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This month we take a look at a well-established estate planning strategy used by clients to reduce the size of their estate for future estate tax purposes. It’s called a "grantor retained annuity trust," but is typically referred to by its common acronym: a GRAT.
GRATs are a special type of trust that can greatly reduce or eliminate the tax cost of making gifts. Clients find GRATs to be attractive because they have essentially no downside risk.
A GRAT is simply a trust created by a person (we’ll call him or her the "grantor"), who retains the right to receive a fixed annual payment from the trust (the "annuity") for a specified term. At the end of the specified term the assets in the GRAT are either distributed outright to the designated beneficiaries (called the "remaindermen" of the trust), or retained in trust for their benefit.
The transfer of property to a GRAT typically involves a current gift to the remaindermen for gift tax purposes – even though they won’t receive anything until after the end of the specified GRAT term. To determine if there is a gift involved when the GRAT is established (or how much), first the grantor determines the current value of those fixed annual payments he or she will receive (the “annuity interest”), and then subtracts that from the total value of the property transferred to the trust. The difference, if there is any, is a gift to the remaindermen as of the date the GRAT is created and funded.
The IRS publishes interest rates monthly that are used in valuing the annuity interest. With proper planning GRATs can be designed so that the gift to the remaindermen is greatly reduced or entirely eliminated. When the gift element is entirely eliminated the GRAT is said to be "zeroed-out" – that is, there is no gift if the actuarial value of the grantor's retained annuity interest equals the full value of the property transferred to the trust.
That’s a mouthful, so let’s look at a couple simple examples that illustrate the idea:
Example A: Assume that a grantor who is 60 years old funds a GRAT with $1,000,000 in January, 2012. Under the terms of the trust, the grantor receives an annual annuity for 10 years of $75,000. Since the IRS published interest rate was 1.4 percent in January, 2012, the grantor’s retained interest is valued at $695,340, and the remainder interest is therefore valued at $304,660.
Thus, the right to receive a $75,000 each year for 10 years is worth $695,340 on the date the GRAT is created, and the right to receive the remainder at the end of the term, 10 years later, is worth $304,660. The value of the remainder interest, $304,660, would be subject to gift tax upon creation of the GRAT.
But consider: how does the GRAT actually perform? This is where it gets interesting. If the assets in the GRAT generate, say, 4% per year, then at the end of the GRAT term, there should be about $579,786 in assets remaining to distribute to the beneficiaries of the GRAT:
(Start of Year)
Growth (@ 4%)
(End of Year)
In this case, the grantor ends up transferring $579,786 in value to the beneficiaries at a gift tax cost of only $304,660. And if the grantor has not used his or her lifetime exemption from gift tax (currently $5.12 million per person) then there’s no real gift tax “cost” at all.
But let’s make this planning idea even more interesting:
Example B. Assume that a grantor who is 60 years old funds a GRAT with $1,000,000 in January, 2012. Under the terms of the trust, the grantor receives an annuity for 10 years of $107,861. Since the IRS published interest rate again was 1.4 percent, the value of the grantor’s retained interest is $1,000,000; in this case, the remainder interest is valued at $0 (since the value of the annuity equals the amount initially transferred to the GRAT). Since the value of the remainder interest is $0, the GRAT is “zeroed out” and there’s no gift tax upon creation.
Now let’s suppose that the asset transferred to the GRAT is stock in a closely held business that’s appreciating at 15% per year. Now let’s see how the GRAT actually performs in this scenario:
(Start of Year)
Growth (@ 15%)
(End of Year)
In this case, the grantor ends up transferring over $1.8 million in value to the beneficiaries entirely gift tax free and without the use of any lifetime gift tax exemption.
To be sure, the example above was designed to reflect a wildly successful GRAT – it assume a very low IRS interest rate, an annuity amount calculated to “zero-out” gift tax, a grantor who survives the term of the GRAT, and a high rate of appreciation on trust assets. But lest you think the results above are unattainable – the only “unknowns” in the equation are the grantor’s mortality, and the investment performance of the GRAT assets.
