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WE ALTH TR AN S FE R P L AN N I N G

Structuring Transactions to Enhance Financial Results

In this white paper:

Introduction 1

InvestmentManagementConcepts 2

FinancialInstruments(Derivatives) 5

GrantorRetainedAnnuityTrust(GRAT) 9

EnhancingGRATs 11

SaletoIntentionallyDefectiveGrantorTrust(IDGT) 18

EnhancingIDGTs 19

TotalReturnSwapofaSyntheticPortfoliowithanIDGT—anAlternativetotheSaleTransaction? 20

Conclusion 26

Written by:

Bryan D. Austin,CFP®,CIMA®

Director,FinancialPlanning

TA B L E O F CO N T E N T S

1 Wealth Transfer Planning

Introduction1

Simplystated,wealthengineeringinwealthtransferistheprocessofstructuringtransactionstoimprovefinancialresults.Obviously,forecastingresultsdependsonthereliabilityofassumptionsusedintheparticularanalysis.Allfactorsusedintraditionalinvestmentanalysis,includingexpectedreturn,standarddeviationandcorrelationshouldbeutilizedtomodelthewealthtransferstrategyunderconsideration.Inthepast,mostoftheestateplanningcommunityexclusivelyreliedononefactor—expectedreturn—toforecastwealthtransferplanningbenefitsassociatedwithaspecificstrategy.Theinherentproblemwiththislinearfixedreturnanalysisisthatmarketreturnsarerandomanddonotfollowapredictablepattern.Today,agreaternumberofplannersareusingMonteCarloanalysistoforecasttheprobabilityofsuccessfortechniquesinwealthtransfer,whichisavastimprovementoveratraditionallinearanalysis.MonteCarloincorporatesseveralinvestmentfactorsandusesastatisticallysignificantnumberofsimulationsofrandominvestmentreturnstoprojectarangeoffutureresults.WhileaMonteCarlosimulationexercisedoesnotguaranteefutureresults,itdoesamuchbetterjobofidentifyingtheinvestment

risksandtheprobabilityofsuccessforthewealthtransfertechniqueunderconsideration.

Itissafetosaythatmostwealthtransferplanningincorporatesconceptsofleveragetoprojectwinningresults.Theultimatesuccessoftheseplanningstrategiesdependsontheprobabilityofoutperformingareferencerate,suchasthe7520rate,2usedforvariousannuitytrusts.OthersrelyonoutperformingtheApplicableFederalRate(AFR),3arateusedforintra-familyloanbasedstrategies.Aprimarygoalinwealthengineeringistoincreasetheleverageassociatedwithaparticulartransaction.WealthengineeringcouldbeassimpleasusingdifferentnotepaymenttermsinconnectionwithatraditionalsaletoanIntentionallyDefectiveGrantorTrust(IDGT)andanalyzingtheprojectedresults.Itcouldalsobeascomplexasintroducingstructuredderivativeproductstohedgeriskortakeadvantageofuniqueinvestmentopportunities,withtheultimategoalofincreasingthestrategy’sleverageandlikelihoodofsuccess.

Thepurposeofthispaperistoexploresomeofthefinancialstrategiesthatmayincreasethelikelihoodofenhancingtraditionalwealthtransfertechniques.Sincewealthengineeringdependsonareasonableforecastofinvestmentreturns,thispaperwill

Wealth Transfer Planning

2Wealth Transfer Planning

beginwithageneraloverviewofinvestmentconceptsandprinciplesofdiversification.Themostwidelyusedfinancialinstrumentswillthenbeexploredtointroducetheconceptsofriskreductionandleveragebeneficialtowealthtransfer.

Somewealthengineeringprincipleswillthenbeappliedtotwocommonlyutilizedplanningstrategies:theGrantorRetainedAnnuityTrust(GRAT)andasaletoanIDGT.Thefinalsectionofthispaperwillintroduceanalternativewealthtransfertechnique,swappingasyntheticportfoliowithanIDGT,asanexampleofthetypeoftransactionthatwemayseeinthefuturewhenadvisorsfromdifferentdisciplinescollaboratetointroducenewplanningideasdirectedathighnetworthclients.

Investment Management Concepts

Mostofushaveheardneverto“putallofoureggsinonebasket,”andhistoryhasprovidedcountlessexamplesofdevastatingeventsthatcausedindividualstoliterallylosefortunesovernight.Wehavealsoheardstoriesofotherswhoriskedeverythingbutwerefinallyrewardedfortheirefforts.Theconceptofriskandrewardisobviouslynotanewoneand,logically,nooneshouldbewillingtotakeoninvestmentriskunlessthereisarewardassociatedwiththelevelofriskassumed.Theinvestmentrewardforparticipatinginthemarketisgenerallyreferredtoasa“marketriskpremium”and,whileriskpremiumshavevariedoverdifferentinvestmentperiods,higherriskassetslikeequitieshavegenerallyproducedgreaterreturnswhencomparedtomoneymarkets,treasuries,orotherlowriskassets.

Portfolio Theory and the Efficient Frontier

Investmentdiversificationisalsonotanewconcept,buttheapproachdevelopedoverthelastfivedecadesis.Untiltheearly1950s,thedecisiontoinvestinanyassetwasalmostexclusivelybasedonfinancialanalysisandtheasset’sriskandreturncharacteristics.Diversificationwasachievedmerelybyinvestingindifferentfirms,withlimitedconsiderationofwhetherthosefirmsengagedinthesamebusiness.However,in1952,HarryMarkowitzrevolutionizedtheinvestmentdecision-makingprocesswithhisresearchpaper

“PortfolioSelection.”4Dr.Markowitztheorizedthatinvestorsarenotonlyinterestedinearninghighinvestmentreturns,butthattheyarealsointerestedinreducingrisk.Toreducerisk,investorsshouldconsiderhowaninvestmentimpactsaportfolioratherthansimplyfocusingonthemeritsoftheinvestmentitself.Sinceitisassumedthatinvestorsbehaverationally,theywillonlyinvestinthoseportfoliosthatrepresentthehighestreturnforanygivenlevelofrisk.Thisrisk-returntradeoffwasgraphicallyrepresentedinthefirst“efficientfrontier.”5Dr.Markowitzlaterdevelopedaworkingmathematicalmodelforanalyzingportfolioriskandrewardculminatinginwhatisreferredtoas

“Mean-VariancePortfolioTheory.”6

Throughdetailedcalculations,theefficientfrontiergraphicallyrepresentsthesetofdiversifiedportfoliosthatproducethehighestpossiblereturnforanygivenlevelofrisk.Itisideallyderivedfromselectinginvestmentsfromtheentireuniverseofpossibleinvestments.Exhibit1illustratesasampleefficientfrontierwithfivepossibleportfolioallocationsrepresented,rangingfromconservativetoaggressive.Itisimpossibleforanyoneparticularinvestmenttolieonorabovetheefficientfrontier,sinceindividualinvestmentsarebydefinitioninefficient,i.e.,theyarenotdiversified.

Exhibit 1. The Efficient Frontier

4% 5% 6% 7% 8% 9% 10% 12% 13% 14%

12%

11%

10%

9%

8%

7%

6%

5%

Conservative

Moderate/Conservative

Moderate

Moderate/Aggressive

Aggressive

RE

TU

RN

(%

)

RISK (STANDARD DEVIATION %)

Current Portfolio

11%


Thesampleportfolioslieontheefficientfrontierwhilethecurrentportfoliorepresentsahypotheticalinefficientportfolio.Nologicalinvestorwouldchoosethecurrentportfolio,sinceitdoesnotprovideadequatereturnforthelevelofriskassumed.

Efficientfrontiersaregenerallycreatedfromthreefactors:risk,return,andcorrelationofreturns.Riskisgenerallyassessedbythedegreeofvolatilityassociatedwithaportfolio’sreturns.Tomeasureportfoliovolatility,investmentprofessionalsfrequentlyusethereferencecalculationofstandarddeviation.Ahighstandarddeviationindicatesawidevariationofreturnsfromthemeanandthussignificantvolatility.Alowstandarddeviationindicateslowvolatilitywithreturnsthataregenerallyclosertothemean.Twoportfoliosmayhavethesamemeanreturnvaluebutverydifferentstandarddeviations.Standarddeviationiswidelyacceptedasrepresentingtheriskaxisofanefficientfrontier.

Whileportfolioreturnissimplyaweightedaverageofthereturnsofeachinvestment,portfoliorisk,asmeasuredbystandarddeviation,isnotcalculatedfromtheweightedaverageofthestandarddeviationoftheunderlyinginvestments.Thecalculationofstandarddeviationforaportfolioincludesoneotherimportantstatisticalmeasure:correlation.Correlationmeasurestheextentbywhichreturnsofoneassetcanpredictthemovementinanotherandisexpressedinarangebetween+1to-1.Acorrelationof+1betweeninvestmentsindicatesthattheinvestmentreturnsmoveidenticallyinthesamedirection,acorrelationof0indicatesnomovementrelationship,andacorrelationof-1indicatesinvestmentreturnsalwaysmoveinoppositedirections.Diversificationbenefitsareachievedbyaddinginvestmentswithdifferentcorrelationstatisticstoaportfolio,resultinginaloweroverallstandarddeviationthantheindividualcomponentparts.

Forexample,assumeInvestmentAhasa9.0percentexpectedreturnanda16.0percentstandarddeviation,whileInvestmentBhasa9.5percentexpectedreturnanda14.0percentstandarddeviation.Furtherassumethatthecorrelationcoefficientofreturnsbetweenthetwoinvestmentsis.20andtheportfolioisbalanced

equallybetweenAandB.Withoutusingthecorrelationstatistic,onewoulderroneouslycalculatetheexpectedportfolioreturnas9.25percentwitha15percentstandarddeviationbyaveragingbothstatistics.Byaccuratelyincludingcorrelation,theexpectedportfolioreturnisstill9.25percentbutwithamuchlower11.64percentstandarddeviation.7Thus,thecombinationofInvestmentsAandBismoreefficientthanAorBalone,asitproducesahigherlevelofreturnfortheriskassumed.

Itisimportanttobrieflynotethatstandarddeviationmeasuresthetotalinvestmentriskoftheportfolio.Totalriskincludesbothsystematic(market)riskandnon-systematic(firm-specific)risk.Diversificationcanonlylowerthenon-systematicriskofaninvestmentportfolio.Systematicriskcanneverbediversifiedawayandparticipationinthemarketwillalwaysexposeaninvestortotheassociatedmarketrisk.Therefore,movementsalongtheefficientfrontier,fromconservativetoaggressive,mostlyresultfromallocatinglessormoretothemarket.Overall,riskcanbereducedbyallocatinglesstothemarketportfolio,butopportunityisalsoreduced.

Therelativesimplicityoftheefficientfrontierhaswideappeal,sincetheinvestorcanvisuallyseediversificationatwork.Ithasatendencytoleadtoquickinvestmentdecisionsbutitisimportanttonotethateachdecisionmustbecarefullyweighedtomakesurethatitissuitablefortheparticularinvestor.Asstatedabove,theefficientfrontierisderivedfromthreebasicfactors;butitscreationisstilldependentuponseveralotherinputvariables,includingtheuniverseofinvestmentsconsideredaswellastheinvestor’sliquidityneeds,taxsituation,andattitudetowardsrisk.

Forexample,certainassetclasses,suchasprivateequityorcomplementarystrategies,maynotprovidethenecessaryliquidityfortheinvestor.Someinvestorsmaynothaveaccesstocertaininvestmentsduetonetworthorincomelimitations,orpossiblyevenlegalrestrictions.Otherinvestmentsmaybeundesirabletoaparticularinvestorsuchastobacco,alcohol,orpetroleumcompanies.Finally,manyinvestorsviewriskdifferentlydependingonthedirectionofthevolatility.Thisisanespeciallyimportant


considerationthatwillberaisedlaterinenhancingcertainwealthtransfertechniques.

Furthermore,theactualinputsonassetclassreturns(volatilityandcorrelationutilizedtocreatethefrontier)canbesubjecttowidelyvaryingassumptions.Sincepastperformanceisnotanindicationoffutureresults,efficientfrontiersbasedsolelyonhistoricaldatamaybadlymissthemark.Whathistoricaldatawillbeused?Doesitincludethedownmarketof2008andtherelatedperformancedata,wheremostassetsclassesexhibitedextremelypositivecorrelation?Andwhataboutusinganalystforecastsfortheinputs?Shouldrecentextremeeventsbeweightedmoreheavilyordiscountedashistoricalaberrations?

Inreality,manysoftwareprogramsusedtomodeltheefficientfrontiertodayuseacombinationapproach:blendinghistoricaldata,forecastingdata,orusingsimulationsofrandominvestmentreturnswithassignedprobabilitiesforperformance.Theresultisarguablyimprovedadvisorytoolstomeasureandcommunicateinvestmentriskthatallowaninvestortomakebetter-informeddecisionstomeettheirpersonalobjectives.

Linear Versus Monte Carlo Analysis in Wealth Transfer

Communicatingriskisprobablythesinglemostdifficultbutimportantrolethatadvisorshavetoassistclientsinmakinginformeddecisionsaboutmeetingspecificgoalsincludinginvestment,retirement,philanthropy,andwealthtransfer.Althoughrisktakesonmanyforms,thefocushereisoncommunicatingfinancialrisk,especiallyasitrelatestowealthtransfer.Asalludedtoearlier,investorslovethevolatilityassociatedwithpositivemarketmovement,butmostcannottoleratethevolatilityassociatedwithmajormarketdeclines.Unfortunately,volatilitymovesinbothdirectionsandinvestorswhocannottolerateacertainlevelofriskwillmissoutonopportunitieswhenmarketsadvance.

