Creative Use of Stock Options Within a Grantor Retained Annuity Trust (GRAT)

This article summarizes a stock option strategy within a Grantor Retained Annuity Trust (GRAT). While the contents of this article were originally prepared in May 2004 when the §7520 hurdle rate that is necessary for the GRAT to be successful was 3.8% (6.0% in June 2006), nonetheless, the strategy of using options within GRATs is still a relevant and viable tool in today’s financial and estate planning universes.

Please note that I have made at least four (4) assumptions/stipulations in this article:

  1. that the option spread is never unwound;
  2. that the strategy is done only once during the GRAT’s term;
  3. that whenever I say that the price of the stock has increased, I am usually contemplating that price immediately before the spread expires; and
  4. I do not consider the possibility that the price of the underlying stock decreases (because the spread discussed below is costless, a decrease in the stock price is largely irrelevant when deciding whether to use a spread inside of a GRAT).

Suppose that you transferred 100 shares of Microsoft (closing price on May 21, 2004 was $25.89) to a GRAT with your children being the remaindermen of the GRAT. If the price of Microsoft goes up to $27.25, the GRAT produces a 5.2% return (($27.25 -$25.89)/($25.89)), which surpasses the §7520 hurdle rate that is necessary for the GRAT to be successful (3.8% in May 2004). However, what if on the same date that we transferred the shares into the GRAT, we also did the following:

  1. Sold two (2) January ’05 calls with a strike price of $27.50, costing $1.25 per share (closing price on May 21, 2004); and
  2. Used the proceeds from the sale, to buy one (1) January ’05 call with a strike price of $25.00, costing $2.55 per share (closing price on May 21, 2004).

What we have done is create a costless option spread inside of a GRAT. But how has this helped us? Recall that when the price of Microsoft went up to $27.25 and no options were in place, the GRAT yielded a gain of $1.36 ($27.25 -$25.89). By using a spread, and assuming the same price of $27.25, we have more than doubled our return without any additional cost. Here’s how, $1.36 from the stock owned ($27.25 - $25.89), + $2.25 from the $25 call we bought ($27.25 - $25.00) — a total of $3.61.

Once the price of Microsoft exceeds the strike price of the two (2) options sold ($27.50), the return on the GRAT will be maximized at $4.11 ((+$1.61 from the stock owned ($27.50 - $25.89), +$2.50 from the$25.00 call we bought ($27.50 - $25.00)). With the price of Microsoft somewhere between $27.50 and $30.00, the costless spread still produces a better result than without it. For example, if the price of Microsoft is $29.50, the GRAT with the spread produced its maximum return of $4.11, but without the spread, the GRAT would have yielded a gain of only $3.61 ($29.50 - $25.89).

Not until the trading price of Microsoft exceeds $30.00 do you reach the point where it would have been better not using this type of spread. For example, if the price of Microsoft is $31.00, a GRAT without the spread would produce a return of $5.11 ($31.00 - $25.89), as opposed to the maximum of $4.11 it produces when this spread is used.

By doing this costless spread, you have (a) potentially “super-charged” what is left for the remaindermen of the GRAT when the underlying stock trades between certain prices; and (b) depending on the §7520 hurdle rate that month, the spread might be the difference between your GRAT being a winner instead of a loser. Admittedly, if there is a surge in the stock’s price, you would have been better off not using the spread. While this trade-off might not be suitable for everyone, a spread inside of a GRAT should be considered as a potentially viable financial tool when contemplating the use of GRATs.

Please contact us to discuss any questions or comments.

Categories: News and Articles