This article considers the limits that should be considered in using various types of tax-mitigation strategies. A recent major court case has jolted the industry. Another question is how should wealth holders avoid the error of passing so much to their heirs that they end up running short of funds? As lifespans rise, calculations must be readjusted accordingly.

The topic of reducing potential tax bills has acquired an extra edge this fall. A form of trust, grantor-retained annuity trust (GRAT), has drawn attention in a $736 million court case involving a wealthy couple and the Internal Revenue Service. 

Separately, there may be signs that eagerness to mitigate gift and estate taxes by passing wealth to descendants when the owner is still healthy and active has led to “buyer’s remorse.” One lawyer and advisor to UHNW families told this publication that there are cases of clients who have given away too much money, are now short of cash, and wonder what to do next. Some people are trying to reverse course. That costs money. 

As can often happen, a big court case has grabbed attention, illuminating the world of trusts and other structures that aren’t widely understood outside the ranks of HNW and UHNW advisors. This also comes at a time when the air is thick with talk of multi-trillion-dollar wealth transfer, and political noises about wealth taxes. With the mid-term elections taking place this week and politics on the agenda, such topics are at the forefront. This publication has carried a number of commentaries about tax and estate planning approaches, see examples here, here and here. 

A move to recast previous plans may already be under way. The IRS recently complained about how an heiress, Trisha Elcan, and her husband Chuck, used a GRAT to mitigate tax in a way that tests the boundaries of what is acceptable. The couple have taken the case to court, disputing the IRS’s claims. The moves are linked to GRATs that used shares of HCA Healthcare, an operator of hospitals that Trisha’s father and grandfather helped co-found in 1968.

The IRS is pursuing the Elcans for a $736 million tax bill.

GRATs are established for a period from usually two to 10 years, holding assets in the expectation they will rise in value. If assets rise faster than a special federal interest rate in the month the GRAT is established, gains escape transfer taxes. The grantor sets annuity payments to get back amounts that mirror the original contribution, plus interest at the special federal rate, to avoid gift taxes on the contribution. 

The case might scare off some advisors and clients from GRATs, but a dive into the details suggests that is unwarranted, advisors have said.

In the Elcan vs Commissioner case, the IRS isn’t challenging the structure or design of a GRAT, Kristin Yokomoto (pictured below), partner at FBT Gibbons, told FWR. Instead, the IRS is challenging an “administration” aspect of a completed GRAT where the grantor uses a “substitution powers” to reacquire partnership interests and S corporation stock from the GRATs in exchange for promissory notes, and the GRATs later distributed some of those notes back to the grantor in satisfaction of required annuity payments, she said. 

Kristin Yomomoto

The IRS issued notices asserting more than $736 million in total deficiencies and penalties, and its primary position was that the initial GRAT transfers were taxable gifts in their entirety because the retained annuity interests were not “qualified interests” under Section 2702 of the tax code, she continued. Alternatively, the IRS asserted that if the annuity interests were qualified interests, the grantor’s note substitution transactions themselves generated taxable gifts. 

“As such, the impact of the case is not about GRATs, nothing changes about the purpose of a GRAT or using a GRAT as a planning technique for high net worth clients,” Yokomoto said.

The legal case is more about the use of “administration practices” and specifically, the use of the “substitution power” in a GRAT to swap assets for the grantor’s promissory notes and then using the notes to satisfy the required annuity payments, she continued. “Most attorneys would not have recommended a client to do that.”

Another expert on the issue, Jim Thomson (pictured below), partner at law firm Lathrop GPM, agreed that GRATs aren’t the problem per se, but the way they can be used is where matters get difficult.

Jim Thomson

“In Elcan, the grantor purchased assets from the GRATs in exchange for her own promissory notes, and the trustee then turned around and paid the annuities due to the grantor by forgiving portions of those notes. According to the IRS, this was an impermissible attempt to 'end run’ Treasury regulations that prohibit a GRAT from issuing debt, either directly or indirectly, to satisfy annuity obligations," Thomson told this publication.

“Go-to strategy”
“GRATs have become a go-to strategy in these circumstances because they allow future appreciation to pass to the next generation with little or no gift tax cost, while the grantor retains a fixed annuity stream,” Thomson said. “They are particularly attractive when an individual expects substantial upside in a single stock but is reluctant to sell because of business, market, or tax considerations. 

“In practice, many taxpayers use a series of short-term GRATs, often two years in duration, and `roll’ the annuity payments from one GRAT into a new GRAT as each term ends. If the trust assets outperform the IRS’s hurdle rate (commonly known as the `Section 7520 rate’), the excess appreciation can pass to descendants without being subject to gift tax. The strategy is designed to repeatedly capture periods of outperformance while minimizing the impact of any single GRAT that underperforms. If a GRAT `fails,’ the grantor can simply contribute the annuity payments io another GRAT and try again,” he said. 

