014, 200729015,200729016, and 200730011.

6 Bernstein’s analyses use a Monte Carlo modelthat simulates 10,000 plausible future paths ofreturns for each asset class and inflation,and produces a probability distribution of out-

comes. (Bernstein’s model also simulates10,000 plausible paths for the Section 7520rate.) However, the model does not randomlydraw from a set of historical returns to produceestimates for the future. Instead, forecasts(1) are based on the building blocks of assetreturns, such as inflation, yields, yield spreads,stock earnings, and price multiples; (2) incor-porate the linkages that exist among the returnsof various asset classes; (3) take into accountcurrent market conditions at the beginning ofan analysis; and (4) factor in a reasonabledegree of randomness and unpredictability.See the material on Bernstein’s Wealth Fore-casting Analysis in note 14, infra.

7 GRATs are generally not used in conjunctionwith generation-skipping trusts, because dur-ing the annuity term all or a portion of the GRATis subject to inclusion in the grantor’s estate.This period thus constitutes an “estate taxinclusion period” (subject to the “ETIP rule”)during which GST exemption may not be allo-cated to the GRAT. See Section 2642(f) andReg. 26.2632-1(c)(2). However, the grantorcan allocate GST exemption to the GRATremainder upon termination of the GRAT,thereby making it possible for the grantor tomake use of his full GST exemption during lifewithout payment of gift tax.

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EXHIBIT 2GRAT Remainder Passes to IDGT

Rolling GRATs Fund IDGT To Make Iterative Purchases of Real Estate

EXHIBIT 1Value and Growth of Assets

The Role of Rolling GRATs: Scaling Up the Transfer:Rolling GRATs and a Grantor Trust

*Median results; after inflation. All accounts are invested in 100% globally diversified equities. Based on Bernstein estimates of the range of returns for the applicable capital markets over the next 30 years. Data do not represent past per-formance and are not a promise of actual future results or a range of results. See Notes on Wealth Forecasting at the end of this presentationfor further details.

Assumes 7520 rate of 5%, 10% return each year on the GRAT’s assets, and A 30% discount in transfer valuation

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First among the senior Biltmores’goals is to keep the real estate in thefamily. At the same time, they wantto reduce estate taxes to the extentpossible lest the family’s liquid capi-tal be depleted to cover the tax or theybe forced to sell properties—again,something they don’t want to do.

The senior Biltmores havealready used their combined $2 mil-lion lifetime gift tax exclusions tohelp their children purchase per-sonal residences. They also makeannual exclusion gifts to their chil-dren and grandchildren. They haveheard of using an installment saleto an IDGT as a means of trans-ferring illiquid real estate interests,but they understand that an IDGTwould have to be funded with a giftthat would entail their paying gifttax, which they aren’t eager to do.Because their liquid assets are sub-stantial and they are willing to com-mit a portion of them to help trans-fer illiquid assets to the nextgeneration, they consider combin-ing a rolling GRAT strategy withan IDGT as part of their planning.

Bridging il l iquid and liquid assetsWith liquid wealth to draw on, theBiltmores could use a rolling GRATstrategy to transfer marketable secu-rities to one or more IDGTs, whichcould set the stage for effectivewealth transfer of illiquid assets toyounger generations. The trusteeof the IDGT could use the liquidwealth transferred to the IDGT fromsuccessful GRATs to buy fractionalinterests in the real estate (or non-controlling interests in one or moreentities through which the real estateis owned) from the Biltmores with-

out income tax consequences.8 Andbecause the assets the IDGT is pur-chasing are illiquid, they are likelyto be subject to a valuation dis-count—say, 30%—thereby increas-ing the share of the assets the IDGTcould purchase.9 The Biltmores couldthen take the liquid assets receivedas payment for the purchase and startthe process over again, using thoseassets to fund more rolling GRATs.

Assume the Biltmores commit $15million to a rolling GRAT strategywhen the Section 7520 rate is 5%;that means they must get back anannuity payment each year of $8.1million in order to “zero out” an ini-tial two-year GRAT. The rollingGRAT strategy takes advantage ofmarket volatility, so it typicallyrequires time to succeed. But let’sassume for preliminary discussionpurposes that the Biltmores’ initialGRAT assets grow by 10% each year.In that case, the remainder amountat the termination of the GRAT wouldbe about $1.2 million, which wouldpass to an IDGT (see Exhibit 2).

The trustees of the IDGT wouldthen purchase a fractional interestin the Biltmore real estate at a 30%discount, meaning that $1.2 millionwould fund a purchase by the IDGTof $1.7 million in underlying valueof the property, all free of transfertax. At the same time, the Biltmorescould take the $1.2 million in liq-uid assets they receive as paymentfrom the IDGT and plow that backinto the next series of GRATs estab-lished, increasing the amount com-mitted to the strategy and therebyaccelerating the pace of transfer.The Biltmores can then continue thestrategy, following each GRATannuity payment with the fundingof another two-year GRAT until thedesired amount of real estate isbought by the IDGT at a discount.

