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Grantor Retained Annuity Trust (GRAT)
A Grantor Retained Annuity Trust (“GRAT”), allows you to transfer an income producing asset to a Trust for a set number of years, removing it from your Estate, and still receive the income. The asset is usually stock, real estate, or a business. If the income is a set amount, the Trust is called a GRAT. If the income fluctuates, it is called a Grantor Retained Uni-Trust (“GRUT”). When the Trust ends, the assets will be transferred to the beneficiaries, usually your children. Since the beneficiaries did not receive it until the end of a set number of years, the value of the gift is reduced. If you die before the Trust ends, the asset will be in your Estate similar to a qualified Personal Residence Trust. A GRAT is a type of Irrevocable Trust.
A donor sets up a GRAT by gifting an asset into a Trust. The Trust is set up as an annuity whereby the Settlor receives an annual payment from the annuity for a fix period of time. At the end of the term, any remaining value in the Trust is passed on to the beneficiary of the Trust as a gift. The IRS has a number of regulations governing how the remaining value of the Trust at the end of the Term is taxed. When the GRAT is established, a “gift value” of the GRAT is calculated. The gift value is equal to the initial contribution to the GRAT plus a theoretical interest earned on the principal minus the total annuity payments that will be made by the end of the term. The theoretical rate of interest is determined by IRS regulations.
To realize a tax benefit, the sum of the scheduled annuity payments of a GRAT is set to be about equal to the principal plus the theoretical interest. Thus for tax purposes, the initially calculated gift value is zero ($0), since what will be paid back to the Settlor and the annuity payments is anticipated to be about equal to what the Settlor invested, plus interest. If a GRAT is funded with highly volatile assets, however, it is possible that the actual interest earned on the assets will be substantially higher than the IRS theoretical interest. Thus at the end of the Term the value remaining in the GRAT may still be large, even though the initial IRS calculations suggest that it should have been zero. The remaining value is than passed on to the Beneficiary without incurring a gift tax.
By way of example, John holds $1 million of a stock that pays a 10% dividend. John establishes a GRAT with a 13 year term and transfers the stock to his GRAT. Each year the $100,000 dividend is paid to the GRAT. The GRAT than pays the required $100,000 annuity to John. The value of this gift may be as low as $13,710 based upon the IRS theoretical tax schedules. This is a gift of the future interest and does not qualify for the annual exclusion. John must use part of his $1 million lifetime gift exemption or pay a gift tax each year. At the end of the GRAT Term of 13 years, John would have received $1.3 million in annuity payments ($100,000/year x 13 years) the remainder value in the GRAT is the stock and would still be valued at $1 million assuming no depreciation. The stock would then be distributed to the Beneficiaries, John’s beneficiaries, in this case the children, will receive an asset worth $1 million but John only had to report a gift a $13,710.
The term of a GRAT can be as short as two years or as long as the Grantor chooses. If the Grantor dies during the GRAT term, the IRS takes the position that the technique fails and the assets inside the GRAT are included in the taxable estate. If the GRAT Term is shortened, the annuity pay out rate must be increased or a larger reportable gift will occur. It is important to know that the GRAT annuity payment does not have to be made from income. The annuity payment can be satisfied with principal or with the assets that were originally transferred into the GRAT. By way of illustration, this time John transfers $1 million of non-dividend paying stock into a two year GRAT. John retains a 53.17% annuity interest. If the stock grows 10% each year, the GRAT must pay $531,716.70 of value to John each year for two years. This payment can be made by distributing the appreciated stock to John. If the Trust does this for two years, the Trust will have $93,395 of stock remaining after the last payment to John. According to the Walton tax court decision, John made a taxable gift of under $1. The Obama administration and members of Congress are currently debating various tax reform measures. One such measure would require a lengthy minimum term for GRAT’s. One such proposal made by the Treasury department would require that any newly established GRAT have a minimum term of 10 years. The current combination of undervalued assets and low interest rates provide an excellent opportunity for you to generate substantial tax savings by establishing a GRAT. However, that window of opportunity for this Estate Planning technique may be closing rapidly.
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Meurer Law Offices
5347 S. Valentia Way, Suite 220
Greenwood Village, Co. 80111
303.991.3544
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MEURER LAW OFFICES, P.C.
5347 South Valentia Way, Suite 220
Greenwood Village, CO 80111
Phone: 303-991-3544