Riskwithrespecttowealthtransfercannotpossiblybecommunicatedeffectivelytoaclientthroughlinearorfixedreturnmodeling.Linearmodelingassumesthatthesubjectinvestmentwillearnsteady,predictablereturnsoverthegivenperiod,whichisobviouslyunrealistic.8

Italsoignoresthetimehorizon,treatingshort-andlong-termstrategiessimilarly.Fortunately,manyplannerstodayareusingbettertoolstocommunicaterisktoclientsconsideringwealthtransfer.Asmentionedpreviously,MonteCarlosimulationisoneofthetoolsgainingpopularityinthefinancialplanningcommunity,notonlyinmodelingassetsufficiencyfortodayandintoretirementbutalsoinmodelingwealthtransferstrategiesandthelikelihoodforsuccess.

MonteCarlosimulationtraditionallyisbasedonthesamecriteriausedtocreatetheefficientfrontier,namelyreturnsandvolatility.Infact,somesoftwareactuallyusestheMonteCarlosimulationmethodtocreateanefficientfrontier.Basedontheinputtedcriteria,asignificantnumberofsimulationsofrandomreturns(oftenthousands)areselectedoverthesubjecttimeperiodtoprojectarangeoffutureresults.Thesesimulatedprojectionsarethencomparedtoaspecifictargettodeterminethelikelihoodofoutperformingthetarget.

Exhibit2illustratesahypotheticalMonteCarloprobabilitydistributionanalysisforabasicfive-yeartermGRATfundedwitha$10,000,000balancedportfolioandaSection7520hurdlerateof2.0percent.Aswewilldiscusslater,solongasthetrustportfolioreturnsexceedthe7520rate,theGRATshouldbesuccessful.They-axisidentifiestheprojectedendingtrustportfoliovalueandthex-axisidentifiesthepercentageoftrialsgreaterthanatargetof0,meaningbeneficiariesareprojectedtoreceivesomethingwhentheGRATterminates.

Inthissimulation,roughly82percentofthe1,000portfoliotrialswouldsuccessfullytransfervalueattheendoftheGRATterm.However,in18percentofthesimulations,theGRATisprojectedtotransfernothingtobeneficiaries.ComparethismessagewiththatusedinafixedreturnanalysiswheretheGRATisalwaysassumedtobesuccessful,especiallygivenalow7520hurdlerate.Ofcourse,thereareothermethodstoincreasethelikelihoodofsuccesseveninthisbasicexamplethatwewillexplorelater.WhileMonteCarlosimulationdoeshavesomeinherentflaws,fewwouldarguethatitisnotsuperiortofixedreturnmodelingwhenanalyzingtheriskassociatedwithspecificwealthtransferplanningtechniques.10


Exhibit 2. Monte Carlo Probability Distribution9

$6.9 $6.5 $6.1 $5.8 $5.4 $5.0 $4.6 $4.2 $3.9 $3.5 $3.1 $2.7 $2.3 $2.0 $1.6 $1.2

$0.8 $0.4 $0.1

$-0.3 $-0.7

$-1.1 $-1.5 $-1.9 $-2.2

0.0 0.2 0.4 0.6 0.8 1.0

EN

DIN

G V

AL

UE

S (

MIL

LIO

NS

)

PERCENTAGE OF TRIALS GREATER THAN OR EQUAL TO GIVEN LEVEL

Financial Instruments (Derivatives)

Theterm“derivative”hasbecomeanegativereferenceformany,especiallygiventheeventsleadinguptothebankingandfinancialcreditcrisisof2007and2008.OneofthemostwidelypublicizedcommentsregardingderivativescamefromWarrenBuffetin2003,whenhereferredtoderivativesas“financialweaponsofmassdestruction…”11WhileMr.Buffet’sletterattemptedtobroadlyaddressderivatives,itseemedtofocusonunregulatedcontracts,theirassociatedcounterpartyrisk,andproblemsinvaluingcompanieswithsubstantialderivativeexposure.However,derivativeshistoricallyhaveservedavitalfunctionincommerce,helpingcompaniesdealwiththeiruniquebusinessrisk.Properlyused,derivativeshelpindividualsandbusinessesmitigaterisksincludingthoseassociatedwithrisinginterestrates,currencyexchange,commodityprices,andoverexposedequityconcentrations.Unfortunately,thefocusinrecenttimesseemedtobeontheminorityofthosewhoabusedanotherwiseviableinvestmentandriskmanagementstrategy.

Generally,aderivativecontractisadelayeddeliveryagreementbetweentwopartieswherethevalueofthecontractisderivedfromsomethingelse,typicallyreferredtoastheunderlying.Theunderlyingcanbealmostanything:anassetorcollectionofassets,aninterestrate,aspecificcurrency,oracommoditysuchasoil,gold,sugar,orcorn.Abasicderivativecontracthasabuyerandaseller.Thebuyeroftheunderlyingissaidtobe“long”thepositionwhiletheselleris“short”theposition.Thepartiesnegotiatetopurchase/selltheunderlyingatsomespecificdateinthefutureatapredeterminedprice.Theunderlyingassetrarelychangeshands,andpartiesnormallysettlethecontractsbeforematurityincash,enteroffsettingderivativepositionsclosingtheirexposure,orallowcertaincontractstoexpireworthless.Themostcommontypesofderivativesareoptions,futures,forwardsandswaps.Beforeexaminingtheutilityofderivativesinwealthtransfer,itmaybehelpfultobrieflysummarizethesecommonderivativesandidentifysomeoftheirfeatures.

Options

Optioncontractscommonlyfallintotwocategories,callsandputs.Whilethecombinationofdifferentoptionstrategiescanberathercomplex,acallorputisafairlystraightforwardtransaction.Inabasiccalloption,thecontractbuyerofthecallhastheright,butnottheobligation,topurchaseafixedquantityofanassetatafixedprice(theexerciseorstrikeprice)beforetheexpirationdatespecifiedintheoptionagreement.Alternatively,thepurchaserofaputoptionhastheright,butnottheobligation,tosellafixedquantityofanassetatastrikepricepriortothespecifiedexpirationdate.Optioncontractshaveabuyer(theholder)andaseller(thewriter).Theholderoftheoptionpaysthewriterapremiumforacquiringtherighttobuyorsellaspecifiedamountoftheassetundertheagreement.Unlikefutures,forwards,andswaps,anoptionisconsideredaunilateralagreement,sinceonlytheholderhastherighttoforceperformance(i.e.,exercisetheoption).

ThepubliciswidelyfamiliarwiththeAmerican-styleoption,whichcanbeexercisedatanytimeuntilthespecifiedexpirationdate.ContrastthiswiththeEuropean-styleoption,whichcanonlybeexercised


atmaturity.Thetimingofexerciseisthemaindistinctionbetweenthesetwotypesofoptions,notthelocationwheretheoptionisnegotiated.Becauseoftheflexibilityintimingofexercise,logicdictatesthatthepremiumpaidforanAmericanoptionshouldbehigherthanasimilarlystructuredEuropeanoption.Sincesecurityreturnsfluctuateanddonotfollowastraight-linepredictablepattern,theflexibilitytoexerciseanoptionduringanypointoftheoptiontermshouldbemorevaluabletotheholder.

Optionpricesaretraditionallydeterminedfromsixfactors:currentpriceoftheasset,strikepriceoftheoption,expirationdateoftheoption,volatilityoftheasset,therisk-freerateofreturn,andcashflow(e.g.,dividends)fromtheasset.Iftheexistingpriceofanassetinacalloptionishigherthanthestrikeprice,theoptionisconsidered“inthemoney.”Thepremiumforacalloptionlogicallyincreaseswithincreasesintheunderlyingassetprice.Optionpremiumsalsoincreasewithincreasedtimetoexpirationandhighervolatility,sincetheholderhasmoreopportunitiestobenefitfromlargepricemovements.Finally,increasestotherisk-freerateofreturnincreasesthepriceofanoptionduetothetimevalueofmoney.Alternatively,calloptionpricesdecreasewithincreasestothestrikepriceorcashflow(e.g.,dividends)paidfromtheunderlyingassetthattheholderdoesnotreceive.

Forwards and Futures

Incontrasttooptions,bothparties(“counterparties”)toaforwardcontractareobligatedtoperform.Aforwardcontractisaformalagreementbetweencounterpartiestoexchangeaspecifiedamountofanunderlyingassetatafixedpriceonaspecificfuturedate.Theagreeduponpriceisreferredtoastheforwardordeliveryprice,andthespotpriceisthecurrentpriceoftheasset.Whilethevalueoftheforwardcontractfluctuatesoverthetermoftheagreement,nothingchangeshandsbetweenthecounterpartiesuntilmaturity.Althoughsomeforwardcontractsrequirephysicaldeliveryoftheunderlyingassetbytheselleratmaturity,forwardcontractsareoftensettledincash.Forwardcontractsareprivatelynegotiatedbetweentheactualcounterpartiesandarenottradedonaregulatedexchange.Whileincreasedflexibility

oftermsistheadvantage,thereisstillariskthatonepartymaynotperformatmaturity.Thus,thepartiestoforwardcontractsaregenerallylimitedtohighly-capitalizedinstitutionalparticipantsthathavelowerrisksofdefault.

Futurescontractsareessentiallyaseriesofdailysettledforwardcontracts.Likeforwards,futurescontractsoutlineeachparty’sobligationtosellorpurchaseaspecificamountoftheunderlyingassetatmaturity.However,unlikeforwards,futurescontractsaretradedonaregulatedexchange(e.g.,ChicagoBoardofTrade),havestandardizedterms,andaresettleddaily.12Theexchangeestablishesaclearinghousethatispositionedbetweeneachbuyerandseller,guaranteeingeachparty’sperformance.Asfurthersecurityforperformance,counterpartiesmustdepositfunds(“margin”)initiallyandonanongoingbasis.Eachfuturescontractisrevalueddaily(marked-to-market)andpartiesrealizegainsorlossesonthedaytheyoccur.Shouldthevalueofaparty’smarginaccountfallbelowtherequiredthreshold,additionaldepositsmustbemadetorestorethemargin.Sincefuturescontractsarestandardizedandtradedonanexchange,partieshaveadditionalflexibilityinclosingoutpositionspriortomaturitybyenteringintooffsettingfuturescontracts,effectivelyeliminatinganyinvestmentposition.

Futuresandforwardpricesaredeterminedfrommanyofthesamefactorsthatapplytooptions.Theseincludetheunderlyingasset’scurrentspotprice,expectedfuturedeliveryprice,deliverydate,risk-freerateofreturn,andcashfloworyieldfromtheasset.However,futuresandforwardpricesmaydifferevenonthesameunderlyingwiththesamematuritydateastheremaybeadditionalsettlementandtransactioncostsassociatedwithfuturescontracts.

Swaps

Aswapcontractisanagreementwheretwopartiesmakeaseriesofpaymentstoeachotherbasedondifferentscenariosreferencedwithintheagreement.Thecomponentsofaswapcontractincludeareferencedinvestmentorindex,notionalamount,maturitydate,andpaymentfrequency.Thenotionalamountissimplytheoverallvalueofthereferencedinvestmentandgenerallyneverchangeshandsbetweentheparties,butitisused


asaproxytocalculateeachparty’sresponsibilities.Swaparrangementsusuallyinvolveaswapdealerorfacilitatorwhoarrangestomatchcounterpartiestotheswaptransaction.Insomecases,theswapdealermayalsoparticipateascounterparty.However,forpurposesofthisdiscussion,theswapdealerisremovedfromthetransactionanditisassumedthatthecounterpartieshavecontracteddirectly.

Partiesenterintoswapcontractsforroughlythesamereasonstheyusederivativecontracts:riskmanagementandspeculation.Forexample,theholderofacalloptionanticipatesthepriceofanassettoriseduringtheoptionterm,whilethewriterofthesameoptionanticipatesthepriceoftheassettoremainflatordecline.Similarly,inaswapcontractonepartyexpectsthatthereferencedinvestment,orgroupofinvestments,willriseovertheswapterm,whiletheotherpartyanticipatestheoppositeresult.Justasinfuturesandforwards,however,themajordistinctionbetweentheswapandtheoptionisthatbothpartiesinaswaphaveanobligationtoperform.OneofthebetterwaystoillustrateaswapistopresentanexampleofthecommonlyusedinterestratecreditswapaccompaniedbyagraphicalrepresentationinExhibit3.

Exhibit 3. Interest Rate Swap

Semi-annual payments$5 Million x 5%

Semi-annual payments$5 Million x (Libor +2%)

Libor+2%

$5Million

Party A Party B

Bank

Forexample:PartyAhasanoutstandingfloatingrateinterestonlyloanof$5millionthatadjustssemiannually.Theadjustablerateislinkedtothesix-monthLondonInterbankOfferedRate(Libor)andtherateofinterestissix-monthLiborplus2percent.Assumingsix-monthLiboris0.5percent,

thecurrentratewouldbe2.5percent.PartyAwouldbemorecomfortablewithafixedrateloanasthereisconcernthatinterestrateswillrise.PartyBbelievesthatinterestrateswillstaystableormaybetrendlowerovertimeandwouldliketobenefitfromloweradjustablerateterms.

PartiesAandB,the“counterparties,”negotiateafive-yearswapcontractbasedona$5millionnotionalamountonDecember1,2014.Underthetermsoftheswap,PartyAagreestomakeafixedinterestratepaymenttoPartyBatanannualrateof5.0percentonthe$5millionnotionalamounttotaling$250,000annually,or$125,000semiannually.Thisiscommonlyreferredtoasthefixedlegoftheswap.PartyBagreestomakeasemiannualinterestratepaymenttoPartyAonthesamenotionalamountbasedonsix-monthLiborplus2.0percent.Thisisthefloatinglegoftheswap.PartyB’sfirstpaymenttoPartyAwillbe2.5percentof$5milliondividedbytwo,sinceitisinterestforasix-monthperiod,withtheinitialpaymentbeing$62,500.AssumethatthesixmonthLiborratewilladjustsemiannually,December1andJune1,duringthefive-yearterm.Theparty’ssemiannualpaymentresponsibilities(thelegs)arenettedtogether;therefore,PartyAwillinitiallypay$62,500(125,000-62,500)toPartyBonJune1,2015.Futurenettingwilldependonchangestothereferencedindexovertheremainingtermoftheswap.Eachpartyhaseffectively“traded”theirobligationtotheother.

