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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):  

This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor. This material is not intended to be marketing. The recipient should conduct his or her own analysis and consult with professional advisors prior to making any investment decisions.

A Grantor Retained Annuity Trust may be referred to as a GRAT in this presentation. AQR does not establish GRATs nor does AQR currently manage assets in GRATs or any GRAT methodology described in this presentation for external investors. There is no guarantee that any of the approaches described in this presentation will be successful. All information shown is based on hypothetical simulations and not actual investments or GRATs. AQR does not provide tax advice or estate planning and does not establish or maintain GRATS.  In considering this material, please work with a tax advisor before making any decisions.

Risks of Tax Aware Strategies (Not Exhaustive)


1. Underperformance of pre-tax returns: tax aware strategies are investment strategies with the associated risk of pre-tax returns meaningfully underperforming expectations.

2. Adverse variation in tax benefits: deductible losses and expenses allocated by the strategy may be less than expected.

3. Lower marginal tax rates: the value of losses and expenses depends on an individual investor’s marginal tax rate, which may be lower than expected for reasons including low Adjusted Gross Income (AGI) due to unexpected losses and the Alternative Minimum Tax (AMT).

4. Inefficient use of allocated losses and expenses: the tax benefit of the strategy may be lower than expected if an investor cannot use the full value of losses and expenses allocated by the strategy to offset gains and income of the same character from other sources. This may occur for a variety of reasons including variation in gains and income realized by other investments, at-risk rules, limitation on excess business losses and/or net interest expense, or insufficient outside cost basis in a partnership.

5. Larger tax on redemption or lesser benefit of gifting: gain deferral and net tax losses may result in large recognized gains on redemption, even in the event of pre-tax losses. Allocation of liabilities should be considered when calculating the tax benefit of gifting.

6. Adverse changes in tax law or IRS challenge: the potential tax benefit of the strategy may be lessened or eliminated prospectively by changes in tax law, or retrospectively by an IRS challenge under current law if conceded or upheld by a court. In the case of an IRS challenge, penalties may apply.

Disclosures
The information set forth herein has been obtained or derived from sources believed by AQR Capital Management, LLC (“AQR”) to be reliable. However, AQR does not make any representation or warranty, express or implied, as to the information’s accuracy or completeness, nor does AQR recommend that the attached information serve as the basis of any investment decision. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such. This document is intended exclusively for the use of the person to whom it has been delivered by AQR and it is not to be reproduced or redistributed to any other person. Past performance is not a guarantee of future performance.

This presentation is not research and should not be treated as research. This presentation does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR.

The views expressed reflect the current views as of the date hereof and neither the speaker nor AQR undertakes to advise you of any changes in the views expressed herein. It should not be assumed that the speaker will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client accounts. AQR and its affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this presentation.

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the speaker guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision.

There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Target allocations contained herein are subject to change. There is no assurance that the target allocations will be achieved, and actual allocations may be significantly different than that shown here. This presentation should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy.

The information in this presentation may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this presentation, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Performance of all cited indices is calculated on a total return basis with dividends reinvested. 

The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Please note that changes in the rate of exchange of a currency may affect the value, price or income of an investment adversely.

Neither AQR nor the speaker assumes any duty to, nor undertakes to update forward looking statements. No representation or warranty, express or implied, is made or given by or on behalf of AQR, the speaker or any other person as to the accuracy and completeness or fairness of the information contained in this presentation, and no responsibility or liability is accepted for any such information. By accepting this presentation in its entirety, the recipient acknowledges its understanding and acceptance of the foregoing statement.

Diversification does not eliminate the risk of experiencing investment losses. Targets may be subject to change and there is no guarantee that they will be met. There is no guarantee, express or implied, that long-term return and/or volatility targets will be achieved. Realized returns and/or volatility may come in higher or lower than expected.

There is a risk of substantial loss associated with trading commodities, futures, options, derivatives and other financial instruments. Before trading, investors should carefully consider their financial position and risk tolerance to determine if the proposed trading style is appropriate. Investors should realize that when trading futures, commodities, options, derivatives and other financial instruments one could lose the full balance of their account. It is also possible to lose more than the initial deposit when trading derivatives or using leverage. All funds committed to such a trading strategy should be purely risk capital.

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