Low Internal Revenue Service discount rates make this an ideal time to use grantor retained annuity trusts (GRATs), as it's easier now to get over the hurdle that makes the GRAT effective. Still, the fact that one has to beat the IRS discount rate does create uncertainty that still makes some donors reluctant to employ the strategy.
We've identified a way that could improve taxpayers' chances for success. Our research into current stock option premiums suggests that pursuing covered call option writing strategies can meaningfully boost the probability that the returns on investments in a GRAT could exceed the discount rate that is used in creating that GRAT — especially over shorter time frames.
To explain our thinking and research, we offer some simulations. We also offer a method advisors can apply to a client's situation to design and manage a GRAT with a potentially higher probability of achieving its aims.
Typical Use of a GRAT
Of course, a GRAT can help clients achieve a number of financial goals simultaneously. Its basic function is to give the grantor back a predetermined income stream while systematically gifting the appreciation of the GRAT's assets to the grantor's heirs. GRATs also can freeze the value of a particular asset that the grantor hopes or anticipates has significant potential for capital appreciation. The planning objective in any valuation freeze is to make a gift of property during the grantor's lifetime and allow the transferred property to appreciate outside the grantor's estate. By giving the property during the grantor's lifetime, the value of the property can be frozen for transfer tax purposes, and any appreciation that occurs after the gift is made will not be included in the grantor's estate.
The primary limitations to a GRAT stem from its two great uncertainties: The first is the risk that the grantor may die before the GRAT matures, thereby causing the assets in the trust to be included in the grantor's estate.1 One way to reduce this first risk is to shorten the term of the GRAT. But shorter-term GRAT structures heighten the second risk: underperformance. The assets may not appreciate in excess of the IRS-mandated discount rate over the short time frame. If they don't, the value of the payments back to the donor may actually equal or exceed the ultimate value of the assets in the GRAT, nullifying the donor's attempts to transfer wealth to his heirs.
A popular variation of the GRAT is a so-called “near-zero” GRAT. In a near-zero GRAT, the donor creates a short-term GRAT whose annuity payments to himself are sufficiently large to eliminate all but token tax liability. A near-zero GRAT is particularly useful as it can satisfy the need for a short time frame with little impact from estate and gift taxes. Near-zero GRATs can serve as a means of reducing a taxable estate in the last years of clients' lives. By returning the vast majority of the principal of the trust back to a donor in the form of annuity payments, the taxable gift portion of the transfer to the trust can be largely eliminated. Donors perceive little risk in this strategy, because if the GRATs don't succeed in delivering the hoped-for estate-tax benefits, the assets would have been taxed in the donor's estate anyway.
As with a traditional GRAT, all growth in the assets above the Internal Revenue Code Section 7520 discount rate used in calculating the GRAT's fixed annuity payment still would pass to a grantor's designated beneficiaries. The question is how to help ensure that these assets grow at a rate that results in significant wealth transfers.
To illustrate these issues, let's look at a two-year near-zero GRAT with an initial gift of $1 million in stock.2 Assume a senior executive has substantial holdings in his company's stock. He believes those shares can appreciate an average of 11 percent a year over the next two years. The IRS Section 7520 discount rate as of April 2008 is 3.4 percent. The donor's advisor calculates an annuity rate that will result in annuity payments to the grantor that equal the present value of the property the grantor is transferring, making the present value of the remainder interest essentially zero for gift- and estate-tax purposes. In this case, an annuity rate of 52.565 percent of the trust principal each year creates a two year near-zero GRAT. So what do we have? The grantor is giving $1 million to the trust and getting about $1.051 million back in annuity payments over the two years. But the appreciation in the shares, if realized both before and after the first annuity payment, raises the value of the holdings to $1,174,278, leaving nearly $123,000 of value to the grantor's heirs at no gift-tax cost. In this way, the appreciation of the property above the 3.4 percent is transferred to the beneficiaries free of gift or estate tax.3 (See “GRAT Math,” this page.)
The need to beat the IRS Section 7520 discount rate creates both challenges and opportunities. April 2008's rate of 3.4 percent4 was substantially lower than July 2007's rate of 6.0 percent. (See “Opportunity Knocks,” p. 59.)
One strategy that may offer particular promise is to use the shares of a single stock held in the GRAT to support a yield-enhancement strategy of writing (selling) covered call options. A call option is a contract that gives the purchaser the right to buy the underlying stock at a predetermined price (that is to say, the call's exercise price) on a future date. The GRAT (as the seller) would receive the option premium for granting the buyer this right. The amount of premium received by the GRAT is, to a large extent, determined by the perceived risk (that is to say, the volatility) of the underlying stock. Our research shows that stocks with high implied volatility appear to offer the most meaningful potential for beating the discount rate.