Themethodologyforpricingswapsissimilartootherderivatives,usingtheunderlyingasset’scurrentandexpectedfutureprice,contractterm,risk-freerateofreturn,andcashflowfromtheasset.Intheaboveexample,PartyApaysafixedrateofinterestinexchangeforafloatingrate.PartyAiswillingtopayahigherfixedrateforinterestrateprotection,buthowmuchofahigherratewilllargelydependonmarketinterestrateprojectionsoverthetermoftheswap.Atinceptionoftheswap,thepresentvalueofthefixedlegshouldbeequaltothepresentvalueoftheforecastedfloatingrateleg,sincenopartywouldpresumablypaymorethanthemarketpriceforareadilyavailableinvestment.Overtime,duetochangesininterestrates,onepartytotheswapcontractmaybuildaprofitinthecontractwhiletheotherwouldhaveacorrespondingloss.Atall


timesthough,thenettingofprofitandlossforeachlegshouldbezero.

Finally,acentralconceptinpricingofallderivativesisthatthereshouldbenoopportunitytomakearisk-freeprofit.Thisisreferredtoasno-arbitrageorrationalpricing.Thatisnottosaythatthereareneveropportunitiesforarbitrage.Considertheoneemptylineinanotherwisecrowdedgrocerystore.Manyofusthinktoourselvesthatsomethingmustbewrongbecause,ifthatlinewerereallyopen,peoplewouldhavealreadytakenadvantageofit.However,oncesomeonedoesmakethefirstmovetothatemptyline,othersfollowandtheopportunitydisappears.Itisprobablymoreaccuratetosaythattherearelimitedopportunitiesforfinancialarbitrage,butthosearbitrageopportunitieswillquicklydisappearastheyareexploitedbymarketpressuresandopportunisticinvestors.

Risk Management and Opportunity

Muchofthemediaattentionoverthelasttwodecadeshasfocusedonthe“evils”ofderivatives.ThenearcollapseofhedgefundmanagerLong-TermCapitalManagement(LTCM)inthelate1990smadeheadlinesaroundtheworldandbecameacasestudyincorporatedinmanyfinancetextbookstoday.From1995through1997,LTCMproducedannualreturnstoinvestorsofapproximately40percent,40percent,and20percent,respectively,byengaginginhighlyleveragedderivativetradingactivities.13However,inAugust1998alone,thefundlostapproximately$1.8billion,or44percentofitsequity.14Thefirm’slackofliquidityledtoaseriesofeventsresultinginthefund’sclosurein2000.Inresponsetoeventsliketheseandtherecentbankingandfinancialcreditcrisis,PresidentObamasignedintolawtheDodd-FrankWallStreetReformandConsumerProtectionActonJuly21,2010.15Oneofthepurposesofthislegislationwastolowerrisk,promotetransparency,andprotecttheAmericanpublicbyregulatingtheover-the-counterderivativesmarket.

Whiletheycanbeusedforspeculation,onepracticaluseforderivativesisriskmanagement.Forexample,acompanythatdependsonacommodityforbusinessoperations,suchasheatingoil,maybehighlysensitivetocommoditypricemovements.Alarge,unanticipatedprice

increaseinheatingoilwoulddramaticallyimpactthecompany’sbottomlineasitmaynotbeabletopassthiscostontoitscustomers.Derivativesmaybeusedbythecompanytomitigatetheriskassociatedwithsuchasignificantpriceincrease.Additionally,derivativesareextremelyusefulformanagingriskofinvestmentportfolios.ConsideraninvestmentmanagerwithaninvestmentportfoliohighlycorrelatedtotheS&P500whohasashort-termbearishviewoftheeconomy.Themanagerhastwoalternatives:increasecashbyliquidatinginvestmentpositionsoruseashort-termderivativestrategy(e.g.,S&Pfuturescontract)tomitigatetheriskresultingfromalargemarketcorrection.Thefuturesroutewouldprobablybemorecosteffectiveandquickertoimplement.Inshort,whenproperlyused,derivativesprovideaneffectivemeansof

“insurance”protection,therebymitigatingtheriskassociatedwithunanticipatedevents.

Derivativesmayalsobeusedtosimulatecertaininvestmentstrategiesmoreefficientlyorcapitalizeonspecificmarketopportunitiesnototherwisepracticalfordirectinvestment.Consideraninvestmentmanagerwhomaintainsamarketneutraloutlookbutbelievesthatmajoreconomicnewsiscomingthatwillsignificantlyimpactthemarket.Themanageranticipatesatremendousshort-termincreaseinmarketvolatilitybutdoesnotstronglyfavoraspecificdirection.Theinvestmentmanagermayconsideraderivative(orcombinationofderivatives)thatcapitalizesonshort-termincreasesinmarketvolatilityineitherdirection.Forexample,astraddleisacommonlyusedoptionstrategythatcombinesalongcallandlongputonthesameunderlyingsecurityorindexwithbothoptionshavingthesameexpirationandsamestrikeprice.Asaresult,extremepricemovementsinthesecurityorindexineitherdirectionresultsinaprofittotheholder.Derivativesmayalsobeusedtoinvestinmarketsorindividualassetsnototherwiseaccessible.Forexample,certainmarketsmayhaveexistingtradingrestrictionsthatprohibitforeigninvestmentormakedirectinvestmentuneconomical.

Thereislittledoubtthatderivativeshaveareputationofbeingcomplexorrisky,but,aslongastheiruseisconsistentwithaninvestor’sriskobjective,derivativesserveacriticalrole.Even


BerkshireHathawayhadexposureto$62billioninnotionalvalueofderivativecontractsattheendof2009,aninterestingfactgivenWarrenBuffet’s

“weaponsofmassdestruction”commentsin2003.Thisisnotacriticismoftheexposurebutmerelymeanttoillustratethatderivativesareanintegralpartoftoday’sfinancialmarkets.Astowhetherincreasedregulationofderivativeswillhaveasignificantimpactonitsperceivedabuseinthefuture,onlytimewilltell.

Grantor Retained Annuity Trust (GRAT)

Description and Authority

OneofthemoreenduringandpopularwealthtransferplanningstrategiesusedoverthelasttwodecadeshasbeentheGrantorRetainedAnnuityTrust(GRAT).ThisparticularstrategyisdifferentfromothersbecauseitderivesitsbasicdesignandauthoritydirectlyfromtheInternalRevenueCode.

Section2702waspassedin1990toeliminatethegifttaxbenefitsofcertainintra-familytransactions,suchasGrantorRetainedIncomeTrustsandjointpurchases.Thesection’smethodineliminatingthebenefitswastotreattheentirevalueofatransferasataxablegift.However,atthesametime,Section2702establishedcertainexceptionsthatwerestillvalid—oneofthoseexceptedstrategiesistheGRAT.16Asaresult,thestructure,asdefinedbytheCode,givestaxpayerssomecertaintythat,ifproperlystructuredandmanaged,aGRATwillnotlikelybechallenged.

AGRATisatechniquewhereanindividual,the“grantor,”transfersassetstoatrust(theGRAT)inexchangeforanannuitystreamforaperiodofyears.Attheendoftheterm,theremainingassetsbecomethoseoftheremaindermen,oftenthedonor’schildren.TheamountofanytaxablegiftrelatedtothetransferisdeterminedatthetimeoftheinitialfundingoftheGRAT,andthesizeofthegrantor’sannuityreducesthevalueofthetaxablegift.Theactualcalculationofthegiftelementisperformedbyapplyingthe“7520rate”ofinterest.Eachmonth,theIRSpublishesatableofinterestrates,includingthe“7520rate,”whichisusedasadiscountratetocalculatethepresentvalueoftheGRATannuity.TheannuityvalueisthensubtractedfromthevalueofassetstransferredtotheGRAT,resultinginthenetvalueoftheremainder,thetaxablegift.(SeeExhibits4and5.)

Ifstructuredwithalargeenoughannuity,thetaxablegiftcanactuallybereducedtozero.ThisisadistinctadvantageofGRATs.Taxpayerscanengageinthisplanningstrategy,eveniftheyhaveotherwiseusedalloftheirlifetimegifttaxexemption,withouthavingtopayanytaxout-of-pocket.AGRATwithsuchastructureisreferredtoasa“zeroed-outGRAT”ora“WaltonGRAT,”namedafterthecourtcasethateffectivelyvalidatedit.17Forexample,to“zero-out”thegiftforatwo-yearGRATwhenthe7520rateis1.8percent,theannualannuitywouldbesetat51.35316percent.18However,foraten-yearGRAT,theannuitywouldbesetat11.01649percent.19

GRAT Risks

ThereareessentiallytwomainriskswithaGRAT.Thefirstismortalityrisk:Ifthegrantordiesduringtheannuityterm,thevalueofsomeoralloftheassetsintheGRATwillbeincludedinthegrantor’staxableestate.Asaresult,thetransfermayhavebeenineffectivefromawealthtransferplanningperspective.Thesecondisperformancerisk:Iftheassetsperformatalevelhigherthanthe7520rate,theGRATisconsidered“inthemoney,”andalltheappreciationinexcessofthatratepassestotheremaindermenfreeoffuturetransfertaxes.However,iftheassetsunderperform(i.e.,theGRATis“outofthemoney”)theassetsareeffectivelyreturnedtothegrantorthroughtheannuity,andtheremaindermenwillreceivenothing.Again,theeffectisasiftheGRATwereneverimplemented.Forbothrisks,thisquirkinthesystemmeansthataGRATisa“headsyouwin,tailsyoutie”formofstrategy.Asaresult,thesolecostoffailureunderbothrisksisessentiallythecostofimplementingandoperatingthetrust.

Administration’s Proposal to Extend Minimum Term of GRATs

TheapplicationofcertainvariationsonGRATsmaybelimitedbyfuturelegislation.Forseveralyears,theObamaadministrationhasannuallyproposedtolimittheperceivedabusivenatureofcertaintypesofGRATs.TheseproposalsgenerallyincluderequirementsthataGRAThaveaminimumtermoftenyearsoramaximumtermoflifeexpectancyoftheannuitantplustenyears.Otherproposedchangesincludeprohibitionsonzeroed-outGRATsanddecreasingannuitypaymentstructures.


Exhibit 4. 10-Year 9% GRAT

Thefollowingexampleillustratesa10-yearGRATwithapayoutannuityrateof9%.Assumptionsare$10millionbeginningprincipal,a1.8%7520rate,andatotalannualreturnontrustassetsof6%.

Beginning 4.00% 2.00% GRAT Year Principal Growth Annual Income Annuity Remainder

1 $10,000,000 $400,000 $200,000 $900,000 $9,700,000

2 $9,700,000 $388,000 $194,000 $900,000 $9,382,000

3 $9,382,000 $375,280 $187,640 $900,000 $9,044,920

4 $9,044,920 $361,797 $180,898 $900,000 $8,687,615

5 $8,687,615 $347,505 $173,752 $900,000 $8,308,872

6 $8,308,872 $332,355 $166,177 $900,000 $7,907,404

7 $7,907,404 $316,296 $158,148 $900,000 $7,481,849

8 $7,481,849 $299,274 $149,637 $900,000 $7,030,760

9 $7,030,760 $281,230 $140,615 $900,000 $6,552,605

10 $6,552,605 $262,104 $131,052 $900,000 $6,045,762

Summary $10,000,000 $3,363,841 $1,681,921 $9,000,000 $6,045,762

Results:UponthefundingoftheGRAT,thegrantormustreportataxablegiftof$1,830,430.However,attheendofthe10-yearterm,thebeneficiariesreceive$6,045,762freeoffurtherestateandgifttax.

Exhibit 5. 10-Year Zeroed-Out GRAT

Thefollowingexampleillustratesa10-yearzeroed-outGRAT.Assumptionsare$10millionbeginningprincipal,a1.8%7520rate,andatotalannualreturnontrustassetsof6%.


1 $10,000,000 $400,000 $200,000 $1,101,649 $9,498,351

2 $9,498,351 $379,934 $189,967 $1,101,649 $8,966,603

3 $8,966,603 $358,664 $179,332 $1,101,649 $8,402,950

4 $8,402,950 $336,118 $168,059 $1,101,649 $7,805,478

5 $7,805,478 $312,219 $156,110 $1,101,649 $7,172,158

6 $7,172,158 $286,886 $143,443 $1,101,649 $6,500,838

7 $6,500,838 $260,034 $130,017 $1,101,649 $5,789,240

8 $5,789,240 $231,570 $115,785 $1,101,649 $5,034,945

9 $5,034,945 $201,398 $100,699 $1,101,649 $4,235,393

10 $4,235,393 $169,416 $84,708 $1,101,649 $3,387,867

Summary $10,000,000 $2,936,238 $1,468,119 $11,016,490 $3,387,867

Results:Thegifttaxvalueiszero,ascalculatedondayonesincethepresentvalueoftheannuityisequivalenttotheamountinitiallytransferred.Attheendofthe10-yearterm,thebeneficiariesreceive$3,387,867freeofestateandgifttax.


LengtheningtheminimumtermtotenyearsmaymaketheGRATlessattractiveasmoreassetsmaybeincludedintheestateiftheGrantordoesnotsurvivetheterm.Itwouldalsoeliminatetheabilitytostructureaseriesof“rolling,”short-termGRATs,averyfavorablewealthtransferstrategywhichwillbediscussedlater.AsforlimitingthemaximumdurationofaGRAT,itappearsveryfewadvisorsarerecommendingthelong-termGRATasaviablestrategy,eventhoughitmayprovideauniquebenefitinanincreasinginterestrateenvironment.