What does this strategy achieveover time? When we ran the numbers,based on a range of 10,000 possiblepaths of return for the marketable

securities contributed to the GRAT10

(instead of the hypothetical 10%return assumed in the prior example),and looked at the probable outcomesover different time spans, we saw thatin 15 years, in median market con-ditions, the IDGT could purchaseabout $33 million of inflation-adjust-ed real estate from the Biltmores. Over20 years, the IDGT could purchasemore than $50 million in median mar-kets (see Exhibit 3).

If markets were poor (say, atthe bottom decile of forecastedreturns), those numbers would bedifferent ($13 million passed in 15 years, and $23 million over 20 years)—but still impressive interms of the amount of propertytransferred. Indeed, if the value ofthe Biltmores’ real estate portfoliogrew in line with inflation for those20 years, they’d have moved theentire value of the properties out oftheir estate, in median markets,without paying a dollar in gift tax.

World enough and time:Leveraging the strategyNow, the senior Biltmores are only 60years old, so it’s likely that they wouldhave enough time to move all, or asignificant portion, of the real estateout of their estates through such repet-itive purchases. However, mortalityis nonetheless an important consid-eration, and multiple unleveraged pur-chases of real estate interests over timewill almost certainly entail higher val-uation costs and other transactioncosts as well as greater complexity.

To accelerate the pace of trans-fer, the Biltmores could increase theamount committed to the rollingGRAT strategy above $15 million.As Exhibit 1 indicates, an attrac-tive feature of the strategy is its scal-ability. So, for example, doublingthe value of marketable securitiescommitted to the strategy will dou-ble the projected value of success-ful GRAT remainders—and thus thecumulative value of real estate that

8 See note 3, supra.9 The appropriate valuation discount, if any,

applicable to an asset must be determinedby a qualified professional appraiser. Bern-stein is not a valuation advisor; if appropri-ate, consult a qualified appraiser.

10 Assets are invested in globally diversifiedequities (35% U.S. value, 35% U.S. growth,25% developed foreign markets, and 5%emerging markets).

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EXHIBIT 4Leveraging the Strategy

GRATs Can Seed IDGT and Fund Payment of Note Principal

EXHIBIT 3IDGT’s Purchase of Real Estate

The Next Generation’s Stake in the Family Business Grows over Time

3 6 9 12 15

95%

85%

75%

65%

55%

45%

35%

25%

15%

5%

(Year)9 14 19 24 29

95%

85%

75%

65%

55%

45%

35%

25%

15%

5%

(Year)

Probability of Accumulating $3.5 Million (Real) in the IDGT($15 Million Initial GRAT Funding Source)

Probability of Paying Back $3.5 Million (Nominal) Note($15 Million Initial GRAT Funding)

Liquid assets received by the IDGT as remainders from successful GRATs are immediately used to purchase real estate from the senior gen-eration, and then are recommitted to the rolling GRAT strategy. Assumes the senior generation has sufficient liquid assets to pay taxes from addi-tional assets that were not committed to the rolling GRAT strategy. Assumes 30% discount on initial transfer of RE equity to IDGT.

*Range of outcomes is based on Bernstein’s long-term forecasts of capital markets, does not represent any past performance, and is not a prom-ise of actual future results.Please refer to Notes on Wealth Forecasting System for further details.

can be purchased by the IDGT ona fully funded basis—and willshorten the time required to accu-mulate the initial target amount.

The Biltmores could also use therolling GRAT strategy in conjunc-tion with an installment sale to theIDGT. For example, they mightimplement such a sale as soon as thevalue of remainders from successfulGRATs accumulated in the IDGTprovides sufficient seed funding tosupport a leveraged purchase of a50% noncontrolling interest in anentity that owns the Biltmore realestate, at a total purchase price of,say, $35 million (once again, assum-ing a 30% discount from the $50 million fair market value of a pro-portionate share of the underlying realestate). As the left side of Exhibit 4indicates, with a commitment of $15 million to the rolling GRAT strat-egy, there is a 50% probability of accu-mulating at least $3.5 million of seedfunding (inflation adjusted)11 withinfive years of the strategy’s imple-mentation—and a 90% probabilityof doing so in 11 years.

A key benefit of the installmentsale is that the senior Biltmoreswould immediately reduce theirestates by approximately $15 mil-

lion—the discount in valuing thenoncontrolling interest in the under-lying property purchased on afinanced basis. That is ten timesthe amount ($1.5 million) thatwould be removed immediately fromtheir estates if they instead used liq-uid assets to purchase property ona fully funded basis. In addition,post-sale appreciation and incomeattributable to the larger financedproperty purchase would be exclud-ed from their estates rather than onlythat attributable to the smalleramount of property that could bepurchased on a fully funded basis.Transaction costs also would bereduced since fewer purchases of realestate interests would be required.

