Estate Planning Council of Greater Miami The Bankers

Estate Planning Council of Greater Miami The Bankers Club of Miami, One Biscayne Tower, 2 South Biscayne Blvd. , 14 th Floor, Miami, Florida “ 6 CREATIVE GRAT STRATEGIES!” April 18, 2013 Mark R. Parthemer, Esq. AEP Bessemer Trust Managing Director Senior Fiduciary Counsel, Southeast Region Head Palm Beach, FL (561) 655 -4030 parthemer@bessemer. com Copyright © 2013 by Bessemer Trust Company, N. A. All rights reserved.

Thoughts on Tax Law “The only difference between death and taxes is that death doesn't get worse every time Congress meets. ” - Will Rogers “I like to pay taxes. It is purchasing civilization. ” - Oliver Wendell Holmes “I am proud to be paying taxes in the United States. The only thing is I could be just as proud for half of the money. ” - Arthur Godfrey “The way taxes are, you might as well marry for love. ” - Joe E. Lewis “There’s nothing wrong with the younger generation that becoming taxpayers won’t cure. ” - Dan Bennett 2

Administration’s Budget Released April 10, 2013. Include: 1. Exemptions and rates to 2009 system. . . $3. 5 M and 45%. 2. Cap on short-term GRATs plus cap of length at life expectancy + 10 years; no declining annuities. 3. 90 duration of GST exemption. 4. Eliminate HEET trusts by only permitting GST exemption for payment of health and education expenses from individuals. 5. Grantor trust redux. Here again for the second time, but narrowed to focus on installment sales to grantor trust. 6. Basis consistency. 3

Nearly zeroed-out Grantor Retained Annuity Trust Step 1 Initial GRAT Funding Returned to Grantor $2, 062, 049 $2, 000 Step 2 Annuity*** Year 1: $937, 295 Year 2: $1, 124, 754 Amount transferred $2, 000 Value of annuity $1, 999 * Value of remainder (Gift) $1 * Assumes § 7520 rate of 2. 00 %. ** Assumes trust assets grow at 8%. *** Assumes 20% increase in annuity annually. Step 3 Remainder after 2 years: $197, 798 (no gift tax) (Grantor) Trust for Children $197, 798

Three Keys to Advanced GRAT Planning • Fundamental Determination: Optimal Term • Probability Analytics: Annuity • Free flip of the transfer coin: “Heads I Win; Tails I Get My Money Back” – Freeze technique, but – Advisors should “Wait” on GRATs…like a table server at a busy fine dining establishment! 5

Understanding GRATs as a Freeze Technique “Hypothetical” One-year 4% GRAT with 3% Return* All value returns to grantor 4% 3% Return to Grantor** * The hypothetical examples included in this presentation are for illustration only and are not projections of future returns, tax rates or exemption amounts. ** The hypothetical examples included in this presentation assume an Internal Revenue Code § 7520 rate of 4. 0%.

Often, Focus Is Only on Return “Hypothetical” One-year 4%* GRAT with 10% Return** 10% 6% Transfer To Next Generation 4% Return To Grantor 4% * The hypothetical examples included in this presentation are for illustration only and are not projections of future returns, tax rates or exemption amounts. ** The hypothetical examples included in this presentation assume an Internal Revenue Code § 7520 rate of 4. 0%.

Portfolio GRAT: Flat versus Increasing Annuity — Impact of Path Dependency Three sample growth patterns of $1, 000 investments $1, 610, 000 8

Path Dependency: Increasing Annuity Creates Benefit 5 year GRAT Results 9

1. Leveraged Mixed Asset GRATs • Fund GRAT with discounted asset, hard-to-value asset or alternative assets. Add fixed income portfolio. • Use fixed income to fund annuity first. • Gives time for other assets to percolate. • Creates arbitrage between annuity based on partial discount yet paid in non-discounted assets. • To ease timing on funding and ease on transfer throughout, drop hard-to-transfer assets (e. g. , private equity) into an LLC. 10

Leveraged Mixed Asset GRAT Step 1 Create Family Entity and Trust Assets With Growth Potential LLC Units Fixed Income Step 2 • Contribute LLC units and fixed income into GRAT. • GRAT trustee first uses fixed income to satisfy annuity payments. Annuity Payments GRAT • GRAT Remainder into Grantor Trust. 11

5 Year GRAT with 50% Private Equity and 50% Fixed Income April 2013 7520 Rate 1. 40% Fixed Income/Yield $ 1, 000 3. 00% Private Equity/Growth $ 1, 000* 20. 00% $ 2, 000 $ 1, 800, 000 $ 1, 600, 000 $ 1, 400, 000 * For illustrations purposes, assumes no valuation discount. Private Equity* $ 1, 200, 000 $ 1, 000 $ 800, 000 $ 600, 000 Fixed Income $ 400, 000 $ 200, 000 $Initial 1 2 3 4 5 12