Enhancing GRATs

EventhoughtheGRATisacreatureoflegislationwithitsbasicelementssetbytheCode,therearestillmanyopportunitiestoincreasethelikelihoodandmagnitudeofsuccessforwealthtransfer.Certainly,theartfuldraftingofthetrustdocumentitselfplaysanimportantroleinthesuccessoftheGRAT.AskilledattorneywilldraftadocumentthatcreatesthebestchancefortheGRATtostanduptochallenge,escapeestateinclusion,leveragegrantortrustrules,andofferprotectionfromcreditors.However,thefocushereisonlyonthedesignsthatimprovethefinancialsuccessofthestrategy.

InlookingatwealthengineeringstrategiesforGRATs,someinvolvethedesignandstructure

ofthetrustitself,includingthespecificsoftheannuitypaymentandthelengthortermofthetrust.However,mostinvolveexecution,ratherthandesign,centeringonthechoiceofassetusedtofundthetrustandongoingadministrationofthetrust.Designandstructurewillbediscussedfirst,andthenexecution.

Length of Term: Long Versus Short-term and Rolling

Oneofthefirstconsiderationsindesigningthetrustisthelengthoftheterm.Generallyspeaking,withalongerterm,theannuitycanbefixedataloweramountwhilestillkeepingthegifttaxamountatornearzero.ThisbecomesespeciallyimportantwhentheassetsusedtofundtheGRATareilliquidanddon’tprovidesufficientcashflowtofundalargeannuity.Ingeneral,iftheassetsdon’tprovideenoughcashflow,theassetitselforsomeportionofitmustbereturnedtothegrantortosatisfytheannuity,reducingtheeffectivenessoftheGRAT.Therefore,itisimportanttosettheannuitylowenoughthatitisabletobesatisfied,whichinturnmayrequirealongertermtokeepthegiftvaluelow.

Along-termGRATcanlockinalow7520rateatthebeginningoftheterm.Forexample,the7520rateforMarch2015was1.8percent.Thisinterestratewasapplicableregardlessofthe

Exhibit 6. Rolling GRAT

Thefollowingexampleillustratesaseriesoftwo-yearrollingzeroed-outGRATs.Assumptionsare$10millionbeginningprincipal,a1.8%7520rate,andatotalannualreturnonallassetsof6%

Rolling GRATs GRAT Remainder Trust

Beginning Income and Payout Annuity Ending Beginning GRAT Ending Year Principal Growth % Annuity % Year Payment Balance Balance Funding Growth Balance

Yr1GRATS

1 $10,000,000 $600,000 51.35% 1 $5,135,000$5,465,000

2 $5,465,000 $327,900 51.35% 2 $5,135,000 $657,900 $0$657,900 $39,474$697,374

Yr2GRATS

1 $5,135,000 $308,100 51.35% 2 $2,636,823 $2,806,278

2 $2,806,278 $168,377 51.35% 3 $2,636,823 $337,832 $697,374 $337,832 $62,112$1,097,318

Yr3GRATS

1 $7,771,823 $466,309 51.35% 3 $3,990,831 $4,247,301

2 $4,247,301 $254,838 51.35% 4 $3,990,831 $511,308 $1,097,318 $511,308 $1,608,626

Results:Attheendofthe4years,thebeneficiariesreceive$1,608,626freeofestateandgifttax.Thisrollingstrategycouldbecontinuedindefinitely,creatingadditionalwealthtransferandlimitedexposuretoestatetaxinclusionforthegrantor.


GRATterm.Verysimply,theappreciationabovethat1.8percentratewouldpasstotheremainderbeneficiaries.Therefore,itmaybeverybeneficialtolockinahistoricallylowrateoveralongperiodoftime.Additionally,notallassetsareincludedinagrantor’sestateshouldthegrantornotsurvivetheterm.Infact,theamountofincludedassetsisbasedonthevalueofassetsnecessarytoproducethesamepayoutfortheremainingnumberofyearsbasedontherateinexistenceatthetimeofthegrantor’sdeath.Therefore,ifinterestrateshaveincreaseddramaticallysincethedateofGRATformation,significantlylessassetswillbeincludedinthegrantor’sestate.20

However,inmanycases,ashort-termGRATwillbepreferred.First,ashortertermreducesthelikelihoodthatthegrantorwilldieduringtheterm,causinginclusionoftrustassetsintheirestate.Second,aseriesofshort-termconsecutiveGRATsreducestheimpactofoneortwoyearsoflowperformanceontheoverallfinancialperformance.

Thisisbecauseofthe“headsyouwin,tailsyoutie”aspectofGRATswhereaperiodoflowperformanceisisolatedandreturnedtothegrantor.Periodsofhighperformancearelikewiseisolatedforthebenefitoftheremainderbeneficiaries.

Evenso,thestrategydoesnotendwiththeshorterterm,butisthencontinuedthroughthecreationofsuccessive,“rolling”GRATs.Eachyear,asthegrantorreceivesanannuitypayment,acontributionismadetoanewshort-termGRAT.This“rollingGRAT”strategycancontinueindefinitely.Bydesign,astheGRATsroll(aftertheinitialGRATterm),acertainamountisremovedfromexposuretoestatetaxastheremainderispassedtothebeneficiaries.Inaddition,highorlowperformanceisisolated,optimizingthestrategy.

Again,asnotedabove,short-termGRATsmaybeunderthreatfromfuturelegislation,whichmaymandateaten-yearminimumtermforallGRATs.

Annuity Amount: Level, Increasing and Decreasing Payout Structures

Often,thenextfactorconsideredinthedesignofaGRATisthedeterminationoftheannuityamount.Inmostcases,asnotedabove,theannuityissetatalevelhighenoughtominimizethegifttaxvalue(potentiallytozero),yetlowenoughtobe

achievablewiththecashflowexpectedtobecreatedbythetrust’sassets.

ThedeterminationoftheoverallannuityamountisoftenaconsiderationnecessitatedbythefactorsoftheassetsusedtofundtheGRAT—aconsiderationthatbecomesmuchmorerelevantfortrustsfundedwithilliquidassetsprovidinglimitedcashflow.Iftheassetsareliquid(e.g.,marketablesecurities),theannuitycanbesatisfiedregardlessofcashbywayofdistributingtheassetsinkind,therebyallowingahighannuitypayment(andpotentiallyashorterterm).Ontheotherhand,illiquidassets(e.g.,realestate)cannotbeeasilypartitionedtofundtheannuitypayment,andtheinitialdeterminationoftheannuityamountbecomesagreaterconcern,largelydependentonexpectedcashflow.Still,thegeneralideaisusuallytosettheannuityashighaspossible.

Additionally,thereisnorequirementthattheannuitypaymentbelevelthroughthetermoftheGRAT.Infact,theannuitypaymentcanbesettoincreaseordecreaseatregularintervals.Currently,itispermissibletostructureaGRATwithanannuitythatincreasesupto20percentperyear,ordecreasesbyanapparentlyunlimitedamount.

Increasing Annuity

Anincreasingannuitycanbeadvantageousindeferringaportionoftheannuitypayabletothegrantor,allowingassetstoaccumulateinthetrust.Iftheassetsthenoutperformthe7520rate,therewillbemoreassetsinthetrustattheendofthetermpassingforthebenefitoftheremainderbeneficiaries.Anincreasingannuitycanalsobehelpfulwithilliquidbusinessorrealestateassetsthatareexpectedtoproducecashflowsthatwillincreaseovertheterm.Insuchacase,anincreasingannuitymaybettermatchtheexpectedtrustincome.

Decreasing Annuity

Ontheotherhand,adecreasingannuitymaybebeneficialforelderlyorillgrantorsasitreducesthevalueofthetrustmorequickly,therebydiminishingthepotentialexposuretoestatetaxinclusionifthegrantorweretodieduringthetermofthetrust.Sincetheestatetaxinclusionamounthasbecomemoresettled,GRATsstructuredwith


Exhibit 7. 10-Year GRAT, 20% Increasing Annuity

Thefollowingexampleillustratesa10-yearzeroed-outGRATwithanannuityincreasingannuallyat20%.Assumptionsare$10millionbeginningprincipal,a1.8%7520rate,andatotalannualreturnontrustassetsof6%.


1 $10,000,000 $400,000 $200,000 $435,400 $10,164,600

2 $10,164,600 $406,584 $203,292 $522,480 $10,251,997

3 $10,251,997 $410,080 $205,040 $626,976 $10,240,141

4 $10,240,141 $409,606 $204,803 $752,371 $10,102,178

5 $10,102,178 $404,087 $202,044 $902,845 $9,805,464

6 $9,805,464 $392,219 $196,109 $1,083,414 $9,310,378

7 $9,310,378 $372,415 $186,208 $1,300,097 $8,568,904

8 $8,568,904 $342,756 $171,378 $1,560,116 $7,522,923

9 $7,522,923 $300,917 $150,458 $1,872,139 $6,102,159

10 $6,102,159 $244,086 $122,043 $2,246,567 $4,221,721

Summary $10,000,000 $3,682,750 $1,841,375 $11,302,403 $4,221,721

Results:Attheendofthe10-yearterm,thebeneficiariesreceive$4,221,721freeofestateandgifttax.

Exhibit 8. 10-Year GRAT, 20% Decreasing Annuity

Thefollowingexampleillustratesa10-yearzeroed-outGRATwithanannuitydecreasingannuallyat20%.Assumptionsare$10millionbeginningprincipal,a1.8%7520rate,andatotalannualreturnontrustassetsof6%.


1 $10,000,000 $400,000 $200,000 $2,395,152 $8,204,848

2 $8,204,848 $328,194 $164,097 $1,916,122 $6,781,017

3 $6,781,017 $271,241 $135,620 $1,532,897 $5,654,980

4 $5,654,980 $226,199 $113,100 $1,226,318 $4,767,961

5 $4,767,961 $190,718 $95,359 $981,054 $4,072,985

6 $4,072,985 $162,919 $81,460 $784,843 $3,532,520

7 $3,532,520 $141,301 $70,650 $627,875 $3,116,597

8 $3,116,597 $124,664 $62,332 $502,300 $2,801,293

9 $2,801,293 $112,052 $56,026 $401,840 $2,567,530

10 $2,567,530 $102,701 $51,351 $321,472 $2,400,110

Summary $10,000,000 $2,059,989 $1,029,995 $10,689,873 $2,400,110

Results:Attheendofthe10-yearterm,thebeneficiariesreceive$2,400,110freeofestateandgifttax.NoticehowtheGRATbalance(andthereforeestateexposure)ismorequicklyreducedthanintheincreasingannuityexample.


decreasingannuitiesmaybecomemorecommon.Thismaybeespeciallytrueinanincreasinginterestrateenvironmentwheremortalityriskmaybeoffsetbyhigherinterestratesresultinginlowerestatetaxinclusion.

Ontheotherhand,asdiscussedpreviously,theuseofadecreasingannuityisitselfthreatenedbyfuturelegislationthatmaynolongerallowanydecreasewithinthefirsttenyears.

Investment Management

Managing Volatility Generally

Investmentprofessionalstypicallyattempttoreduceaportfolio’sstandarddeviationwhilemaximizingtheexpectedreturn.Alowervolatilitynormallycausesahigherendingvalueoveralongenoughperiodoftime.SeeExhibit9.

Exhibit 9. Volatility

Considerthereturnsoftwoportfolios:BothPortfolio1andPortfolio2realizethesamesimplearithmetictotalreturnof45percentandthesamearithmeticaverageannualreturnof9percentover5years.

Year Portfolio 1 Portfolio 2

1 15% 9%

2 35% 9%

3 -12% 9%

4 12% 9%

5 -5% 9%

Simple Total 45% 45%

1.6M

1.4M

1.2M

1.0M

Portfolio 1

Portfolio 2

Year 5Year 4Year 3Year 2Year 1

Results:Eventhoughbothportfoliosrealizethesameaveragereturn,thefinalresultisbetterinPortfolio2.Aninvestmentof$1,000,000growsto$1,538,624forPortfolio2,whilePortfolio1onlygrowsto$1,453,637(geometric/compoundedreturns).Inotherwords,reducedvolatilityandconsistentcompoundingovertimeresultinahigherbalanceforPortfolio2.

Managing Volatility in GRATs

—Generally

Theobjectivetoreducevolatility,whilegenerallyimportantformostinvestmentportfolios,isnotnecessarilyasimportantanobjectiveforGRATs.RememberthattheGRATisa“headsyouwin,tailsyoutie”strategy.Becauseofthat,thedownsideofnegativevolatility(i.e.,fast-occurringinvestmentlosses)isminimizedandtheupsideofpositivevolatility(i.e.,fast-occurringinvestmentgains)ismaximized.ChasingvolatilitycanbeaneffectivestrategyforaGRAT.Highervolatilitycanincreasetheamountthatpassestotheremainderbeneficiariesifpositivevolatilityisachieved;ifnegativevolatilityisexperienced,theassetssimplyreverttothegrantor.

—Separate GRATs

OneveryeffectivewaytochasevolatilityistoisolateitbyseparatingassetswithnegativecorrelationsandhighvolatilityintoseparateGRATs.Forexample,ifaclientholdstwovolatileassetswithahighnegativecorrelation(onemovesupwhenonemovesdown)andifthoseassetswereheldinoneGRAT,thetrustmayexperiencealoworevenflatcombinedreturnovertime,underperformingwhencomparedtothe7520rateandresultinginanunsuccessfulGRATstrategy.If,however,thoseassetswereplacedinseparateGRATs,onemaybeunsuccessful(but,“tailsyoutie”)whiletheothermaybewildlysuccessful(“headsyouwin”).ThenetresultisthenasuccessifassetsaretransferredintoseparateGRATs,whilethenetstrategywouldhavebeenunsuccessfulifcombinedinoneGRAT.

Therefore,whenanalyzingthevariousassetsinaninvestmentportfolioidentifyingthoseassetswithnegativecorrelationsandhighvolatility(i.e.,highstandarddeviations)maypresentanopportunity.Thoseassetsmaythenbeisolatedanddedicated


toseparateindividualGRATs,eachwiththeirowntrustdocumentandinvestmentaccount.Inthisway,theclientmayhaveabetterchancetooptimizethesuccessoftheGRAT.SeeExhibits10and11forexamplesofseparateGRATstrategies.