Higher volatility generally increases option premiums, as call option buyers are willing to pay more for the options because of the increased likelihood of profiting during any subsequent upswing. Additionally, option sellers want higher premiums for the options they sell because the transaction is riskier for them. The stock market's recent volatility has had a measurable impact on option market's main volatility index (the VIX). (See “Wild Ride,” p. 60.)
The higher implied volatility makes it possible for a seller of options to receive high initial premiums while writing calls whose exercise price is substantially different (higher or lower) from the current share price. Because the premium is received upfront, the GRAT can earn interest on the premium in addition to receiving dividends on the underlying stock.
The premium, the interest on premium and the dividends serve to enhance the overall yield — helping the GRAT to surpass the Section 7520 rate with a higher degree of certainty. Our findings suggest that the shares of younger, faster-growing companies and financial services firms may be good candidates for this approach.
Moreover, the grantor can retain voting rights on the shares he contributed to the GRAT. The GRAT keeps the premium, interest on premium and dividends; it also retains the underlying stock's growth potential up to the call's exercise price. The grantor can customize the term of the GRAT, and manage the maturity and exercise price of the options positions according to his individual investment outlook and financial needs.
But let's be clear about the downside as well. The major negative in setting up a covered call option selling strategy is the potential loss of any appreciation above the call option's exercise price, the so-called “opportunity cost” of an option-writing strategy. It's also important to realize that the GRAT may be forced to sell the shares at the exercise price, at any time — even on the day the option was sold, and even if the option sold is out-of-the-money. Also, an option assigned before the ex-dividend date will result in a loss of dividends.
The potential benefits of implementing an options-based strategy become clearer if we illustrate them. Assume a grantor creates a two-year near-zero GRAT by transferring $1 million worth of shares to it. At a Section 7520 rate of 3.4 percent, and a $1 gift value, the discounted present value of that $1 million transfer is equal to two consecutive annuity payments of $525,652.
The grantor seeks to sell call options with different future expiration dates, in our case, expiring at time frames of one year and two years. The longer the time to expiration, the greater the likelihood that the share price can appreciate; therefore, the higher the time value of the premium he receives.
To reduce the probability of the buyer exercising the option thereby calling the GRAT's stock away, the grantor may choose to sell deep out-of-the-money call options. This particular strategy comes at a price, because it reduces the premium he receives. The reasoning is intuitive: Because the holder of the call option has the right to buy the stock at the option's exercise price, the value of the call option will decrease as the exercise price increases. In our example, we assume an exercise price 40 percent higher than the current stock price, which would be referred to as selling a “deep, out-of-the-money” call option. Also note that any commission charges may have a significant impact on the potential return of the strategy.
The returns from setting up a GRAT structure and writing covered calls on the underlying stock include the following assumptions:
The gains from any appreciation of the stock up to the exercise price, or any declines from the current stock price. Once the exercise price is reached, the grantor will forego future appreciation. In our example, we've assumed a current stock price of $195 per share and an exercise price of $273.
The returns on the GRAT are enhanced by premiums received from selling the call options. For example, we've assumed a premiums $9.90 and $16.60 per contract for options expiring at the end of a one- and two-year time horizon, respectively.
The returns on the GRAT's investments are further supplemented by investing these premiums at the risk-free rate, which is assumed to be 2 percent.
Our assumptions for the appreciation of the underlying shares reflect a capital asset pricing model (CAPM)5 return of 11 percent, with a historical standard deviation of 33 percent. In addition, if the stock pays dividends, that income will accrue in the GRAT during its term and the taxes will be paid by the grantor up until the GRAT matures. In our example, we've assumed that the stock pays no dividend.
In contrast, investors forsake two economic benefits when they use a pure stock buy-and-hold-strategy within a GRAT. They lose the returns generated from receiving premiums by selling call options, and they pay the cost of lost opportunity by not receiving returns generated by investing these premiums at the risk-free rate.
To compare the potential returns from this covered call option writing strategy with those from a traditional “transfer and hold” strategy using these theoretical shares and options characteristics within a GRAT structure, we ran a Monte Carlo simulation using 10,000 iterations of potential future returns. (See “Clients' Choice,” p. 61.)
What emerges is a clear portrayal of the tradeoffs of a passive stock-only strategy and a strategy of holding the stock and writing covered calls. By holding a single stock in the GRAT, a grantor has the potential for passing along more wealth to his heirs (free of gift and estate taxes) — but the probability of that wealth transfer occurring is actually lower. Here's why:
The GRAT employing a passive stock-only strategy experiences failure in up to 45 percent of the iterations, meaning it produces positive wealth transfer in only 55 percent of the cases. By employing a covered call writing strategy, the grantor could expect a failure in only 30 percent of these cases, meaning that a positive wealth transfer occurs in 70 percent of these outcomes — a measurably higher probability. The results of the Monte Carlo simulation also add dimension to the viability of our strategy. The overall return patterns show that the choice of adding a covered call writing strategy to a short-term GRAT is better in 85 percent of the 10,000 iterations than simply holding a single-stock position in the GRAT.