Bonus: Leveraged Mixed Asset GRAT with Loan from GST Exempt Trust Step 1 Create Family Entity and Trust Assets With Growth Potential LLC Units Fixed Income Step 2 • Contribute LLC units and fixed income into GRAT. • GRAT trustee first uses fixed income to satisfy annuity payments. Loan Annuity Payments GRAT GST Exempt Trust • GRAT Remainder into Grantor Trust. • Grantor Trust repays loan with LLC units. 13

2. Portfolio GRATs: Separate GRATs for Correlated or Concentrated Positions Diversification: • Prudent (Imperative) under Modern Portfolio Theory, but • Anathema to a Portfolio GRAT! 14

Portfolio GRAT: Asset Selection Not Enough Return Ending Value 1, 000 @ $50 Company A +20% $60 $6, 000 1, 000 @ $50 Company B -20% $4, 000 $40 $10, 000 Minimum annuity to grantor* $10, 140, 000 Amount transferred to next generation – 0 – * Assumes a 1. 4% § 7520 rate and for illustration and emphasis purposes only, a fictitious one year GRAT term. 15

Split Uncorrelated Assets into Separate GRATs GRAT 1: Company A +20% $60 $6, 000 Minimum annuity to grantor* $5, 070, 000 Amount transferred $930, 000 GRAT 2: Company B -20% $40 $4, 000 Minimum annuity to grantor* Amount transferred Total Transferred $5, 070, 000 – 0 – $930, 000 * Assumes a 1. 4% § 7520 rate and for illustration and emphasis purposes only, a fictitious one year GRAT term. 16

3. Portfolio GRATs: Use Substitution Power to Manage Performance Resulting Raw Volatility Creates Likelihood of Greater Swings Focus on Swings; Not Just Return over Term Tactically Deploy Substitution Power to: • Lock-in Winners • Re-GRAT Losers 17

Portfolio GRAT: Active Management via Substitution Power Capture intermediate appreciation Swap Zone! Expected Volatility 8% Time Maturity 18

Portfolio GRAT: Active Management via Substitution Power Expected Volatility Why waste reversion to mean? 8% Swap Zone! Time Maturity 19

Case Study: $2, 500, 000 Portfolio GRAT #1 - $380, 000 GRAT #2 – Failed GRAT #3 - $610, 000 Total - $980, 000 If still original GRAT - Failed 20

4. “Shelf” GRATs Four Risks to a Rolling GRAT Program: 1. Donor dies. 2. Assets decline in value. 3. 7520 rises dramatically. 4. Law change prohibits new short term GRATs. Shelf GRATS can mitigate risks #3 and 4. 21

4. “Shelf” GRATs Step One: Create inventory of mid through longer GRATs. Step Two: Fund currently with low volatile assets. Step Three: Set on “Shelf” (but pay annuities). Step Four (when needed): Swap in volatile assets to activate. • Article April/May edition of Probate & Property. 22

Impact of Minimum 10 Year Term 7520 Rate 1. 40% Annuity Growth 20% 10 9 8 7 6 5 4 3 2 1 4. 24% 5. 24% 6. 53% 8. 26% 10. 65% 14. 08% 19. 35% 28. 29% 46. 44% 2 5. 09% 6. 28% 7. 84% 9. 92% 12. 78% 16. 89% 23. 22% 33. 95% 55. 73% 3 6. 10% 7. 54% 9. 41% 11. 90% 15. 33% 20. 27% 27. 86% 40. 74% 4 7. 32% 9. 05% 11. 29% 14. 28% 18. 40% 24. 33% 33. 43% 5 8. 79% 10. 86% 13. 55% 17. 13% 22. 08% 29. 19% 6 10. 55% 13. 03% 16. 26% 20. 56% 26. 49% 7 12. 66% 15. 63% 19. 51% 24. 67% 8 15. 19% 18. 76% 23. 41% 9 18. 23% 22. 51% 10 21. 87% First 5 years: 31. 54% 23

Why Prohibit “Front-Loading” of Annuity 7520 Rate 1. 40% Annuity Growth -50% 10 9 8 7 6 5 4 3 2 1 51. 44% 51. 49% 51. 58% 51. 77% 52. 15% 52. 94% 54. 63% 58. 40% 67. 91% 2 25. 72% 25. 74% 25. 79% 25. 88% 26. 07% 26. 47% 27. 31% 29. 20% 33. 96% 3 12. 86% 12. 87% 12. 90% 12. 94% 13. 04% 13. 24% 13. 66% 14. 60% 4 6. 43% 6. 44% 6. 45% 6. 47% 6. 52% 6. 62% 6. 83% 5 3. 22% 3. 24% 3. 26% 3. 31% 6 1. 61% 1. 62% 1. 63% 7 0. 80% 0. 81% 8 0. 40% 9 0. 20% 10 0. 10% First 3 years: 90. 02% 24