Hedging Against Mortality Risk

OneofthemainrisksofaGRATismortalityrisk(i.e.,theriskthatthegrantorwilldieduringtheannuityterm),whichmeansthatsomeorallofthetrustwillbeincludedinhisorherestate.Asdiscussedearlier,theGRATistrulya“headsyouwin,tailsyoutie”strategy,inthatifthestrategyfails,nothingislostexceptfortransactioncosts,gifttaxespaid(ifany),andopportunity.Still,grantorsmaywanttohedgeagainstthepossibilityofestateinclusion.

Onesimpleandsometimescost-effectivewaytohedgeagainstmortalityriskistopurchaselifeinsuranceonthegrantor.Ifthegrantorpassesawayduringtheannuityterm,thelifeinsurancedeathbenefitisreceivedbytheestatewhentheadditionaltaxliabilityisincurred.Ofcourse,theefficiencyofthelifeinsuranceasahedgedependsonavarietyoffactorsincludinginternalpolicychargesandreturns,premiumcosts(largelyduetothehealthandageoftheinsured),quantityofpremiumspaid(yearsuntiltheinsuredpasses),and,ofcourse,thefinancialabilityoftheinsurancecompanytopaythedeathbenefit.Aqualifiedinsurancespecialistshouldbeconsultedtoensuretheacquisitionofanappropriatepolicy.Inaddition,anIrrevocableLifeInsuranceTrust(ILIT)canbeusedtopurchaseandholdtheinsurancepolicyinordertokeepthedeathbenefitsoutsidetheinsured’staxableestate.

Hedging to Lock in Returns: Immunization and Substitution

WhenaGRAThasprovensuccessfulduringanypartofitsterm(bywayofsignificantappreciationoftheassetsinexcessofthe7520rate),itmaybecomeimprudenttocontinuetosubjecttheGRATassetstotheriskofloss.Bythesametoken,itmaybewisetoisolateand“write-off”aGRATthathassufferedsignificantlosseswhenitappearsunlikelytorebound.Whensuchsignificantgainorlossoccurs,itmaybeprudentto“lock-in”thereturns.Therearemanywaystoaccomplishthis.

Oneofthemostcommonmethodsisthepracticeof“immunization.”

Immunizationissimplytheprocessofattemptingtolock-inthesuccess(foran“in-the-money”GRAT)orisolatetheloss(foran“out-of-the-money”GRAT)byexchangingorreallocatingassets.Onesimpleoptionisforthetrusteetoliquidatecertainassetsandpurchaseotherlowvolatilityassetstolockingains.Equitiesorotherhighstandarddeviationassetsarereallocatedintocash,fixedincome,certainhedgefunds,oranynumberofotherassetclassesthatarelessvolatile.TheriskoffuturelossintheGRATisreduced,makingthefinalsuccessofthetransactionmorelikely.ThisworksespeciallywellinrollingGRATswhereshort-termvolatilityhasgreaterimpact.

Anotheroptionistoexercisethepowerofsubstitution,apowercommonlyreservedtothegrantorinmanytrustdocuments.ThepowerasoutlinedinSection675(4)(C)allowsthegrantortore-acquirethetrustcorpusbysubstitutingotherpropertyofequivalentvalueandcausesthetrusttobetreatedasagrantortrustforincometaxpurposes.Underthegrantortrustrules,thegrantorhasthelegalobligationtopayanyincometaxesontrustassets.Thisallowsthetrusttogrowunreducedbyanyincometaxliability.Whilethepowerofsubstitutioncreatesanidealtransfertaxenvironment,thepowerhasbroaderapplicationandcanbeusedbythegrantorfromtimetotimetoenhancetheGRAT’seffectiveness.

ThepowerofsubstitutionmaybeappliedbythegrantorwhenitbecomesdesirabletoimmunizetheGRATbyexchanginghigh-performingassetsintheGRATforless-volatileassetsofequivalentvaluethatareheldindividually(e.g.,exchangingequitiesforbonds).Becauseofthegrantorstatusofthetrust,suchatransactionisignoredforincometaxpurposesandcreatesnorecognizedgainorloss.Effectively,thegrantorisexchangingassetswiththemselves.Asaresult,usingthepowerofsubstitutionisgenerallymoretaxeffectivethanperformingimmunizationinternallyviathetrusteeliquidatingtrustassets.

Ifthegrantorwantstocontinuethewealthtransfercycle,afterthesubstitutionthegrantorcanthenre-GRATthehigh-performingassetstoanewGRAT.Thisprocesscancontinue


indefinitely.Inthatway,thehigh-performingassetscontinuetoofferwealthtransferpotential,andsuccessorfailureisperiodically“locked-in.”Whencombinedwithashort-term“rollingGRAT”strategy,regularimmunization(byusingthepowerofsubstitution)canprovideevengreaterpotential.Asdiscussedearlier,ashort-termrollingGRATgenerallyprovidesmorewealthtransferpotentialthanalong-termGRATbecauseofthecontinuedutilizationandtransferofassets.Infact,performingregularimmunizationonatwo-yearrollingGRATattheendofthefirstyeareffectivelyturnsitintoaone-yearrollingGRAT.

Consideronecaveatthatmaygoagainstconventionalwisdom:WhileimmunizationmaycreateagreaterlikelihoodtoachievesuccessforaparticularGRAT(andfortheoverallsuccessofaseriesofGRATs),theoverallamountofwealthtransferredmayactuallybeloweronaverage.Thisisbecauseswitchingtothelower-volatileassetsmaygenerallybeexpectedtoproducealowerreturn.ThisisthetypicalriskandrewardconundrumandbecomesaquestionofwhetherthegrantorismoreinterestedincreatingagreaterpotentialforGRATsuccessorinmaximizingthe

potentialamounttransferredtoheirs.Oneanswermaynotbecorrectforall.

Overall Family’s Asset Allocation Considerations

Whilethestrategiesdiscussedabovesurroundinginvestmentoptions,volatility,correlationandisolationcanbeimportantinthesuccessorfailureofaGRAT,onemustnotoverlookthetrust’srelationtotheoverallinvestmentstrategyforthefamily.Advisorsshouldnotignoresuchitemsasthefamily’srisktoleranceandoverallassetallocation.AGRATinvestmentstrategythatmakessenseonaspreadsheetmaynotbeagoodfitwhenconsideringthefamily’sotherinvestments.Forexample,ifthefamily’sotherassetsarebalancedinaratherconservativeandwell-diversifiedallocation,itmaynotmakesensetofocustheGRATonhighlyvolatileequities,evenifthatstrategyisexpectedtoworkwellfromanestatetransferperspective.

Certainly,therisktolerancesandinvestmentpolicyconcernsofallstakeholdersinthetransactionmustbeconsidered.Thegrantor/annuitantandtheremainderbeneficiariesmayhaveverydifferentinterests,risktolerances,andinvestmentpolicy

Exhibit 10. 2-Year GRAT

Thefollowingexampleillustratesa2-yearzeroed-outGRAT.Assumptionsare$10millionbeginningprincipal,a1.8%7520rate,andvaryinginvestmentreturns.

Case #1: GRAT with Investment Gains

Beginning Income and Income and Annuity Ending Year Principal Growth % Growth % Annuity % Payout Year Payment Balance

Yr1GRATS

1 $10,000,000 10% $1,000,000 51.35% 1 $5,135,000 $5,865,000

2 $5,865,000 12% $703,800 51.35% 2 $5,135,000 $1,433,800

Case #2: GRAT with Investment Losses


Yr2GRATS

1 $10,000,000 -10% -1,000,000 51.35% 1 $5,135,000 $3,865,000

2 $3,865,000 -12% -463,800 51.35% 2 $3,401,200 $0

Results:InCase#1,theassetsoutperformthe7520rateand$1,433,800passestotheremainderbeneficiaries,freeofestateandgifttax(i.e.,“headsyouwin”).InCase#2,theassetsunderperformandtheGRATis“outofthemoney.”Thetrusthasnoassetstopasstotheremainderbeneficiaries.Inessence,theassetsareallpassedbacktothegrantoranditisasiftheGRATwasneverimplemented(i.e.,“tailsyoutie”).


Exhibit 11. Combined Versus Separate GRATs

Thefollowingexampleillustratesa2-yearzeroed-outGRAT.FirstanalysisassumesonecombinedGRATofassetswithnegativecorrelationsand,therefore,combinedminimalreturns.SecondanalysisassumescreatingtwoGRATs,oneforeachnegatively-correlatedassetclass.Assumptionsare$10millionbeginningprincipal,a1.8%7520rate,andvaryinginvestmentreturns.

Case #1: Combined GRAT with Negative Correlation Assets


Yr1GRATS

1 $10,000,000 1.1% $110,000 51.35% 1 $5,135,000 $4,975,000

2 $4,975,000 2.7% $135,240 51.35% 2 $5,110,240 $0

Case #2: Separate GRATs with Negative Correlation Assets

Separate GRAT#1


Yr1GRATS

1 $5,000,000 10.5% $525,000 51.35% 1 $2,567,500 $2,957,500

2 $2,957,500 11.2% $331,240 51.35% 2 $2,567,500 $721,240

Separate GRAT#2


Yr1GRATS

1 $5,000,000 -8.3% -$415,000 51.35% 1 $2,567,500 $2,017,500

2 $2,017,500 -9.7% -$196,000 51.35% 2 $1,821,500 $0

Combined Results of Separate GRATs


Yr1GRATS

1 $10,000,000 1.1% $110,000 51.35% 1 $5,135,000 $4,975,000

2 $4,975,000 2.7% $135,240 51.35% 2 $4,389,000 $721,240

Results:InCase#1,theassetscollectivelyunderperformthe7520rateandthetrusthasnoassetstopasstotheremainderbeneficiaries.InCase#2,thesameassetsaresplitintotwoseparateGRATs.WhileSeparateGRAT#2underperformsandnoassetspasstothebeneficiaries,SeparateGRAT#1doesoutperformand$721,240passestothebeneficiaries.Collectively,theGRATstrategyperformsbetterwhentheassetsaresplit-up.


concerns.TheGRATinvestmentallocationshouldbedesignedtofacilitatethepaymentoftheannuitytothegrantorwhilealsoprotectingthetrustassetsfortheremaindermenundernormalfiduciaryconsiderationsandPrudentInvestorrules.IftheGRATstrategyisnotconsistentwiththefamily’soverallframework,itislikelynotappropriate.

Sale to Intentionally Defective Grantor Trust (IDGT)

Description and Authority

AsaletoanIDGTisfundamentallydifferentfromaGRATinthattheIDGTnormallyinvolvesaninitialgiftfollowedbythesaleofassetstothetrust,ratherthansimplyagift.InanIDGT,thesaleofassetstothetrustisoftenmemorializedbyapromissorynote.Thenotecontainsallthetermsofanormalnote,includinginterestrate,payment,security,guarantees,anddefaultprovisions.Becausethetransactionisgenerallyintra-family,thetermsmaybesomewhatfriendlierthansomepublicthird-partytransactions,buttheyshouldstillresembleabonafidearm’slengthtransactionortheywillnotberespectedbytheIRS.

ThetermsoftheIDGTtransactionarefarmoreflexiblethanaGRATbecause,unliketheGRAT,theIDGTisnotastatutorystrategy.Thatis,theIDGT’sauthoritydoesnotcomedirectlyfromtheCodeitself,butfromahistoryofcaselawandIRSrulings.Assuch,theremaybeasomewhatgreaterriskofchallengefortheIDGTwhencomparedtotheGRAT.TheIRShasrecentlybecomemoreaggressiveinchallengingsaletransactionstoIDGTs,assertingthatthepromissorynoteisnotbonafidedebt.Ifthenoteisdisregarded,itfollowsthatthesaletransactioncouldbecharacterizedasagift.Thefullvalueofthetransfercouldthenbetreatedasataxablegiftandthereisalsoapossibilitythatthetrustassetswouldbeincludedinthegrantor’sestate,adisastrousresult.GiventheincreasedriskassociatedwiththissaletransactionwhencomparedtoaGRAT,itisimportanttostructurethesetransactionscarefully,followtheappropriateguidelines,andengagequalifiedlegalcounsel.

TheIDGTisconsidered“defective”becausethetransferofpropertyiscompleteforestatetaxpurposesbutincompleteforincometaxpurposes.Thatis,thegrantorisconsideredtobetheownerofthetrustpropertyforincometaxpurposes.Thisisaccomplishedbyhavingthegrantorretainenoughcontrolor“strings”totriggertheincometaxgrantortrustrulescontainedinSections671through679.However,thedraftingattorneymustbecarefultomakesurethatthetrustassetsarenotincludedinthegrantor’sestate.Oneofthemostcommonmethodstotriggerthegrantortrustruleswithoutcausingestateinclusionisbygivingthegrantorthepowerofsubstitution.Aspreviouslydiscussed,thisadministrative(non-fiduciary)powerallowsthegrantortore-acquirethetrustcorpusbysubstitutingotherpropertyofequivalentvalue.21

BecausetheIDGTis“defective”forincometaxpurposes,asaletransactionbetweenthegrantorandtrustisconsideredtobebetweenthegrantorandthemselvesandis,therefore,ignored.Anotherkeybenefitofgrantortruststatusisthatthegrantorcontinuestopaythetrust’sincometaxliability,evenpotentiallyafterthenoteisrepaid.Effectively,thisrepresentsacontinualtax-freegifttotheremainderbeneficiariesofthetrust.