This more robust payoff pattern carries a price: When the stock price can be expected to rise by a disproportionate amount, the call option writing strategy underperforms (in 15 percent of the 10,000 iterations) because of the upper limit placed on that appreciation by the call options' exercise price.
But what makes this strategy potentially powerful is that a grantor now can choose between increasing either the likelihood or the magnitude of a wealth transfer. That's a welcome flexibility — at least for those stock positions with options-writing capabilities.
Now May Be the Time
The lower Section 7520 rates created by falling interest rates provide good opportunities for transferring assets. By identifying covered call option writing as a potential investment strategy for use in a GRAT structure, we hope to increase the range of investment environments favorable to wealth transfer planning techniques in general, and in particular, the number of choices available to grantors seeking to transfer wealth to their heirs. The methodology we've presented is suitable for evaluating the securities held by individual grantors and their potential as covered call writing candidates, enabling a personalized assessment for each individual's situation.
—The authors thank Steven Wong and the rest of the US Analytic Lab team at the Citi Private Bank for their contributions to this article. We also thank Joel Yudenfreund of Citi Trust for his input, support and suggestions; and Lee Montgomery of Citi's GWM Marketing Group for his help in editing and drafting.
— Investment products are not FDIC-insured, not bank-guaranteed and may lose value. Citi Private Bank is a business of Citigroup, Inc. This article is for informational purposes only, and does not constitute a solicitation of any kind. Opinions expressed are those of the authors and may differ from the opinions expressed by departments or other divisions or affiliates of Citigroup. Although information in this article is believed to be reliable, Citigroup and its affiliates do not warrant the accuracy or completeness and accept no liability for any direct or consequential losses arising from its use. Past performance is not a guarantee of future results. Neither Citigroup nor any of its affiliates provides tax or legal advice. Clients should consult independent counsel/tax advisors in connection with matters covered in this article.
Options are not suitable for all investors. Before entering into any transaction using listed options, investors should read and understand the current Options Clearing Corp. Disclosure Document Characteristics and Risks of Standardized Options at www.optionsclearing.com/publications/risks/riskstoc.pdf. Also, copies of this document may be obtained by contacting the Citi Private Bank, 388 Greenwich Street, 3rd Floor, New York, NY 10013.
- Proposed changes to Internal Revenue Code Section 2036, Revenue Ruling 76- 273, 1976-2 Congressional Bulletin 268 and 82-105, 1982-1 C.B 133, www.irs.gov. These are Internal Revenue Service proposals that may allow the exclusion of some assets in a grantor retained annuity trust (GRAT) from estate taxation, but they are not factored in to our discussion.
- Some commentators have suggested putting depressed stock in a family limited partnership (FLP) or limited liability company (LLC) to further depress the value. This would have a positive impact on the amount of wealth transferred.
- We used the software program NumberCruncher by Leimberg Associates, Inc. and customized Excel worksheets in our estate-planning calculations. The projections or other information generated by NumberCruncher regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect investment results and are not guarantees of future results.
- IRC Section 7520 rates (current and historical) can be found on the IRS website, www.irs.com.
- The capital asset pricing model (CAPM) is used in finance to determine a theoretically appropriate required rate of return of an asset. The CAPM formula takes into account the asset's sensitivity to market risk, often represented by the quantity beta (β) in the financial industry, as well as the projected return of the market and the projected return of a theoretical risk-free asset. Strategic return estimates are no guarantee of future results.
Ajay Badlani is a managing director and Thomas Mendham is a vice president in the US Investment Solutions group at Citi Private Bank in New York
Here's how to ensure that growth in assets above the Internal Revenue Code Section 7520 discount rate results in significant wealth transfers
Assume a grantor believes his company's stock will appreciate an average of 11 percent over two years. He gives $1 million in stock to a grantor retained annuity trust (GRAT) and gets $1.051 million back in annuity payments over 2 years. The appreciation raises the value to $1,174,278, leaving almost $123,000 of value to the donor's heirs at no gift tax cost.
|Year||Beginning Principal||Growth at 11%||Annual Payment(a)||Balance at End of Year|
|Summary||1,000,000||174,278||Remainder to heirs (1,051,303)||122,975|
|(a) The annual payments reflect an annuity of 52.56515 percent on $1,000,000. |
(b) Calculations reflect the IRS rate of 3.4 percent as of April 2008.
(c) The present value of the future assets, equal to $122,974, removed from your taxable estate is equal to $118,000; using a 2 percent discount rate over 2 years.
|Less adjusted taxable gift(b)||($1)|
|Future assets removed from taxable estate(c)||$122,974|
|Federal estate tax rate||45%|
|Potential tax savings||$55,338|
|— Ajay Badlani and Thomas Mendham|