Recent volatility results in fat GRAT discounts for lack of marketability. Lance Hall leads the estate and gift tax valuation practice of FMV Opinions, a valuation and financial-advisory services firm.

In the 16 trading days between 19 September and 10 October, the S&P 500, a broad gauge of U.S.-stock performance, dropped 28.4%. This market mayhem has led many investors to seek the safety in U.S. Treasury bills. This leads to an obvious conclusion for the estate-planning community: this is a great time to gift.

Using grantor retained annuity trusts (GRATs) at relatively low applicable federal tax rates will result in substantial benefits if the stock-market returns to its 19 September level within two years; that's pretty obvious. But what the estate-planning community may not have grasped so firmly is that there is an even greater reason to gift now: volatility.

Volatility index

The Chicago Board Options Exchange's Volatility Index (VIX) measures the expected near-term volatility of S&P 500 option prices -- in other words, it's an indicator of the amount of the level of fear or greed in U.S. and global capital markets. When fear rules the roost, the VIX is significantly higher than normal." On 19 September 2008, the VIX stood at 32.07; a level reflecting fear in the marketplace. Between 2003 and the end of August 2008, the VIX averaged 16.37. It exceeded the 19 September level just once: on 17 March 2008, the first trading day after the collapse of Bear Stearns. By October 10th, VIX reached a record level of 69.95, reflecting almost absolute panic. On Friday it reached 89.53.

Volatility and liquidity

In times of uncertainty investors seek safety and liquidity. The safest and most liquid instruments are short-term U.S. Treasury bills. From 2 January 2008 through 10 October 2008, the average three-month Treasury bill yield was 1.71%. On 19 September, the T-bill yield was already an extremely low 0.99%. On 10 October, however, the yield had reached 0.25%. Clearly, between 19 September and 10 October, investors were abandoning equities for the safety and significantly greater liquidity of short-term T-bills. In sum, during times of uncertainty, investors prefer safer and more liquid assets. Discounts for lack of marketability

The leading discount for lack of marketability methodology (and the methodology increasingly favored by the courts) is to perform a comparison with private placements of restricted stock of publicly traded companies. Restricted stock is generally defined as the unregistered stock of a public company that can't usually be sold in the public marketplace but may be sold in a private placement to sophisticated investors. As a result of the reduced liquidity, restricted stock sold in private placements sell at discounts to the otherwise liquid registered stock of public companies.

The FMV Restricted Stock Study, a database of restricted-stock transactions, indicates discounts ranging from premiums to discounts greater than 70%. To understand which variables affect the magnitude of the discount, FMV has sorted the data into quintiles from lowest to highest discount. We then determined the median characteristics of the companies within each quintile. The following table shows the relationships of a few of the characteristics examined.

|image1| The median discount in the third quintile represents the median of the entire study. What stands out is the relationship between size (market value, total assets, book value and revenues) and the magnitude of the discount. More important, however, is the relationship between a firm's stock price volatility and the magnitude of the discount. FMV has also sorted the transaction data from lowest to highest volatility to show volatility's impact on the magnitude of the discount for lack of marketability. This relationship is reflected in the following table.

|image2| As you can see, the greater a firm's stock-price volatility the greater the discount.

To further understand the relationship between broader market volatility and discounts for lack of marketability, FMV looked months where the VIX was higher than normal and compared the restricted-stock transaction discounts observed during those months to the average discount during the entire period (VIX = 19). The following table examines the restricted stock transaction discounts during times of greater volatility as reflected in the 60th to 80th percentile and the 80th to 100th percentile of transactions.

|image3| This table indicates that moving from a VIX of 19.0 to a VIX of 23.6 results in an increase in the discount of 1.2%, or a 5% premium to the average discount. Moving from the average VIX of 19.0 to a VIX of 26.7 results in an increase in the discount of 5.1%, or a 20.5% premium to the average discount.

It is important to note, however, that in today's volatile environment, volatility is significantly greater than ever recorded historically or reflected in the historical restricted stock data. If there is a linear relationship between VIX and the discount for lack of marketability, as of 19 September when VIX was 32.07, the discount for lack of marketability should be 9.7% higher than the discount selected during normal times, or a premium to the normal discount of 38.9%. With a VIX reading of 69.95, as on 10 October, the discount for lack of marketability should be 41.9% higher, or a premium to the normal discount of 168.4%.

Taking advantage of volatility

Today, stock prices, real estate and interest rates are relatively low. As a result, an aggressive program of gifting or utilizing the inherent leverage of GRATs appears justified. However, given the significantly larger discounts for marketability during times of abnormally high market volatility, gifting now is imperative.

Even if market values do not change over the next year, periods of extreme volatility are relatively short. As a result, despite steady asset prices, discounts for lack of marketability are sure to decline. -FWR

This is not intended or written to be used by any taxpayer or advisor to a taxpayer for the purpose of avoiding penalties that may be imposed upon the taxpayer or advisor by the IRS. This writing is not legal advice, nor should it be construed as such.

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