Although it might seem that your clients have little in common with the inside executives at Twitter, the company's initial public offering (IPO) documents would indicate otherwise.
The Twitter executives developed a plan to reduce their eventual gift and estate taxes in advance of their IPO, which could, of course, cause the value of the company to skyrocket.
(Indeed, the shares were trading around $43 Friday morning after the offering was priced Wednesday evening at $26 a share. But how the company performs in the longer term remains to be seen – Ed.)
A closer look at the planning strategies employed by Twitter shows that your client does not have to be sitting on the next hot silicon valley IPO to benefit from their use. Even if your client does not own pre-IPO shares, the freeze and discounting strategies used can save them from a hefty tax bill.
Twitter's Trust Strategy
Twitter's IPO documents indicate that both its chairman and largest shareholder have transferred substantial amounts of their stock holdings into what the documents call "annuity trusts," which are believed to be grantor retained annuity trusts (GRATs). Further, the company's chief executive and his spouse transferred shares into an irrevocable gift trust.
The rationale behind these trust strategies is simple — the executives anticipated the value of their pre-IPO shares to grow substantially and logically wish to shelter this appreciation from taxes to the greatest extent possible.
The strategy works — and can work equally well for your clients — because it freezes the value of the shares at their pre-IPO prices for transfer tax purposes.
Mechanics of the Trusts
A GRAT essentially combines a trust that is established for a certain predetermined period of time with an annuity that pays the trust creator (the grantor) a set value each year of the trust's existence. This annuity payout is the grantor's retained interest. The remaining value passes to the grantor's beneficiaries, and, thus, out of the grantor's estate.
The value of the taxable gift to the GRAT beneficiaries is equal to the fair market value of the property transferred into the GRAT minus the grantor's retained interest. The grantor's retained interest is the actuarially calculated value of the annuity stream he will retain over the GRAT's life based on the Section 7520 rate in effect for the month in which the GRAT is created. In a low interest rate environment, the GRAT strategy can substantially reduce the value of the taxable gift, resulting in lower transfer taxes generally.
The primary downside of the GRAT strategy is that the grantor must outlive the trust term for it to work. In the case of the Twitter executives, who are all under 50 years old, the odds are good that the strategy will succeed.