Bona Fide Debt

Inordertomakesurethetransactionistreatedasasaleandnotagift,certainbestpracticesneedtobefollowed.Themainconcernistostructurethenotesothatitistreatedasbonafidedebtandnotequityoraretainedinterest,asdiscussedabove.Inmanycases,thisisaccomplishedbymakingsurethetrustalreadypossessesenoughequityor“seed”capitaltomakethetransactioneconomicallyviable.Thatis,wouldanunrelatedandarm’slengthlenderprovidealoantothetrustunderthegivencircumstances?Unfortunately,thereisverylittleguidanceontheseedcapitalrequirement.Manypractitionersbelievethattheminimumamountofseedcapitalinthetrustis10percentofthetrustassets.Thatis,thetrustshouldhaveatmosta9:1debttoequityratio.ThisguidancelargelycomesfrominformaldiscussionswithIRSofficialsandhasneverbeenofficiallyruledon.Inonecase,theIRSspecificallychallengeda9:1ratiobutthecasewassettled


priortotrial,sonoauthoritywasestablished.22Manypractitionerscontendthatamorecommonsenseapproachshouldbefollowedthansimplyfollowingaratio,andthatoneshouldtakeanoveralllookatthetrust’sfinancialsituationtoensurethattherearesufficientassetsandincomeinthetrusttoeconomicallyjustifythetransaction.

Becauseoftheseedrequirement,unlessapreviouslyfundedtrustisusedfortheIDGTtransaction,theIDGTwillgenerallyinvolvesomeamountofgift.Anotheroptionistoensurethebonafidenatureofthedebtisaccomplishedthroughpersonalguarantees,oftenfromthebeneficiaries.Ifthebeneficiariestrulyhaveastrongenoughbalancesheetandcredithistory,itmaybepossibletoobtainpersonalguaranteesforthedebtfromthemthatwouldsuffice.23Guaranteescanbeaneffectivewaytoreducetherequiredseedorgiftamount,oraddsomeassurancetoatrustthatisalreadyadequatelyseeded.Inanyevent,manypractitionersareuncomfortablestrictlyrelyingonpersonalguaranteesassecurity.Ifbeneficiariesaren’tsufficientlycreditworthy,onemightconsiderobtainingaguaranteefromanotherunrelatedindividual,again,aslongasthattransactionappearsfinanciallyreasonable(i.e.,isforsufficientconsideration,givenallthecircumstances).Obviously,thekeyisforallthetermsofthetransactiontobebonafideandtoreflectarms-lengtheconomicrealities.

Interest Rate

TheinterestrateonthenoteshouldreflectataminimumtheApplicableFederalRate(AFR).Asmentionedpreviously,theAFRisdeterminedbyascheduleofinterestratesissuedeachmonthinaRevenueRulingissuedbytheIRSandvariesaccordingtothetermofthenote(thesamemonthlyrulingalsoprovidesthe7520rateusedforGRATs).IftherateissetatorabovetheAFR,absentotherfactors,thereisnogiftelementtothesale.IftherateissetbelowtheAFR,theloanwillbeconsidereda“below-marketloan”andinterestwillbeimputedattheAFRwiththedifferencebetweentheimputedandstatedinterestbeingtreatedasataxablegiftfromthelendertotheborrower.24

Enhancing IDGTs

Structuring the Sale and Note

AkeyadvantageoftheIDGTasawealthtransferstrategyascomparedtoothers(e.g.,GRATs)isthatthesalestructureandnotemaybedesignedwithagreatdealofflexibilityandcustomization.Themainconsiderationsarounddesignaregenerally:1)Maximizingthewealthtransfer;2)workingwiththeavailablecashflowandeconomicsoftheassets;and3)ensuringthesalewillbetreatedasabonafidesale,ratherthanagift.

Becauseoftheavailableflexibilityofthenote(unliketherigidformoftheannuityintheGRAT),thenotecanbestructuredtoreflectthecashflowandeconomicsoftheassetsandtomaximizethewealthtransfer.Inmostcases,thismeansdeferringpaymentonthenote.Frequently,thenoteisstructuredasaninterest-onlynotewithaballoonpaymentattheendoftheterm.Inthisway,theassetsinsidethetrustareabletogrowandthearbitrageofthereturninexcessoftheAFRisleveragedaslongaspossible.TheabilitytodeferpaymentmakestheIDGTmoreattractivethanaGRATforilliquidassetswithonlyminimalcashflow.Ofcourse,theprincipalwillneedtoberepaideventually,sohowthatistobeaccomplishedmustbeconsidered.Thereshouldbesomeend-gameenvisionedtorepaythenote,oftenthroughafutureliquidityevent.Iftheliquidityeventdoesnotcometopass,itmaybepossibletorefinancethenotebutagain,economicrealitiesmustbeconsidered.Wouldanarm’slengthlenderrefinancethenoteorwouldtheyforecloseandtakethesecurity?Ifthelenderweretoagreetorefinance,wouldtheyrequiresomesortofadditionalfeeorpremium?Itisimportantthatallthenegotiationsgenerallyreflectanarm’slengthmarket.

Illiquid Assets and Valuation Discounts

Asdiscussedabove,becauseoftheavailableflexibilityoftheIDGTstructure,thestrategylendsitselfparticularlywelltoplanningwithilliquidassetsincludingbusinessinterests,partnerships,andLimitedLiabilityCompanies(LLCs).TheGRAT,ontheotherhand,ismoreinflexibleasitmustpayaregular,oftensizableannuity,andtherefore


isn’taswell-suitedtoplanningwithilliquidassetsthatcannotbeeasilybroken-uptosatisfythepayments.Onemajoradvantageofplanningwithilliquidassetsisthepotentialforvaluationdiscountsontransfer.

Valuationdiscountsareacommonelementineffectivewealthtransferplanning.Takenadvantageofeveninsimplegiftingsituations,valuationdiscountscanprovideasimpleandimmediatetransferofwealth.TheirapplicationinanIDGTisequallyaseffective.Generallyusedwhentransferringminorityinterestsinpartnerships,LLCs,orotherentities,theconceptisactuallyquitestraightforward.Forgiftandestatetaxpurposes,thefairmarketvalueofpropertyismeasuredas“thepriceatwhichthepropertywouldchangehandsbetweena[hypothetical]willingbuyerandawillingseller,neitherbeingunderanycompulsiontobuyortosellandbothhavingreasonableknowledgeofrelevantfacts.”25Assumeagroupofassetsisworth$1million.Now,assumethatthoseassetsarecontributedtoanLLCthatcontainsbothvotingandnonvotinginterests.Next,assumethattheowner/memberoftheLLCofferstosella10percentminoritynonvotinginterestinthatLLC.Thebuyerwouldnothavetheabilitytochoosedirectors,selltheirinterest(excepttoothermembers),oraccesstheunderlyingassets(withoutothermembers’permissions).Howmuchwouldthebuyerpayforthatinterest?$100,000(10%x$1million)?Probablynot,and,asaresult,theminorityinterestisnotworthitsshareoftheunderlyingLLCassets.Discountsarebrokendownintotwomainelements:Thediscountforlackofmarketability(the“marketabilitydiscount”orDLOM)andthediscountforlackofcontrol(the“minoritydiscount”orDLOC).Inaddition,courtshaveincreasinglyrecognizedathirdelement:discountsforbuilt-in-capitalgainstaxes.26Totalcombineddiscountsoftenareinthe20–50percentrange.27

ValuationshavenotbeenpopularwiththeIRSorCongress.Overthelastseveralyears,theIRShasdemonstratedanincreaseddesiretochallengediscounts.Likewise,Congresshasintroducedtaxbillsinthepastthatwouldeliminatemanyofthediscountsavailableinintra-familytransactions;however,noneofthebillshavemadeitoutofcommittee.

Still,whenthevaluationdiscountisvalidandsupportable,theresultiseffectivelyaninstanttax-freegiftofthediscountamount.WhentheconceptisappliedtoanIDGT,theeffectisthesame,asthereducedvaluationtranslatestoareducedsalepriceandreducednote,allowingmoreassetstopasstotheremainderbeneficiaries.EveniftheassetsintheIDGTdonotperformwell,thestrategycouldverywellstillbeeffective,solelybecauseofthevaluationdiscountappliedoriginally.

Life Insurance Policies

AnIDGTcanbeusedtopurchaselifeinsuranceontheseller/settlorasawaytocombineanormal(ILIT)strategywiththeIDGT.Essentially,ifthereareexcesscashflowsintheIDGT,theycanbeusedtopaypremiumsonthelifeofthesellerdirectlyfromthetrust.Inotherwords,thetrustbecomesself-funding.Inthatway,thesettlorisnotrequiredtomakeannualcontributionstothetrust,andallthenormalissuesofanILITandCrummeywithdrawalpowersareavoided.28Atthesametime,ifstructuredcorrectly,theinsurancepolicydeathbenefitsareremovedfromthesettlor’sestate,justastheywouldbeinaproperlystructuredILIT.

Dynasty Trusts

InaGRAT,onegenerallycannotdoeffectiveGenerationSkippingTransfer(GST)taxplanningbecauseallocationofGSTexemptionisgenerallysuspendeduntiltheannuityperiodends.29However,GSTexemptioncanbeallocatedtoassetsinanIDGTfrominception.Asaresult,inthosejurisdictionswheretheruleagainstperpetuitieshasbeenrepealed,theIDGTcanbedesignedasadynastytrust,continuingindefinitely.

Total Return Swap of a Synthetic Portfolio with an IDGT—an Alternative to the Sale Transaction?

Withpotentiallegislationthatcouldlimittheuseofshort-termGRATs,ultra-high-net-worthindividualsandfamiliesmaylogicallygravitatetowardmoreIDGTtransactionstoaccomplishtheirwealthtransferobjectives.Asmentionedpreviously,IDGTsaregenerallymoreflexiblethanGRATsandmaybemorefavorableforfamiliesengaginginmultigenerationalordynasticplanning.Overthelastdecade,theplanningcommunityhas


seenaproliferationintheuseofIDGTtransactionsandthattrendshouldcontinue.Wecanalsoexpectnewnon-traditionaltransactionstoemergeasadvisorsfromdifferentdisciplinescollaboratetodevelopplanningstrategiesbeneficialtotheirultra-high-net-worthclients.ThissectionwillintroduceonepossiblealternativetothetraditionalsaletotheIDGT,theswapofasyntheticportfoliowithanIDGT,asthismaybeoneofmanywealthengineeringstrategiesthatweseeusedinthefuture.

The Synthetic Portfolio

Whatifyoucoulddevelopaportfolioconsistingofvirtuallyalloftheworldwideinvestmentopportunities,regardlessofcostorlimitationsonforeignaccess?Whatifthisportfoliocouldincludeaccesstosomeofthebestinvestmentmanagerswhoarenotcurrentlyopentonewinvestorsorrequirerelativelyhighminimuminvestmentcommitments?Wouldtheseinvestmentopportunitiesbeadditivetoportfolioreturnsorpotentiallyreduceriskintheportfolio?

Recallthattheefficientfrontierisagraphicalrepresentationofportfolioriskmeasuredbystandarddeviationandreward,which,inturn,ismeasuredbyexpectedreturn.Byadding

additionallowcorrelationassetstotheinvestmentportfolio,diversificationofnon-systematicriskeffectivelyreducestheportfolio’sstandarddeviation,resultinginamoreefficientportfolio.Theidealefficientfrontiercanalsovarybetweeninvestors,dependingoneachinvestor’soverallgoals,liquidityneeds,personalbias,andaccesstoinvestmentalternatives.Forexample,someliquidityneedscanbesatisfiedbymovingtowardamoreconservativeallocationalongtheefficientfrontier,astheconservativeallocationmayintroducemorefixedincomeandcashequivalentstotheoverallinvestmentportfolio.Thiswouldpotentiallynotimpacttheefficientfrontierasthedecisionismerelytheselectionofasuitableportfolioalongthefrontieritself.However,liquiditycanalsobeimprovedwithinthemarketportfoliobyallocatinglesstoilliquidinvestmentsoreliminatingthecategoryfromconsideration.Thisreductionorpotentialeliminationofaninvestmentcategorycouldtheoreticallyshifttheefficientfrontier.

Hypothetically,allmajorinvestmentopportunitiesshouldberepresentedtoconstructthemostefficientfrontier.Theoptimalcombinationofalloftheseopportunitieswithinaportfoliowouldeffectivelyreducetheportfolio’svolatilityandthe

Exhibit 12. IDGT with Valuation Discounts

ThefollowingexampleillustratesasaletoanIDGTwithvaluationdiscounts.

Beginning 2.00% Principal 4.00% Annual Note Year (Undiscounted) Growth Income Payment Remainder

1 $13,000,000 $520,000 $260,000 $162,000 $13,618,000

2 $13,618,000 $544,720 $272,360 $162,000 $14,273,080

3 $14,273,080 $570,923 $285,462 $162,000 $14,967,465

4 $14,967,465 $598,699 $299,349 $162,000 $15,703,513

5 $15,703,513 $628,141 $314,070 $162,000 $16,483,723

6 $16,483,723 $659,349 $329,674 $162,000 $17,310,747

7 $17,310,747 $692,430 $346,215 $162,000 $18,187,392

8 $18,187,392 $727,496 $363,748 $162,000 $19,116,635

9 $19,116,635 $764,665 $382,333 $9,162,000 $11,101,633

Summary $13,000,000 $5,706,422 $2,853,211 $10,458,000 $11,101,633

Results:Attheendofthe9-yearnote,becauseofthevaluationdiscountandthefactthattheassetsoutperformtheAFR,thebeneficiariesreceive$11,101,633fromtheIDGTfreeofestateandgifttaxes.

Assumptions are: ■ AgeofSeller/Settlor:82years

■ IDGT — GifttoIDGT:

$1,000,000 — Undiscountedvalue

ofassetsoldtoIDGT:$12,000,000

— Discountedvalue:$9,000,000

— Assumedgrowthandincome:6%

■ Note: — Principalamount:

$9,000,000 — Term:9years — Mid-TermAFR:1.53%


resultingefficientfrontierwouldrepresentthehighestlevelofreturnachievableforthegivenlevelofrisk.Unfortunately,manyinvestorsdonothaveaccesstoallinvestmentalternatives.Investmentaccessisoneconstraintthatmayhavethegreatestimpactonbuildingthemostefficientportfolio.

