businesses, real estate and collectibles are. The valuation and discounting of these assets invites an audit from the IRS, which can argue either with the valuation or with the discount. One of the ways to avoid incurring a gift tax on an audit is to use something called a“ defined value clause”— language that locks in the value of the gift at a certain dollar amount rather than an identified portion of the assets. Such language can help families reduce their risk of incurring a gift tax because of an audit and help grandchildren meet their exemption requirements when applying generation-skipping transfer taxes. While the IRS might challenge some of this language, some U. S. Tax Court decisions have defended the move.
GRATs: Estate Freeze Meets Market Recovery
One of the vehicles uniquely suited for assets hurt by down markets( but expected to rapidly appreciate in a future recovery) is the grantor-retained annuity trust. Structured properly, a GRAT can transfer all the appreciation of what it pays out to heirs without being burdened by gift taxes, as long as the growth is paid out at a certain interest rate( set by Internal Revenue Code Section 7520). For example, the May 2025 Section 7520 rate is 5 %. If the stock on a startup company has fallen by 50 %— but is expected to recover fully in two years— if you transfer stock currently worth $ 1 million to a GRAT with a term of two years, and with an annuity rate that returns the $ 1 million of stock plus 5 %, then there is no tax due on the funding of the GRAT.
This is because the GRAT funder can take advantage of low valuations to“ zero out” the taxable gift— in other words, make annuity payments equal to or greater than the amount of assets given to the trust. And if the assets appreciate— particularly family LLC interests or collectibles that are expected to recover— then any excess will flow to heirs outside the estate. If values don’ t recover, the GRAT simply returns the property to the grantor, creating a no-harm, no-tax scenario.( See the sidebar.)
One strategy has been to devise shorter-term“ rolling GRATs,” in which one short-term trust vehicle rolls into another, to make them more effective and make it more likely that the funder will survive the length of the trust. But these strategies have been the target of tax reform proposals by Senators Bernie Sanders and Elizabeth Warren, which means a GRAT with a term of 10 years or longer may be safest.
Tax-Free Freeze And Flexibility
Another strategy has been to put assets into intentionally defective grantor trusts, which let a grantor freeze an estate’ s value by exchanging appreciating assets for promissory notes. The grantor pays no capital gains tax on the sale and all future appreciation escapes estate taxation.
Unlike a GRAT, a trust of this sort allows allocation of a generation-skipping tax exemption up front, which aids dynasty trust planning. It also allows more flexibility in
How The GRAT Works
1. Say Acme Co.’ s stock value falls 50 % in a market crash.
2. Your client previously bought 10,000 shares of Acme stock for $ 2 million, which, after the decline, has a value of $ 1 million.
3. Your client puts the 10,000 shares, now worth $ 1 million, into a two-year GRAT. It pays $ 537,807.89 each year( 53.78 % of the $ 1 million— which is the annuity required to zero out the gift of the future remainder of the trust).
4. Since the value of the annuity equals the value of the stock, the gift value of the remainder of the trust going to the children at the end of year two is zero.
5. Acme stock then recovers all its value over the next two years( we assume that means 50 % growth in each year).
6. At the end of year one, the 10,000 shares of stock are now worth $ 1,500,000( the original value plus the growth), or $ 150 per share. note structure. This kind of structure also uses minimum interest rates, known as“ applicable federal rates,” which are often lower than the 7520 rate, so the“ hurdle” to success is smaller than it is with a GRAT.
For senior clients in uncertain health, self-canceling installment notes and private annuities offer ways to shift value without using exemptions. Self-canceling notes are promissory notes in which a seller transfers assets to a buyer in return for a promissory note which, by its terms, is canceled at the death of the seller. To compensate the seller for the risk that they may die before the end of the term of the note, the interest rate is increased. If the seller does die during the term of the note, the canceled balance due on the note is not included in the seller’ s estate.( The IRS requires actuarial adjustments to avoid classification as a partial gift.) The estate may recognize income on the payment of interest on the note, but total taxes are
7. The client then receives a distribution of 3,585 shares of Acme, worth $ 537,807.89 from the GRAT, leaving 6,415 shares of Acme stock in the trust worth $ 962,192.11 in the GRAT.
8. Acme stock in the GRAT grows 50 % again, by $ 481,096.06, in year two, so at the end of year two the 6,415 shares of Acme stock in the trust are worth $ 1,443,288.17( the year end value of $ 962,192.11 plus the growth in the trust of $ 481,096.06) or $ 225 per share.
9. The client then receives the second required distribution of 2,390 shares of Acme stock worth $ 537,807.89, leaving 4,025 shares of Acme stock, worth $ 905,480.89, as the remainder going to the children gift tax free.
10. The result is, at the end of year two, the client has 5,975 shares of Acme at $ 225 a share worth $ 1,344,375 and the children have 4,025 shares of Acme at $ 225 a share worth $ 905,625.
54 | FINANCIAL ADVISOR MAGAZINE | MAY 2025 WWW. FA-MAG. COM