Risks
Thomson addressed risks with GRATs.

"One reason GRATs are so popular is that, so long as the grantor survives the trust term, there’s generally very little downside to creating one. In the typical case, the worst outcome is that the GRAT assets fail to outperform the Section 7520 rate, causing little or no value to pass to the remainder beneficiaries," he said. "Aside from the cost of establishing and administering the GRAT, the grantor is generally no worse off than before the strategy was implemented."

"The bigger risk is mortality. If the grantor dies before the GRAT term ends, some or all of the GRAT assets may be included in the grantor's taxable estate, potentially eliminating the transfer-tax benefit the strategy was designed to achieve. That risk is one reason practitioners often favor shorter GRAT terms, which reduce the likelihood that the grantor will die during the trust term," he said. 

The GRAT case has raised questions as to whether legislative proposals to rein in GRATs could resurface, and what that would mean for existing estate plans.

"Past proposals to rein in GRATs have primarily come from Democratic politicians, so it’s hard to imagine significant GRAT restrictions gaining traction in a period of divided government," Thomson said. 

"Some of the most recent proposals advanced during the Biden administration would not have eliminated GRATs, but they would have significantly reduced their effectiveness, for instance by requiring a minimum 10-year term (which would eliminate the two-year 'rolling GRAT' strategy) and requiring a meaningful taxable remainder interest, which would significantly increase the gift tax cost to the grantor.

"Were these proposals to reappear, GRATs would lose a significant portion of their luster as an efficient strategy for transferring appreciation from highly volatile assets, including concentrated stock positions," he said.

Curb the aggression
One takeaway, advisors said, is that the Elcan tussle should encourage more clear definition between acceptable “aggressive” GRAT administration and conduct that risks exposing the entire amount transferred to the GRAT to gift tax.

“For now, the key takeaway from Elcan has been to steer well clear of the technique the IRS has chosen to attack. If it is necessary or advisable to swap assets with a GRAT, practitioners are more likely to look first to cash or marketable securities or, if those are unavailable, to third-party financing to provide liquidity for the transaction. At least until the case is resolved, many advisors view the use of the grantor's personal promissory note as an unnecessary risk,” Yokomoto said. 

The topic of how “aggressive” methods to mitigate tax can cause tax collectors to object was raised by family business advisor and Legacy Traps author Alejandro Cárdenas Villa (pictured below).

Alejandro Cárdenas Villa

“The more aggressive someone is with tax planning, the closer they are to tax evasion,” Cárdenas Villa told this publication. 

There are tensions in play that must be balanced and understood, he continued. 

“On one hand, people need to decide how much risk they want to take with a very efficient tax position/strategy which could be questioned by the tax authority; and another idea is how people affect their life (their day-to-day) simply to avoid taxes, which is a contradiction. Wealth, which is supposed to generate wellbeing, ends up becoming a prison (i.e. individuals can become slaves of their wealth),” he said. 

Cárdenas Villa gave one case of a person he knows who moves around the world and is not in the same place for more than six months at a time. This person is in the early 80s and has been living in this way for more than two decades.

With tax mitigation strategies, it is important for parents to consider whether their arrangements become an onerous burden for children. 

“When founders or the older generation have reached a certain age, tax strategies should be shared and agreed with the next generation because it is they who will have to answer to the tax authority. Some heirs might prefer to pay more taxes but sleep well at night,” he said. 

Cárdenas Villa reflected on the behavioral aspects that drive tax strategies. 

“One issue is the dislike of losing money being more painful than the pleasure of making it – what behavioral scientists call `loss aversion’,” he said. 

Among some founders, their view is that they have sacrificed so much to build a business that paying taxes is losing money, he added.

Giving too much away?
One lawyer told FWR that there’s a trend of families where the elders regret giving away as much as they did. Hindsight, of course, is easy. 

An option is what are called Spousal Lifetime Access Trusts, or SLATs. They allow one spouse to transfer assets to an irrevocable trust, removing those assets from the estate while still providing indirect access through distributions to the other spouse. This strategy can preserve lifestyle flexibility while reducing estate tax exposure.

The need for flexibility also fits with the “decanting” point made in a recent article about how, if the trust deeds are drafted correctly, the trusts can be kept up to date in ways that reduce rather increase potential for family arguments. 

A conclusion from these issues is that tax mitigation, when handled within certain rules, is worthwhile for families of considerable wealth, but it is wise not to let concerns about tax dominate to the exclusion of everything else.