A grantor retained annuity trust, better known as a “GRAT”, is a powerful tool to transfer wealth, free of gift tax. For individuals who are fully utilizing (1) their annual exclusions, (2) the tuition and medical expense exclusion, and (3) their lifetime gift tax exemption equivalent, GRATs remain a popular strategy to transfer wealth by persons who have significant exposure to federal estate tax, even after utilizing these exclusions and exemption. Under the current, extremely low interest rate environment, GRATs present a very attractive opportunity for these people to shift future growth to their children while paying little or no federal gift tax on the transaction.
Through the use of a GRAT, the donor (called a “grantor”) contributes property that is expected to significantly appreciate to an irrevocable trust and retains the right to receive annuity payments for a specified number of years. The amount of the annuity payments is based on an applicable interest rate. Due to the retained annuity payments, the trust is designed so that there should be no taxable gift to the trust’s remainder beneficiaries — a so-called “zeroed-out GRAT.” Because little or no taxable gift is created at the inception of the trust, the donor will not have to use either the donor’s lifetime gift tax exemption equivalent or any of the donor’s gift tax annual exclusions to avoid incurring a substantial gift tax upon the trust’s creation.
If the investment performance of the GRAT exceeds the applicable interest rate used to calculate the retained annuity payments, the balance of the trust’s assets at the expiration of the GRAT’s term will pass to the GRAT’s remainder beneficiaries, typically the grantor’s children, free of federal gift tax.
Under I.R.C. § 2702(a)(2)(B), the GRAT’s annuity payments must be calculated by using a qualified interest rate published by the Internal Revenue Service (“IRS”) under I.R.C. § 7520 for the month in which the GRAT is created. New rates are published monthly. For example, if a GRAT is established in January 2008, the interest rate used to “zero-out” the trust gift is 4.4% per annum. If the trust principal and income appreciate at a rate greater than 4.4% per annum, that excess appreciation will pass to the grantor’s remainder beneficiaries free of federal gift tax. At the same time, the grantor’s taxable estate will only appreciate at the § 7520 rate (4.4% per annum) so long as the grantor survives the expiration of the GRAT’s term.
In order to have a qualified GRAT, a number of requirements must be satisfied. In addition to the use of the IRS’s specified interest rate, some of the more important requirements are:
1. The retained annuity must be structured as an irrevocable right to receive either a stated dollar amount or a fixed percentage of the initial fair market value of the contributed property. Although the annuity payment need not be the same each year, it cannot exceed 120% of the annuity payment in the preceding year;
2. The governing instrument must contain certain provisions relating to adjustments for any incorrect determination of the fair market value of the contributed property;
3. The annuity must be payable to the grantor at least annually;
4. The GRAT must prohibit prepayment of the annuity;
5. Additional contributions after the initial contribution to the GRAT must be prohibited; and
6. The GRAT must prohibit the trustee from using a note or other debt instrument in satisfaction of the annuity, although a payment-in-kind with other trust property is permissible and commonly occurs.
An in-kind annuity payment will not trigger any gain recognition to the GRAT or the remainder beneficiaries as the GRAT property will be treated as owned by the grantor for income tax purposes. This is especially useful where the GRAT is formed with ownership interests in closely-held businesses or other illiquid investments.
The GRAT’s term must be fixed at its creation, and may be for the grantor’s life, for a specified term of years, or for the shorter of those periods. Since the death of the grantor during the term of the GRAT will cause the GRAT strategy to fail, the term of the GRAT is typically a specified term of years, which ends before the grantor’s life expectancy. A short term is often chosen to minimize this risk. Other factors which affect the selection of the GRAT’s term include: (1) the grantor’s health; (2) the grantor’s age; (3) the nature of the GRAT’s investments; (4) any anticipated interest rate increases; and (5) the possible use of multiple GRATs with varying terms.
The potential wealth transfer effect of a GRAT is demonstrated by the following example. Assume a $1,000,000 zeroed-out GRAT is created, with interest calculated at the applicable IRS rate for January 2008 of 4.4% per annum. The GRAT thus makes an annual annuity payment of $193,251.50 to the grantor (or to the grantor’s estate if the grantor dies) for six years. If the trust earns 6% per annum, $70,528 will pass to the remainder beneficiaries at the end of the GRAT’s term without any wealth transfer tax (assuming the grantor survives the expiration of the GRAT). If the trust earns 9% per annum, $223,204 will pass to the remainder beneficiaries at that time – free of federal gift tax.
Under the current, extremely low interest rates, as the example shows, the present opportunity to shift substantial wealth tax-free using the GRAT strategy should not be missed. The GRAT strategy poses relatively low risk because the IRS has already acquiesced to a United States Tax Court decision that approved the use of a zeroed-out GRAT to pass wealth without federal gift tax (the case involved a member of the Walton family who owned part of the Wal-Mart fortune). The principal risks of the GRAT strategy are: (1) disputes with the IRS over the valuation of trust property, thereby possibly incurring some gift tax if the IRS’s valuation prevails; (2) the failure of the grantor to survive the expiration of the GRAT’s term; and (3) the failure of the GRAT’s investments to yield a return in excess of the IRS’s applicable interest rate. Even if the latter two events occur, the grantor is simply in the same position as if the grantor did not undertake the GRAT strategy: namely, inclusion of the GRAT property in the grantor’s taxable estate.
The McGrath North Tax Group specializes in estate planning and has successfully implemented the GRAT strategy for many clients. If this strategy appeals to you, or may be of interest to some of your clients, please contact us to discuss the strategy further.
- A GRAT is a powerful wealth-shifting tool that, if properly structured, can pass substantial wealth gift tax-free without utilizing the donor’s lifetime gift tax exemption equivalent or any gift tax annual exclusions.
- The GRAT’s advantage is critically important where the donor has exhausted his or her lifetime gift tax exemption equivalent and does not want to incur gift tax in order to transfer wealth during his or her lifetime.
- Since the GRAT requires the payment of a qualified annuity to the donor, who is called the “grantor,” for a specified number of years, the opportunity to shift wealth is directly related to the spread between the investment yield of the GRAT’s property and the interest rate that is prescribed under I.R.C. § 7520 to determine the required annuity payment.
- The extremely low current interest rates favor the creation of GRATs now because the opportunity to realize a favorable spread in yield is as high as it has ever been.
- In order for the wealth transfer to be successful, the grantor must survive the GRAT’s term. Selection of the trust term is a critically important decision.
- If the GRAT strategy fails, due to either the grantor’s death or a failure to realize favorable investment performance in excess of the § 7520 rate, the worst that can happen is the grantor is left where he or she started, with inclusion of the trust property in the taxable estate.
PRACTICE POINTERS: WHEN SHOULD YOU OR YOUR CLIENTS CONSIDER A GRAT?
1. Ideal candidates for a GRAT include individuals who have taxable estates, have exhausted their lifetime gift tax exemption equivalent, and are otherwise fully utilizing their gift tax annual exclusions, but would like to do substantially more gifting without incurring federal gift tax.
2. Investments that are ideal for funding a GRAT include closely-held business interests that are expected to grow at high single-digit or double-digit rates.
3. Fast appreciating S corporation stock is another ideal investment for funding a GRAT as cash dividends on the stock generally are distributed income tax-free. A GRAT is eligible to own stock in an S corporation without jeopardizing the corporation’s S election.
4. Because the grantor, not the GRAT, pays the income taxes due with respect to the GRAT’s taxable income, the trust assets will grow without reduction for income taxes, thereby substantially increasing the probability of a significant wealth transfer to the GRAT’s remainder beneficiaries.