In regard to the grantor’s mortality, current GRAT rules require that if the grantor dies before the end of the GRAT term, substantially all the value of the GRAT is includible in his or her estate for estate tax purposes. However, the downside risk for the grantor is very limited: if the grantor dies during the term of the trust, the GRAT property will be subject to tax in his or her estate -- which is what would have occurred if the grantor had not created the GRAT in the first place. Essentially, only the legal and accounting costs of establishing the GRAT are at risk.
Even this mortality risk can be mitigated by shortening the term of the GRAT. For example, if the GRAT is funded with assets that will appreciate significantly, then the GRAT term could be shortened to 2 or 3 years and still produce solid tax results.
The other “unknown” in the equation is investment performance. As indicated by the examples, a GRAT will be successful in transferring property to the remaindermen at little or no tax cost if the total return generated by the GRAT investments exceeds the IRS interest rate that applied in valuing the remainder interest when the GRAT was first created.
If the overall return on the GRAT property does not exceed the assumed rate, the annual distributions to the grantor will completely exhaust the property in the trust, and nothing will remain for distribution to the remaindermen. In this case, again, the only downside risk to the strategy is the initial cost of establishing it.
There are other important tax consequences that a grantor should be sensitive to when approaching this wealth-shifting strategy.
Let’s understand how this works. In our second example above, the GRAT makes the annuity payment of $107,861 to the grantor in the first year, yet we assumed that the GRAT earned a total of $150,000 of taxable income. In that first year, the grantor will be taxed on the full $150,000 - even though the GRAT pays the grantor only $107,861. If the grantor’s combined state and federal tax burden is 40%, the grantor’s tax liability associated with the GRAT will be about $60,000 – or about 55% of the distribution he or she received.
But there's an upside from a wealth transfer standpoint: obligating the grantor to pay the income tax on all GRAT income allows more funds to accumulate in the trust, free of tax burden, for ultimate distribution to the remaindermen at the end of the GRAT term. This payment of the GRAT’s tax burden can be viewed as another gift-tax-free transfer to the GRAT’s ultimate beneficiaries.
If the grantor dies during the term of a GRAT, its assets will receive a new basis to the extent they are included in the grantor's estate. Generally, the basis of an asset that is included in a decedent's gross estate is the value at which it was included in the decedent's estate—usually its fair market value on the date of the decedent's death. This rule has resulted in a "free" step-up in basis.
The GRAT will have the legal obligation to make the annuity payments for the term of the GRAT. If the assets in the GRAT do not earn enough interest or dividends to make the required annuity payment, the trustee of the GRAT will have to satisfy the obligation in other ways. For example, a trustee might borrow funds to make the required payment. Or the trustee might make distributions in kind to the grantor (“in kind” means returning some of the GRAT assets back to the grantor).
Even though the transfer of the original property back to the grantor does not require the recognition of any capital gain, returning the property to the grantor may defeat the purpose of the plan in the first place. If the grantor receives back the property that he or she was trying to dispose of in the first instance (such as stock in a closely held business), the failure of the assets in the GRAT to generate sufficient income to make the annuity payments can have an adverse impact on the estate planning goals of the grantor.
A few weeks ago, the White House issued its clunky-sounding “General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals” – sometimes less formally called the Green Book.
This document explains some of the assumptions that are built into the President’s budget. While the Green Book is not the law, it represents the current Administration’s thinking on various tax topics, and puts taxpayers on notice that certain changes in tax law might be coming. As it impacts our discussion on GRATs, a couple important observations are in order:
While GRATs are only one option to consider when looking at the tools available for the transfer of wealth to family members, they are often a very good one. This is particularly true in our current low interest rate environment.
If you are intrigued by this planning option, or question how it might fit into your estate plan, we invite you to contact Bill Cotter or any of the other members of Coman & Anderson, P.C.’s Estate Planning and Wealth Transfer Group (Dan Coman, Mark Anderson or Lynn Cagney).