Following the installment sale, liq-uid assets distributed to the IDGTfrom successful GRATs could also beused to fund payments on the install-ment note and then could be recom-mitted to the rolling GRAT strate-gy.12 Again, in the case of a $15million commitment to the rollingGRAT strategy and a $35 millioninstallment note purchase (see Exhib-it 4, right side), there is a better than50% probability that the continuingrolling GRAT strategy could itselffund payment of the nominal amount

of principal due under the note with-in 17 years of the installment sale,and a 90% probability within 24 years, assuming that the combi-nation of the initial liquid seed fund-ing of the IDGT and cash flow fromthe underlying real estate interestsfund annual interest payments, butnot principal.13 And if necessary toachieve fully the Biltmores’ ultimatewealth transfer goals, further lever-aged purchases of additional inter-ests in the Biltmores’ real estate, andpossibly other illiquid assets, couldbe made by the IDGT at whateverfuture point in time the net equityowned by the IDGT (as a result ofthe combination of note paymentsand real estate cash flow and appre-ciation) would support them.

ConclusionComprehensive wealth transferplanning is a complicated exercise,and when that wealth includes sig-nificant illiquid assets, it is evenmore so. Rolling GRATs and IDGTsprovide a powerful synergy thateither alone or in combination withinstallment sales can leverage liquidwealth to effectively achieve a fam-ily’s illiquid asset transfer goals.14 �

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11 To support the purchase of $35 million ofreal estate (inflation adjusted).

12 The law is unclear regarding the income taxconsequences if the grantor dies while thenote is outstanding. For example, it is possi-ble that the IRS would take the position thatthe grantor’s death results in capital gainrecognition by the grantor or his estate. Forthat reason, payment of the note in full dur-ing the grantor/payee’s life is desirable.

13 Some planners structure the note so that inter-est is capitalized rather than paid each yearand the IDGT makes no payouts until the noteterm expires.

14 Notes on wealth forecasting analysis. TheBernstein Wealth Forecasting Analysissm

(“WFA”) is designed to assist investors in mak-ing a range of key decisions, including set-ting their long-term allocation of financialassets. The WFA consists of a four-stepprocess: (1) Client Profile Input: the client’sasset allocation, income, expenses, cash with-drawals, tax rate, risk-tolerance goals, andother factors; (2) Client Scenarios: in effect,questions the client would like our guidanceon, such as which vehicles are best for inter-generational and philanthropic giving, whathis/her cash-flow stream is likely to be, whetherhis/her portfolio can beat inflation long term,

when to retire, and how different asset allo-cations might affect his/her long-term secu-rity; (3) The Capital Markets Engine: our pro-prietary model, which uses our researchand historical data to create a vast range ofmarket returns, taking into account the link-ages within and among the capital markets(not Bernstein portfolios), as well as theirunpredictability; and (4) A Probability Distri-bution of Outcomes: based on the assetsinvested pursuant to the stated asset allo-cation, 90% of the estimated returns and assetvalues the client could expect to experience,represented within a range established by the5th and 95th percentiles of probability. How-ever, outcomes outside this range are expect-ed to occur 10% of the time; thus, the rangedoes not establish the boundaries for alloutcomes. Further, we often focus on the 10th,50th, and 90th percentiles to represent theupside, median, and downside cases. Asset-class projections used in this publicationare derived from the following: U.S. valuestocks are represented by the S&P/Barra ValueIndex, with an assumed 20-year compound-ing rate of 8.2%, based on simulations withcapital market conditions as of 12/31/07; U.S.growth stocks by the S&P/Barra Growth Index(compounding rate of 8.1%); developed inter-national stocks by the Morgan Stanley Cap-

ital International (“MSCI”) EAFE Index of majormarkets in Europe, Australasia, and the FarEast, with countries weighted by market cap-italization and currency positions unhedged(compounding rate of 8%); emerging marketsstocks by the MSCI Emerging Markets Index(compounding rate of 6.6%); taxable bondsby diversified securities with seven-year matu-rities (compounding rate of 5.4%); real estateinvestment trusts (“REITs”) by the NAREITIndex (compounding rate of 5.3%); a singlestock with a beta of 1.0, volatility of 30%,and a dividend yield of 0% (compounding rateof 5.3%); and inflation by the Consumer PriceIndex (compounding rate of 2.5%). Expect-ed market returns on bonds are derived tak-ing into account yield and other criteria. Animportant assumption is that stocks will, overtime, outperform long-term bonds by a rea-sonable amount, although this is by no meansa certainty. Moreover, actual future resultsmay not be consonant with Bernstein’s esti-mates of the range of market returns, as thesereturns are subject to a variety of economic,market, and other variables. Accordingly, thisanalysis should not be construed as a prom-ise of actual future results, the actual rangeof future results, or the actual probabilitythat these results will be realized.

Reprinted with permission Warren, Gorham & Lamont of TTA