Itispossibletousederivativestoreplicateinvestmentreturnsofanunderlyingassetorgroupofassets,eventhoseinvestmentsthatarenotdirectlyaccessible.AssumethataforeigncompanyisinterestedinpurchasingstockintheUnitedStates.TheforeigninvestorcanchoosetoinvestdirectlyandpurchasetheU.S.stockor,alternatively,investsyntheticallythroughaderivativethatreplicatesthetotalreturnofthesubjectstock.30Takingthisastepfurther,itappearsplausiblethataderivative,suchasaswap,canbeusedtosimulatethereturnsforahypotheticalportfoliocreatedfrommoreinvestmentalternativesthantheinvestorcouldaccessdirectly.Solongaseachinvestmentopportunitymaintainsaminimumleveloftransparencyandtherelatedreturncanbeproperlytracked,thereseemstobenoreasontheopportunitycouldnotbeincludedinasyntheticportfolio.

Atthispoint,itisimportanttostressthatthesolepurposefordiscussingthesyntheticportfolioistoillustrateahypothetical,non-traditionalwealthtransferstrategybetweenprivateparties.Assuch,thereisnointentiontointroduceitasanalternativeorimprovementtotraditionalportfolioconstructionutilizingsound,directinvestmentprinciples.

The Total Return Swap

Asdiscussedearlier,aswapisacontractwheretwopartiesmakeaseriesofpaymentsbasedonaspecificnotionalamountofareferencedassetorgroupofassets.Totalreturnsonaninvestmentportfolioconsistofincome,dividends,andgrowthcomponents.Wherethepaymentresponsibilityofatleastonepartyisbasedonthetotalreturnofanunderlyinginvestment,thetransactioncanbereferredtoasatotalreturnswap(TRS).SincetheTRShassignificantdesignflexibility,theagreementcanstructurepaymentresponsibilitiesonlylimitedbythecreativityoftheparties.For

example,counterpartiesmaytradereturnsondifferentequityorcommodityindexes,onepartycantradeequityreturnsforafixedorfloatingratetiedtosomereferenceinterestrate,orpartiesmayarrangeanyotherpossiblecombinationofreferencedinvestmentreturns.

Exhibit 13. Total Return Swap

Party A

Party B

Semi-annual payments $20 Millionx

Total return on S&P 500 Index

Semi-annual payments $20 Millionx

Total return on Russell 2000 Index

$100 MillionLarge Cap

Stocks

Forexample,consideralargecapinvestmentmanager(LCM)witha$100millioninvestmentportfoliohighlycorrelatedtotheS&P500.LCMhaslimitedtonosmallcapexposureandwouldliketoreallocate20percentoftheportfoliotothisassetclass.Ratherthansell$20millionoftheportfolioandpurchasesmallcapstocksortheRussell2000smallcapindex,LCMcanenterintoa$20millionnotionalTRSwithanotherparty.LCMcouldagreetopaytherelatedS&P500returnwhilereceivingthereturnsassociatedwiththeRussell2000index,therebycost-effectivelydiversifyingwhilesimulatingan80-20portfolio.Exhibit13illustratesthisTRStransaction.Similartointerestrateswaps,theparties’paymentresponsibilitiesarenetted,resultinginasinglepaymentfromonetotheotherondatesspecifiedintheagreement.

Total Return Swap with an IDGT

RecallthatthegrantorofaproperlystructuredIDGTistreatedastheownerofalloraportionofthetrustforfederalincometaxpurposes.31Assuch,allitemsofincomeanddeductionsattributabletotheportionownedbythegrantor


arereportedandtaxedonthegrantor’sindividualincometaxreturn.Additionally,ifthesamepersonistreatedasowningpropertyforincometaxpurposesbeforeandafteratransaction,thetransactioniseffectivelydisregarded.Aspreviouslydiscussed,forintra-familytransactionsbetweenagrantorandanIDGTusingapromissorynote,theappropriatereferenceratetoavoidadversegifttaxconsequencesistheSection7872AFR.32Therefore,tobesuccessful,theassetstransferredinexchangeforthepromissorynotemustearnareturninexcessoftheSection7872hurdlerate.

Comparingalternativegiftingtechniquesandotherwealthtransfertechniquesisoftenchallengingsincethestructure,legalandtaxconsiderations,andperformanceassumptionsaredifficulttoobjectivelyreconcile.Blanketstatementsthatonetechniqueisbetterthananotherareoftendeterminedfromaninconsistentapproachtobothsidesoftheanalysis.TheTRSswapwithanIDGTatfirstblushlooksverysimilartoasaletoIDGTtransaction.Infact,economicallyitappearstobeidenticalifyouusethesameportfolioreturn,seedgift,andappropriatereferencerateassumptionsinbothtransactions.

Forexample,usingafixedreturnanalysistomaintainsomesimplicity,assumethegrantordedicates$11milliontoagiftingstrategynotsubjecttoanyvaluationdiscounts.ThegrantorinitiallyfundsanIDGTwitha$1millionseed

gift,33effectivelyusingpartoftheirlifetimegiftexemption.Inthesaletransaction,thegrantorsellstheremaining$10millionportfoliototheIDGTinexchangeforathreeyearsimpleinterestpromissorynoteatAFR,payableannuallywithaballoonprincipalpaymentattheendofthreeyears.IntheTRStransaction,thegrantoressentiallyswapstherelatedreturnsona$10millionportfoliowiththeIDGT.ThegrantoragreestopaythereturnsontheportfoliototheIDGToverthethreeyearterm.ThegrantorwillreceivetheAFRfixedrateonthe$10millionnotionalamount.Again,forsimplicity,assumethatthepaymentresponsibilitiesforthepartiesarenettedannually.Assumethatthe$11millionportfoliohasanexpectedtotalreturnof7.7percentwitha7.3percentstandarddeviation.Theshort-termAFR,applicabletotransactionsuptothreeyears,isassumedtobe0.5percent.Exhibit14comparestheresults.

NotethattheeconomicanalysisinExhibit14confirmsthatthetwotransactionsareidenticalwhenusingafixedreturnanalysis.Thatbegsthequestion,whywouldanyoneconsiderusingtheTRSasanalternativetothesale?Inaddressingthisquestion,rememberthattheprimarygoalinusingwealthengineeringwithwealthtransferistheuseofleverageorreductionofrisktoimprovetheprobabilityofachievingsuccess(successbeingmeasuredbypotentialtransfertaxsavings).TransactionssuchasGRATsandIDGTsattempttofreezethevalueofthegrantor’sestate.Allgrowth

Exhibit 14. Total Return Swap with an IDGT

Gift + Sale to Intentionally Defective Grantor Trust

Beginning IDGT Portfolio Beginning Note Note Payment Ending Note Ending IDGT Year IDGT Portfolio Return Principal Balance to Grantor Principal Balance Portfolio

2015 $11,000,000 $847,000 $10,000,000 $50,000 $10,000,000 $11,797,000

2016 $11,797,000 $908,369 $10,000,000 $50,000 $10,000,000 $12,655,369

2017 $12,655,369 $974,463 $10,000,000 $10,050,000 $0 $3,579,832

Gift + Total Return Swap with Intentionally Defective Grantor Trust

Beginning IDGT Portfolio Notional Portfolio Fixed Payment Net Payment Ending IDGT Year IDGT Portfolio Return Return to Grantor to IDGT Portfolio

2015 $1,000,000 $77,000 $770,000 $50,000 $720,000 $1,797,000

2016 $1,797,000 $138,369 $770,000 $50,000 $720,000 $2,655,369

2017 $2,655,369 $204,463 $770,000 $50,000 $720,000 $3,579,832

Results:Attheendofthreeyears,thebeneficiariesreceive$3,579,832underbothscenarios.


inexcessofthereferencedhurdlerateinurestothebenefitofthegrantor’sbeneficiariesandisremovedfromthegrantor’sestate.Ifapurportedtransactioncanaidintransferringmoreassetstobeneficiariesatthesamelevelofriskorincreasetheprobabilityofachievingsuccessintransferringthesameamountofassets,thattransactionshouldbeexploredasanalternative.

Comparison of the TRS to a Sale

Duetoitsdesignflexibility,theTRScouldoffersomeadvantages(otherthanportfolioefficiency)whencomparedtoatraditionalsaletoanIDGT.Thesemayincludetransactionefficiency,incometaxsavings,andflexibilityinunwindingthetransaction.ThedisadvantagesoftheTRSincludethelegalandtaxuncertaintyofusingtheTRSinprivatetransactions,appropriatevaluationoftheswapand,inparticular,thehurdlerateforthefixedlegtoavoidadversegifttaxconsequences.

Transaction efficiency.Unlikedirectinvestment,theTRSprovidesforimmediateparticipationinalloftheunderlyinginvestmentopportunities.Additionally,therearenotransactioncostsinacquiring,andnoadditionalcustodialcostsinholding,theinvestmentpositions.However,therewillbeatransactioncostassociatedwithdraftingtheTRSagreement.Therefore,anycostssavingsresultingfromtransactionefficiencymaynotbefinanciallysignificant.

Potential income tax savings. Althoughsyntheticderivativessimulatinginvestmentpositionsbetweenpartiescannotgenerallyavoidfederalincometax,theTRSstrategycombinedwiththeIDGTmaybetheexception.IncomeassociatedwiththedirectinvestmentportfolioownedbytheIDGTistaxabletothegrantor,butcanthegrantorgenerateincometaxinatransactionwhichisignoredforincometaxpurposes?IfasaletransactiontoanIDGTproducesnoincometaxeventandnotepaymentsbacktothegrantorareequallyignored,itisunlikelythatasimulatedinvestmentpositionbetweenthegrantorandtheIDGTwouldproducetaxableincome.Withincometaxratesprojectedtoincrease,theTRSstrategymaythereforeprovidesubstantialbenefitswhencomparedtoatraditionalsale,butthisisdifficulttopredictwithanycertainty.

Flexibility in unwind.Duetoitsdraftingflexibility,theTRScanbedesignedtoterminateonaspecificdate,potentiallyeventhedateofthegrantor’sdeath.Additionally,thepartiesmayagreetoclosethetransactionatanytimebyunwindingtheswapandcompensatingonepartyforanybuilt-inprofitintheswap.Althougheachlegoftheswapwouldneedtobevaluedtoprotectagainstanyadversegiftorestatetaxconsequences,aslongasthegrantor(orthegrantor’sestate)andtheIDGTeachpaytheappropriatefairmarketvalueconsiderationtotheothertoclosethetransaction,nogiftorestatetaxissueshouldarise.Thismaypresentslightlymorecomfortwhencomparedtoasale,sincesomeplannersarestillconcernedwiththeuncertaintaxconsequencesassociatedwiththegrantorholdingapromissorynotefromtheIDGTatdeath.

Appropriatereferencerateisthecriticalinquiry.Ifweassumethatbothtransactionsareincometaxequivalentandthatotherincidentalbenefitsarenotfinanciallysignificant,themostimportantfactorincomparingtheTRSstrategytoatraditionalsaleistheappropriatereferencehurdlerate.IftheappropriaterateforboththepromissorynoteandthefixedlegoftheswapistheSection7872AFR,theportfolioefficiencygainedfromusingthesyntheticportfoliointheTRSshouldimprovetheprobabilityforsuccess.IfitislaterdeterminedthattheAFRisnottheappropriateratefortheTRSandtheratemustbesethighertoavoidadversegifttaxconsequences,anyleverageassociatedwithusingtheTRSstrategycouldeffectivelybelost.

Comparing the TRS and Sale Using Monte Carlo

ToillustratethepotentialadvantageoftheTRS,letusmakethefollowingassumptions:

•Thesyntheticportfoliowillbemoreefficientthanaportfoliothatcanbeobtaineddirectly

•Returnsonallassetsusedinconstructingthesyntheticportfoliocanbeaccuratelytracked

•TheappropriatereferencerateusedforthefixedlegpaymentfromtheIDGTtothegrantorintheTRSisidenticaltothesale,namelytherelatedshort,mid,orlong-termAFR


•AninitialgiftseedingoftheIDGTwithasale(orswapofthenotionalamount)equaltotentimesthetrustassetsissufficienttoenterintobothtransactions34

•Transactionefficiencyandtransactioncostsarenotsignificantandwillbeignored

•AlthoughthepotentialincometaxsavingsassociatedwiththeTRScouldbesubstantial,itwillbeignoredforpurposesofthisanalysis

Forexample,expandingonthesameexampleusedpreviouslywithan$11millioninvestmentportfolio,assumethesaletoanIDGTrepresentsadirectinvestmentportfoliowithanexpectedtotalreturnof7.7percentanda7.3percentstandarddeviation.However,assumethattheTRSportfoliohaseither(a)anexpectedreturnof7.7percentwithreducedvolatility,namelya6.8percentstandarddeviation,or(b)ahigherexpected

returnof8.2percentwiththesame7.3percentvolatility.Theshort-termAFRwhichisapplicabletotransactionsupto3yearswillbeassumedat0.5percentwhiletheassumedmid-termAFR,fortransactionfrom3to9yearswillbe2.0percent.Exhibit15comparestheresultsfor3and9yeartransactionsrespectively.

ItisnotsurprisingthatthemoreefficientTRSportfolioswouldgenerallyimprovethewealthtransferprojectionsunderMonteCarlo.Inboththe3and9yearanalyses,theIDGTbalancesinTRSportfoliosproducebetterdownsideprotectionthanthedirectownershipportfoliointhesale.Additionally,theassumedhigherreturnTRSportfolioproducesbetterupsidepotentialinthe3and9yearsimulations,alsoasexpected.

