Advanced Estate Planning

Grantor Retained Annuity Trusts

A grantor creates a GRAT by transferring assets to an irrevocable trust that is created for a certain period of time. The terms of the trust will provide that the grantor has an irrevocable right to receive a specified amount annually for the term of the GRAT. The annuity payments come from interest earned on the assets underlying the trust or as a percentage of the total value of the assets. The grantor is entitled to receive the annuity regardless of the income produced by the trust assets.

The grantor creating the trust pays a tax when the trust is established. For federal transfer tax valuation purposes, the grantor’s retained interest is deducted from the fair market value of the property transferred to the GRAT. The grantor would be required to pay gift tax on the value of that remainder interest, but the gift is measured by the present value of the remainder interest. At the end of the designated term, the remaining trust estate is transferred to the remainder beneficiaries, either outright or retained in further trust for their benefit.

The goal of the GRAT is to transfer assets to the trust that will generate a total return of income and appreciation during the GRAT term that will be greater than the Internal Revenue Service’s measuring standard (§7520 interest rate). To the extent this goal is accomplished, when the trust is set up, any amount earned beyond current interest rates will be estate-tax free. Additionally, the appreciation in the GRAT assets will pass to the beneficiaries free of gift and estate tax. If the GRAT grows each year at precisely the §7520 rate used, there would be no remainder left at the end of the term.

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Typically a parent will fund the GRAT with appreciating assets (i.e.: stocks). Taking the value of the assets transferred to the trust and using the Internal Revenue Code §7520 rate of interest at the month the trust was created, the value of the parent’s retained interest is calculated (the right to receive the stated annual annuity). The value of the retained interest is then subtracted from the fair market value of the property transferred to the GRAT to ascertain the remainder interest.

A GRAT can be created for any term desired. Providing for a longer trust term would reduce the tax cost of the transfer as the longer the period that an annuity interest in the GRAT is retained by the grantor, the smaller the value of the remainder gift. The downside of a longer term trust is that if the grantor dies during the GRAT term, all or most of the GRAT corpus, the value of the remainder interest, will be included in the grantor’s taxable estate.

Short term GRATs are used to lessen the probability that the grantor will die during the GRAT term. Short term GRATs with high annuity payouts that result in the retained interest being so large as to be equal the value of the entire interest will ultimately reduce the value of the remainder interest and reduce or eliminate the gift tax. This is because the more the grantor receives (retained interest) the less the beneficiaries receive (remainder interest). And, because the gift tax is due on the amount the grantor is giving to the beneficiaries, if the remainder interest in the GRAT is zero, the gift tax on the remainder interest is zero.

Ideally, the GRAT will outperform the assumed IRC §7520 interest rate for the term of the GRAT and all of the benefits of over-performance will pass to the remainder beneficiaries with little or no transfer tax cost to the grantor. Nothing is lost if a GRAT is exhausted by the annuity because the gift tax was zero. Any assets remaining in the GRATs at the end of the term will pass to the remaindermen with no gift tax cost.

To recap, with a longer term GRAT, if the rate of return does not exceed the §7520 rate, there will be a loss of the gift tax on the value of the remainder. But if the GRAT has a shorter term and the annuity rate is high enough, the gift tax on the remainder will be negligible, meaning that if the rate of return does not exceed the §7520, the loss is limited. .

GRATs must comply with the requirements of Internal Revenue Code §2702 if the transfer is a family member to avoid the grantor’s retained interest being valued at zero in which case the gift made by the grantor to the remainder beneficiaries would be the entire value of the trust assets.

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