It takes great effort to build a fortune—and great effort to pass it on to your kids (or others) without the taxman taking a big bite. This case study shows our analysis of four potential wealth transfer strategies that a 40-year-old pair of entrepreneurs considered after selling their business for $34 million—and how they chose among them.
Eric and Eleanor’s goal was to salt away $1 million to give their young children a head start later on, perhaps allowing them to buy homes or start their own businesses. Like many relatively young investors, they hadn’t thought much about estate taxes yet.
Working closely with their financial advisor, they had decided to give $1 million to charity to offset some of the capital gains taxes on the sale. Their financial plan also included putting aside money to pay taxes and buy a bigger home, and investing the rest to fund their eventual retirement and their next venture, and to support their living expenses until the new venture became profitable.
To help them meet their wealth transfer goals, we analyzed four potential structures for them: an irrevocable intentionally defective grantor trust (IDGT), an installment sale to an IDGT, a grantor retained annuity trust (GRAT), and a refinement to the GRAT strategy known as a series of rolling GRATs.
A gift to an irrevocable IDGT would move $1 million outside the estate, along with all the future growth and income on that $1 million, since the couple would pay any income taxes the trust owed. We estimated that if they invested the $1 million in a growth-oriented portfolio suitable to the time horizon and risk tolerance of the children, its nominal value would grow to $3.5 million in 20 years in typical markets; its real (inflation-adjusted) value would grow to $2 million, as theDisplay below shows.
In the unlikely case that the couple died within 20 years, the trust would reduce estate taxes due by about $1 million. If they lived longer, as is reasonable to expect, the trust would grow even more—and so would the estate tax savings that it would generate.
The three other strategies would allow the couple to retain the principal but give the children any appreciation in its value above a stated interest rate. Thus, the gift would be smaller, and possibly nil. However, when interest rates are very low, the likelihood of transferring some wealth is high. (Before adopting any of these strategies, it’s important to consult with an attorney familiar with the legal details and any potential risks of these strategies.)
In the installment sale strategy, the couple would set up an IDGT that would buy financial assets from them in exchange for a note. In this case, the $1 million, 10-year note would pay interest annually at 2.24%, the long-term applicable rate that the IRS sets in the month of the proposed transfer. At the end of the trust’s 10-year term, the IDGT would make the final interest payment and pay off the note in full. Any appreciation in the assets above the interest rate would result in a wealth transfer free of estate and transfer taxes to a trust for their children.
In the GRAT strategy, the couple would contribute money to a trust that makes annuity payments of principal and interest to them over its term. In this case, the couple considered a 10-year term GRAT with an interest rate of 1.8% (the 7520 rate mandated by the IRS at that time). Any appreciation over and above the interest rate would result in a wealth transfer free of estate and transfer taxes to a trust for their children.
One risk in both a GRAT and an installment sale to an IDGT is that one or two years of extremely bad performance in the trust portfolio could cause the trust’s return to underperform the mandated interest rate over the course of the trust’s term. If this occurs, the remainder beneficiaries (the couple’s children) would receive nothing at the end of the term.
A rolling GRAT strategy reduces this risk by setting up a series of two-year GRATs over a 10-year horizon, rather than a single 10-year GRAT. In this case, the couple would contribute $1 million to a two-year GRAT, and at the end of the first year commit the first annuity payment to another two-year GRAT. At the end of the second year, they would commit both the second annuity payment from the first GRAT and the first annuity payment from the second GRAT to fund a third GRAT. This would continue for as long as the couple wants to continue the strategy.
Any GRAT can succeed or fail. The advantage of the rolling GRAT strategy is that it would give them many shots at success. A single long-term GRAT strategy offers only one, which can be derailed by even a brief but severe decline in the trust assets’ value. In addition, the short term of each GRAT in the series gives the couple the flexibility to stop funding new GRATs if their situation changes, or if they become comfortable with the amount of wealth transferred.
The next Display shows our forecasts for each of the three strategies in typical markets. For their $1 million contribution to the trusts, the couple could expect to transfer about $464,000 with an installment sale, $380,000 with the term GRAT, and $655,000 with the series of rolling GRATs.
Eric and Eleanor decided that they preferred to make a $1 million gift to an IDGT for their children. Their attorney suggested that there may be time before the sale to fund the IDGT with their company’s private stock and pay the income taxes on the trust’s behalf.
The couple kept open the possibility of using rolling GRATs and perhaps an installment sale to transfer to their children the future payouts from escrow and earnouts on the sale of their business, as well as any wealth that their new venture might create. Thus, in the future, their estate plan might contain three of the wealth transfer strategies available to them, each designed for a specific purpose and with a different investment strategy.
The views expressed herein do not constitute, and should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. Please consult with your legal or tax advisor regarding your specific situation.
The Bernstein Wealth Forecasting System uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the 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 the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.