Why SPAC Sponsors and Investors Should Consider a GRAT Now
originally published on April 28, 2021 and updated on July 28, 2021
The stars have aligned for the transfer of wealth to next generation family members, but they won’t stay that way indefinitely. For individuals who have utilized most of their estate tax exclusion amount ($11.7 million in 2021) and desire to make additional gifts, grantor retained annuity trusts (“GRATs”) have been a favored strategy in the low interest rate environment, which is just beginning to reverse course, slowly. At the same time, publicly traded special purpose acquisition companies (“SPACs”) have attracted the attention of investors and privately held business owners alike – four times as many SPACs were raised in 2020 than in 2019. The SPAC frenzy may be cooling, but if you are a SPAC sponsor or investor or a potential SPAC merger company owner, now is the time to evaluate a GRAT for gifting.
- The concept. With a GRAT, the settlor of the trust contributes assets expected to appreciate in value to a trust for a term of years and receives annuity payments from the trust for the term. At the end of the term, assuming the settlor survives, the remainder of the trust estate passes to the beneficiaries (typically children). The gift for gift tax purposes is the value of the remainder determined at the inception of the trust, calculated using the IRS determined discount/interest rate. In what is commonly referred to as a “zeroed-out GRAT,” the initial value of the remainder interest is reduced to close to zero.
- Interest rate sensitive. While interest rates are rising from recent rock bottom lows, they are still relatively low (1.2% for August 2021). The lower the interest rate for valuing a remainder interest in a GRAT (known as the Section 7520 rate), the greater the likelihood the trust will “outperform” and additional value will be transferred to the beneficiaries at the end of the GRAT term.
- Performance enhanced. The other success factor for a GRAT is the actual investment performance of the assets in the GRAT during its term. The private company owner thinking forward well in advance of a SPAC merger opportunity and SPAC sponsors or early SPAC investors anticipating material appreciation of their SPAC investment have an opportunity to optimize their family gifting with the GRAT of assets that appreciate. Of course, as the markets from February 2020, down to March 2020, up to their current levels have reminded us all, there are ups, downs, and recoveries. With a GRAT that minimizes the taxable gift, the gift planning downside of a “failed GRAT” that underperforms the discount rate is minimal. The annuity pays out to the settlor and the remainder is exhausted so there is no enhanced gift to the beneficiaries.
Consider, for example, a $1 million contribution to a 4-year GRAT with optimized annuity payments to reduce the gift to zero, assuming a 12% return, at the May 2021 1.2% 7520 rate, compared to a similar GRAT at a 2.2% 7520 rate (the rate in effect as recently as August 2019).
The Section 7520 interest rate just 1% lower increases the benefit of the remainder by 10% under these assumptions. Of course, the outcomes vary depending on the term chosen for the GRAT and the performance of the investments in the GRAT.
For those desiring to primarily benefit grandchildren and more remote descendants, rather than children, the GRAT may be combined with a sale for the remainder interest to a generation-skipping trust for additional long-term family benefit. The logistics of planning a SPAC sponsorship or investment with a GRAT require consideration of lock-up periods and investor qualifications. These conditions and requirements may commonly be addressed with selection of the term of the GRAT, look-through to the settlor, and trustee selection.
A couple closing thoughts of caution and motivation: First, interest rates are on an upward trajectory. Second, the tax rules related to GRATs could become less favorable under tax legislation on the horizon. Thus, now is an ideal time to evaluate a GRAT strategy with a SPAC or similar investment.