A grantor retained annuity trust “GRAT” is an advanced estate planning technique whereby an individual (the “Grantor”), transfers an asset to an irrevocable trust while retaining an income stream from the trust for a period of years. The income stream is in the form of an annuity, set as a percentage of the trust assets. Each year, the GRAT will pay the established annuity payment to the Grantor.
At the end of the GRAT term, the asset will be distributed to the beneficiaries of the GRAT. The beneficiaries of the trust are usually children or close family members – though they do not have to be.
Gift Tax Consequences.
Because the transfer into the GRAT is considered a gift, gift tax consequences must be considered. The value of the taxable gift to a GRAT is determined at the time of the transfer and is done by subtracting the value of the Grantor’s retained interest from the fair market value of the asset at the time of the transfer. As you can see, the taxable gift to the GRAT is always less than the fair market value of the asset when transferred. Thus, the larger the retained interest, the smaller the taxable gift. In many instances the gift taxes due on the gift to the GRAT can be offset by the grantor’s lifetime gift tax exclusion amount.
In some cases, the taxable gift can be reduced to zero.
A “Zeroed-Out” GRAT.
A zeroed-out GRAT is one in which the annuity amount is set so that the value of the amount to be paid to the grantor over the annuity term equals the amount transferred to the GRAT, plus an assumed rate of return. By setting the annuity amount in this manner, the grantor is deemed to have not made a taxable gift to the beneficiaries of the GRAT because the grantor will have received back everything they put into it.
Valuing the gift.
IRS Code Section 7520 sets forth guidelines for establishing the value of the Grantor’s retained interest in the GRAT as well as establishing the interest rate to be used; commonly referred to as the Section 7520 rate or hurdle rate. Due to historically low interest rates, the hurdle rate is currently very low (1.4% as of this writing).
Estate Tax Considerations.
Generally, when an individual gifts an asset, but retains the right to benefit from it during their lifetime, all or a portion of the value of the gift will be returned to, and included in, the individual’s estate for estate tax purposes at their death.
Because of this inclusion for estate tax purposes, the grantor of a GRAT must survive the term of the GRAT in order to have the transferred assets escape their estate for estate tax purposes. If the grantor dies during the term of the GRAT, the balance of the trust needed to generate the remaining annuity payments will be brought back into the grantor’s estate for estate tax purposes; any gift taxes paid will be credited against the estate tax that may be due.
If the grantor outlives the term of the GRAT, any remaining assets in the trust will pass to the named beneficiaries according to the terms of the GRAT. As a result, any appreciation that occurs on the assets in excess of the hurdle rate will pass to the beneficiaries. This appreciation is passed on to the beneficiaries with no additional gift tax, resulting in significant gift-tax savings to the grantor. Additionally, the appreciation on the transferred asset will not be included in the grantor’s gross estate for estate tax purposes – effectively reducing the estate tax.
Assets that work well in GRATs.
As noted, any appreciation in the value of an asset held in a GRAT in excess of the hurdle rate gets passed to the beneficiaries at the end of the GRAT term without any gift tax. If the asset does not appreciate, or appreciates at a rate lower than the hurdle rate, then no transfer tax advantages will be gained. The only real downside was the expense of establishing the GRAT. However, the chances of the GRAT working as intended increase when the asset(s) placed in it are depressed.
Publicly-held securities that have decreased in value in today’s stock market as well as minority interests in family businesses are good potential choices for inclusion in GRATs. That is because these assets have a good chance of outperforming the hurdle rate.
Choosing the term of a GRAT.
A longer GRAT term increases the value of the grantor’s retained interest. It also gives a longer period of time for the asset(s) held in the trust to appreciate. However, the risk is that if the grantor dies during the term of the GRAT, a portion of the GRAT will be included in the grantor’s estate. The shorter the GRAT term, the more likely the grantor is to survive the term and have the appreciation on the asset pass tax free. However, the shorter the term, the lower the value of the retained interest.
Currently, GRAT terms can be as little as two years. However, the President is proposing that the minimum GRAT term be increased to 10 years. This would diminish the appeal of GRATs due to the increased mortality risk.
Using a trust after expiration of the GRAT term.
The asset(s) held in the GRAT do not need to pass outright to the beneficiaries after expiration of the GRAT term. The asset(s) can remain in trust and be managed and distributed to the beneficiaries in accordance with the terms of the trust document. Provisions protecting the inheritance from creditors, predators and failed marriages can also be included.
GRATs are not for everyone.
A GRAT can provide significant estate and gift tax savings. That is why they have been a favorite technique of the rich and famous such as Bill Gates, Warren Buffett and silicon-valley billionaires like Mark Zuckerberg. For example, Google shareholders placed pre-initial public offering (“IPO”) stock worth a fraction of its IPO price into zeroed-out GRATs prior to the initial IPO. They then received an annuity measured by the pre-IPO value and then terminated the GRATs after two years with a transfer of 10 times the pre-IPO value in trust for their kids.
However, GRATs are not for everyone. Gifting an asset to a GRAT requires giving up control over the asset. Only those with sufficient assets and income such that they can afford to gift an asset to the next generation should consider using a GRAT.