Thetrueinquiry,however,isnotwhethertheTRSstrategyissuperiortoatraditionalsale,butrather

Exhibit 15. Total Return SWAP with Monte Carlo Analysis

3-Year Total Return SWAP

Scenario 1 Scenario 2 Scenario 3 Sale Interest Only Balloon TRS Lower S.D. TRS Higher Return

Beginningportfoliovalue $11,000,000 $11,000,000 $11,000,000

PortfolioTotalReturn 7.70% 7.70% 8.20%

Standarddeviation 7.30% 6.80% 7.30%

ProjectedIDGTBalancesatEndofYear3

Bottom5% $870,000 $960,000 $970,000

Average $3,200,000 $3,265,000 $3,430,000

Top5% $5,900,000 $5,900,000 $6,100,000

9-Year Total Return SWAP

Scenario 1 Scenario 2 Scenario 3 Sale Interest Only Balloon TRS Lower S.D. TRS Higher Return

Beginningportfoliovalue $11,000,000 $11,000,000 $11,000,000

PortfolioTotalReturn 7.70% 7.70% 8.20%

Standarddeviation 7.30% 6.80% 7.30%

ProjectedIDGTBalancesatEndofYear9

Bottom5% $2,570,000 $3,230,000 $3,330,000

Average $8,600,000 $8,330,000 $9,350,000

Top5% $15,800,000 $15,960,000 $17,450,000

Results:Inboththe3Yearand9Yearscenarios,theTRSproducesbetterdownsideprotectionasevidencedbythebottom5%results.Additionally,theHigherReturnTRSproducessuperiorresultsacrosstheboard.


whetheritmayemergeasanalternativeinfutureplanning.Whennewconceptsareintroduced,theyarenormallymetwithskepticism.ItishardtobelievethatthesaletoanIDGTconceptwasinitiallyintroducedasawealthtransferalternativeroughlyfifteentotwentyyearsago,butfivetotenyearspassedbeforeitwaswidelyadoptedintheplanningcommunityasaviablealternative.Infact,therearestillafewunansweredtaxquestionstodayduetothescarceauthoritysupportingIDGTtransactionsingeneral.Presently,theonlythingwecanconcludeisthattheTRSstrategyhaspotential.

Conclusion

Thestrategiesoutlinedabovearejustsomeofthewaysthatadvisorscanenhanceexistingandestablishedwealthtransferplanningstrategiesfortheirclients.Asadvisorsfromdifferentdisciplinescollaborateinthefuture,wecananticipatethatmoresophisticatedtransactionswillemerge,someofwhichmaysubstantiallyenhancethelikelihoodthataparticularwealthtransferstrategywillbesuccessful.Whileitiseasytobecomeenamoredwiththe“latestandgreatest”strategiesthatcouldhypotheticallysavesignificantamountsoftransfertax,planningmuststillbealignedwiththeclient’soverallgoalsandobjectives.Additionally,justasinvestmentadvisorscarefullyanalyzeaclient’srisktolerancepriortomakingportfoliorecommendations,wealthtransferplannersshouldcarefullyconsideraclient’s

tolerancefortransactioncomplexity.Sophisticatedplanningprovideslittlebenefitiftheclientisnotcomfortablewiththeunderlyingplan.

Moreover,whileadvisorsmaydesiretobringthebestideastotheirclients,theseideasshouldalsobecomparedandpresentedobjectively.Advisorstodayhavebettertoolstocommunicatesufficientinformationtoallowclientstomakedecisionsintheirownbestinterests.Theriskassociatedwithanytransactionshouldbethoroughlyexplainedandstrategiesshouldbecomparedusingrealworldexampleswithvaried(ratherthanfixed)investmentreturns.

Astrustedadvisorswecanneverforgetthattransferringlargeamountsofwealthisnotnecessarilytheonlyconsiderationourclientshave.Manyclientsarealsoconcernedwiththeemotionalissuesassociatedwithwealthtransferplanning,includinglossofcontrol,currentandfutureaccesstoinvestmentfunds,andtheimpactofwealthontheirfamilymembers.Properplanningcarefullytakesallofthesefactorsintoaccount.

Finally,transactionsshouldbecloselymonitoredtodeterminewhethertheyshouldbemaintained,modified,orterminated.Justasassetreturnscannotbepredictedwithanycertainty,futuretaxlawsmaybeequallyunpredictable.Theplanningthatmayhavebeenappropriateyearsagomaynotbeappropriatetoday.


Endnotes

1 Throughoutthispaper,allinstancesof“Section,”“Code,”“IRC,”“§,”

and“§§”arereferencestotheInternalRevenueCodeenactedby

CongressinTitle26oftheUnitedStatesCode(26U.S.C.)andthe

Regulationsthereunder.

2 IRC.§7520.Eachmonth,theInternalRevenueServicepublishesa

tableofinterestratesinaRevenueRuling,includingthe7520rate,

whichisusedasadiscountratetocalculatethepresentvalueofan

annuityforlifeoratermofyears.The7520rateanditsusewillbe

coveredinmoredetaillaterinthispaper.

3 IRC.§§1274(d),7872(f).TheAFRisalsopublishedmonthlyinthe

sameRevenueRulingthatcontainsthe7520rate.TheAFRandits

usewillbecoveredinmoredetaillaterinthispaper.

4 HarryM.Markowitz,PortfolioSelection,The Journal of Finance,Vol.

7,No.1,77-91(1952).

5 Foraninterestingpersonalaccountleadingtohisdevelopmentof

mean-varianceportfoliotheory,seeIdeasandInnovationacross

MultipleDisciplines:ADiscussionwithNobelLaureateHarryM.

Markowitz,The Journal of Investment Consulting,Vol.10,No.1,6,6-7

(2009).

6 SeeHarryM.Markowitz,Portfolio Selection: Efficient Diversification

of Investments,NewYork:JohnWiley&Sons(1959).

7 Theformulacalculationforvarianceofaportfoliowithtwoassets

isgenerallyrepresentedasσ2=(Wσ)2+(Wσ)2+2(Wσ)(Wσ)ρ,

whereWistheweightoftheinvestment,σisthestandarddeviation

oftheinvestment,andρisthecorrelationcoefficientbetween

thereturnsoninvestments.Standarddeviationoftheportfolio

isobtainedbytakingthesquarerootofthevariance.Thus,c2=

(.5x16)2+(.5x14)2+2(.5x16)(.5x14).2=135.4.Thesquarerootof135.4

is11.6362.

8 Seee.g.,Malkiel,BurtonG.A Random Walk Down Wall Street,W.W.

Norton&Company,Inc.(6thed.1973).

9 Source:WealthTec®(2010).

10 SomeoftheoftencitedcriticismsofgenericMonteCarlosimulation

areitsdependenceonuserinputs,potentialforusermanipulation,

andoftenanassumptionthattheprobabilityofreturnsis“normally”

distributed.

11 SeeChairman’sletterdatedFebruary21,2003,containedin2002

AnnualReporttoShareholders,BerkshireHathaway,Inc.

12 FuturescontractsareregulateddomesticallybytheCommodity

FuturesTradingCommission.

13 SeereportofPresident’sWorkingGrouponFinancialMarketson

HedgeFunds,Leverage,andtheLessonsofLong-TermCapital

Management(LTCM)(April1999).

14 Id.

15 Pub.L.No.111–203.

16 IRC§2702(b)(1).

17 Waltonv.Commissioner,115T.C.589(2000),acq.inNotice2003-72,

2003-44InternalRevenueBulletin964.

18 Assumesatwo-yearGRATwithannualannuitypaymentspaidatthe

endofeachperiod(year)andasection7520rateof1.8%.

19 Assumesaten-yearGRATwithannualannuitypaymentspaidatthe

endofeachperiod(year)andasection7520rateof1.8%.

20 SeeSeeTreas.Reg.§20-2036-1(c)(2).whichdefinetheestatetax

inclusionamountforGRATsandothertrustswithretainedincome

interestsasthelesserofthecorpusremaininginthetrustorthe

amountofcorpusrequiredtogeneratesufficientincometopaythe

annuity.

21 IRC§675(4)C).TheIRSruledinLTR2006030402thatretention

ofthepowerofsubstitutionunderSection675(4)(C)didnotcause

estateinclusion.Anothermethodthatisoftenrecommendedisthe

powertoborrowwithoutadequatesecurityorinterestperSection

675(2).

22 Karmazinv.Comm’r,U.S.TaxCourtDocket#002127-03.

23 InLTR9515039,theIRSheldthatapersonalguaranteewouldbe

sufficienttoqualifythenoteasbonafidedebt,atleastinthecontext

ofaprivateannuitysale,providedthattheguarantorhadsufficient

personalassetstomakegoodontheguarantee.

24 IRC§7872.Asstatedearlier,theIRScouldpotentiallyre-characterize

theentiresaletransactionasagiftundertherationalethatthe

promissorynotewasnotbonafidedebt.

25 Treas.Reg.§20.2031-1(b).

26 See,e.g.,EstateofJensenv.Comm’r,T.C.Memo.2010-182(August

10,2010);EstateofDunn,301F.3d339(5thCir.2002);andEstateof

JelkeIII,507F.3d1317(11thCir.2007),cert.denied(2008).

27 See,fore.g.,Holmanv.Comm’r,105AFTR2d¶2010-721aff’g130

T.C.170,combineddiscountsof22.4%,25%and16.5%forthree

differentyearsofgifts;Litchfieldv.Comm’rTCMemo2009-21,

combineddiscountsforinterestsintwoentitiesof47%and46%

each;Jelkev.Comm’rTCMemo2005-131,combineddiscount

of32%;andAstlefordv.Comm’rTCMemo2008-128,combined

discountsforinterestsintwoentitiesof35%and36%each.

28 ItisbeyondthescopeofthispapertodiscussILITsandissues

relatedtoCrummeywithdrawalpowers.Formoreinformation,

seePrice,J.R.andDonaldson,S.A.,PriceonContemporaryEstate

Planning(2009).(Chicago:CCH,Inc.,2008)ISBN978-0808092346.

29 UnderIRC§2642(f)(1),agrantorcannotallocateherGSTtax

exemptiontopropertytransferredtoatrustuntiltheendofthe

estatetaxinclusionperiod(ETIP).TheETIPistheperiodoftime

duringwhichthevalueofthepropertytransferredwouldbe

includibleinthetransferor’sgrossestate.AssetsinaGRATare

subjecttotheETIPrulebecausethepropertyisincludedinthe

grantor’sestateifthegrantordiespriortotheendoftheGRATterm.

Therefore,GSTexemptionmaynotbeallocatedtotheGRATuntil

theearlieroftheendoftheGRATtermorthegrantor’sdeath.

30 Manyforeigninvestorshavestructuredtransactionsusingtotal

returnequityswapsasamethodofsimulatingreturnsandavoiding

UnitedStateswithholdingtax.However,theHiringIncentives

toRestoreEmploymentAct,P.L.111-147,enactedIRC§871(l),

subsequentlyredesignatedasIRC§871(m)undertheEducation

JobsandMedicaidAssistanceActof2010,P.L.111-226.Thisapplies

awithholdingtaxondividend-equivalentpaymentsmadepursuant

tocertainnotionalprincipalcontracts,includingtotalreturnequity

swaps.Thewithholdingtaxiseffectiveforallpaymentsmadeunder

notionalprincipalcontractsafterMarch18,2012,unlessthecontract

doesnothavethepotentialfortaxavoidance.

31 IRC§§671-77andRev.Rul.85-13,1985-1CB184.

32 See,e.g.,Frazeev.Comr.,98T.C.554(1992).

33 Asmentionedearlier,thereisscarceguidanceontheappropriate

amountofrequiredseedcapitalizationtofacilitateasaletoIDGT

transaction.Whilemanypractitionersadvocatea9:1debttoequity

ratio,forpurposesofthisexample,wewillassumethataseedgift

andasubsequentsaleoftentimesthetrust’sexistingcapitalwill

satisfytherequiredcapitalizationrequirement.

34 Id.

Disclosures

AbbotDowning,aWellsFargobusiness,providesproductsandservicesthroughWellsFargoBank,N.A.,anditsvariousaffiliatesandsubsidiaries.

InsuranceproductsareavailablethroughinsurancesubsidiariesofWellsFargo&Companyandunderwrittenbynon-affiliatedinsurance

companies.Notavailableinallstates.(CaliforniaInsuranceLicense#26-0070024).

Assetallocationanddiversificationdonotassureorguaranteebetterperformanceandcannoteliminatetheriskofinvestmentlosses.

Becauseoftheshort-termnatureofoptions,itislikelythattheinvestorwilltradethemmorefrequentlythanstocksorbonds,andthateachtime

anoption-relatedtradeiseffected,theinvestorwillbechargedacommission.Commissionsonoptiontransactionsgenerallyamounttoahigher

percentageoftheprincipalthancommissionsfornormalstocktrades.Additionally,investorsshouldnotbuyoptionsunlesstheyarepreparedto

losethetotalamountofpremiumsandcommissionspaid.Investorsshouldnotsellcoveredcalloptionsunlesstheyarepreparedtodeliverthe

relatedsecuritiesatthestrikepriceuponexerciseoftheoption.

Thisinformationisprovidedforeducationandillustrationpurposesonly.Theinformationandopinionsinthisreportwerepreparedby

AbbotDowning.Informationandopinionshavebeenobtainedorderivedfrominformationweconsiderreliable,butwecannotguaranteetheir

accuracyorcompleteness.OpinionsrepresentAbbotDowning’sopinionasofthedateofthisreportandareforgeneralinformationpurposes

only.AbbotDowningdoesnotundertaketoadviseyouofanychangeinitsopinionsortheinformationcontainedinthisreport.WellsFargo&

Companyaffiliatesmayissuereportsorhaveopinionsthatareinconsistentwith,andreachdifferentconclusionsfrom,thisreport.

Thisreportisnotanoffertobuyorsell,orasolicitationofanoffertobuyorsellthestrategiesmentioned.Thestrategiesdiscussedor

recommendedinthepresentationmaybeunsuitableforsomeclientsdependingontheirspecificobjectivesandfinancialposition.

WellsFargo&Companyanditsaffiliatesdonotprovidelegaladvice.Pleaseconsultyourlegaladvisorstodeterminehowthisinformationmay

applytoyourownsituation.Whetheranyplannedtaxresultisrealizedbyyoudependsonthespecificfactsofyourownsituationatthetimeyour

taxesareprepared.

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