5. Leveraged GRAT Combined with Sale Transaction. Concept: Client with investment FLP sells and contributes LP units and other assets (e. g. , fixed income) to an LLC; (Discounted) Sale price paid with a Note; Note contributed into a GRAT. • Leveraged GRAT (Strategy #1) effective, plus may serve as revaluation buffer. • Extraordinary leverage if Note interest can fully fund GRAT annuity payments. • Consider SCIN. 25

Leveraged GRAT with Sale Assets With Growth Potential Step 1 FLP LP Units Create Investment FLP. Step 2 Step 3 Fund GRAT with Note. • Client contributes and sells LP units plus other assets to LLC. • LLC pays with a Note. • Could be a SCIN. LLC GRAT annuity funded with Note interest. GRAT • GRAT Remainder into Grantor Trust. 26

6. Derivatives with GRATs Some contribute derivatives into GRATs. There also is an ability to have the GRAT use them. All entail friction costs and must be justified by whatever enhancement may result to the probability of transferring more value (or cap ultimate transfer). 27

One of Two Counter-party Options Public versus Private hedge transactions may minimize costs. Use of grantor’s spouse may avoid reciprocal trust issues and income taxation: • Sales between spouses tax free under section 1041. • Sales between grantor trust and grantor’s spouse tax free. PLR 8644012; PLR 20012007. 28

Derivative Example #1: Sell an Out-of-the- Money Option. Grantor’s spouse (or other party) purchases from the GRAT an out-of-the-money - call option with a strike price that is higher than the market price. Option priced via Black-Scholes or other binomial model. Rev. Proc. 98 -34. Example: Assume that for a $10 Stock, a $12. 50 option sells for $3. 29. Result: 1. Success: Stock rises above $12. 50, remainder beneficiaries receive benefit of 25% return ($12. 50/share) plus 32. 9% option return ($3. 29/share), less § 7520. Balance of upside reverts to grantor’s spouse. 2. Success: Stock does not exceed $12. 50, remainder beneficiaries receive actual growth plus option return of $3. 29, less § 7520. 3. Success: Stock remains at $10, GRAT has $13. 29/share and remainder beneficiaries receive $3. 29, less § 7520. 4. Success or Failure: Stock drops below $10, remainder beneficiaries receive excess, if any, of reduced value plus $3. 29, less $10 and less § 7520. (If 7520 were 0%, stock could drop to $6. 72 and GRAT still would be (barely) successfully. ) 29

Derivative Example #2: Purchase an At-the-Money Option. GRAT purchases at-the-money call option (option's strike price is identical to the price of the underlying security). This provides GRAT right to future growth, if any. Example: GRAT owns 100 shares trading at $100 per share. Trust purchases option on 100 shares at $100. Result: Success: Remainder beneficiaries receive double on growth, if any, less cost of option and less § 7520. Failure: GRAT will fail if stock price goes down, remains flat or is up negligible amount (not enough to offset cost of option plus § 7520). 30

Derivative Example #3: Covered-call Combination. Potential to double gain on modest growth stocks, with little to zero net cash cost. Achieved by giving up excess growth. GRAT: • • Purchases an at-the-money option, and Sells an out-of-the-money call option. Use strike price or limit number of shares so net no cost to GRAT. Example: GRAT owns 100 shares trading at $100 per share. Trust purchases option on 100 shares at $100 (same as Example #2). Further, GRAT sells option on 200 shares at $120 per share. Result: Success: Assuming cost of options net to zero, remainder beneficiaries receive double on growth from $100 to $120, but nothing on growth above $120, less § 7520. Failure: GRAT will fail if stock price goes down, remains flat or growth on 200 shares is less than § 7520. 31

Simplified GRAT Payoff Chart (7520 @ 0%) Share Price Lower GRAT Succeeds Funding Value GRAT Fails Share Price Higher Stock Price 32

Impact of selling a “Covered Call” Strategy Share Price Lower Receive Premium for Agreeing to cap return Share Price Higher Stock Price 33

Payoff Chart of GRAT with “Covered Call” Return is capped Share Price Lower Share Price Higher Stock Price 34

One More Thought on Tax Law “Why does a slight tax increase cost you two hundred dollars and a substantial tax cut save you thirty cents? ” - Peg Bracken 35

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