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Quick Clips: Estate Tax Planning and GRATs

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Quick Clips: Estate Tax Planning and GRATs

Grantor Retained Annuity Trusts (GRATs) are a popular way for U.S. taxable investors to transfer wealth to the next generation.  Hear from AQR’s Portfolio Solutions Group and Specialized Investments Group on the benefits of these estate planning tools, as well as potential ways to maximize their efficiency.

What is a GRAT, and how does it work?
A GRAT is an estate tax planning tool used to transfer assets to beneficiaries in an estate-tax-efficient manner. The Grantor, a taxable investor, contributes assets to a GRAT with the goal of seeing these assets appreciate over the life of the GRAT. Any assets remaining in the GRAT after the Grantor receives all the statutory annuity payments are transferred from the GRAT to the Grantor’s beneficiary without incurring gift tax. The beneficiary can be a person or a trust. Note that if the assets in the GRAT fail to appreciate enough to overcome the stream of annuity payments, no transfer will occur, and the assets will be returned to the Grantor through the annuity payments.  If a transfer does occur, the transferred assets will be outside of the Grantor’s estate and will not be subject to future estate tax.

GRATs address the burden of estate taxes and thereby increase estate-tax-efficiency. However, it is important for investors using GRATs for estate tax planning to also consider the role of income tax efficiency. A GRAT does not pay taxes on gains and income generated by its underlying assets. Rather, the Grantor is responsible for these taxes. So, while income tax burden does not directly reduce the value of the GRAT assets, it reduces the wealth of the Grantor and, therefore, the total amount of wealth he or she is able to ultimately transfer to the descendants. 

How can taxable investors maximize the efficacy of a GRAT?
1. Shorten the length of the GRAT term: Drawing an analogy to baseball, each GRAT represents one “at bat,” or opportunity to score. Shorter-term GRATs create more at bats, or opportunities to transfer wealth. 

2. Increase the volatility of the investments in the GRAT: Higher volatility increases an upside and, therefore, the amount of wealth ultimately transferred to the beneficiary.

3. Contribute distinct assets into separate GRATs: Lowly correlated assets tend to appreciate and depreciate at different times which increases the chances that at least some of the GRATs will be enjoying  an upside. 

4. Invest in assets that are income-tax-efficient: GRATs directly address the burden of estate taxes. However, AQR research has shown that the magnitude of tax savings from income and estate tax planning can be similar. The Grantor can potentially preserve more wealth by becoming tax efficient with respect to both income tax and estate tax. 

Factors that can help maximize potential wealth transfers (0:16):


What types of investments might work best in a GRAT?
Single name stocks, tax inefficient hedge funds, and other volatile but correlated asset classes, like private equity and venture capital, may not be ideal investments for GRATs. However, tax-efficient, lowly-correlated, high-expected-return hedge funds can be helpful in designing an optimized GRAT approach. Contact the AQR U.S. Wealth Group to learn more about GRAT design or about finding potential opportunities to improve the transfers of an existing portfolio. 

Selecting investments for GRATs 1 1 Close Source: Bessembinder, Hendrik (Hank), Do Stocks Outperform Treasury Bills? (May 28, 2018). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=2900447. Table 2A, Panel D. Included are all CRSP common stocks (SHARE TYPE CODE 10, 11, or 12) from September 1926 to December 2016. Lifetime returns span from September 1926, or a stocks first appearance on CRSP, to the stocks delisting, or December 2016.  Delisting returns are included. T‐bill refers to the one‐month Treasury‐bill return. Past performance is not a guarantee of future results.   (1:28):