Grantor Retained Annuity Trusts
By: Julius Giarmarco, Esq. | Posted: 24th March 2010
A Grantor Retained Annuity Trust or “GRAT” is one of the most powerful and tax efficient wealth transfer tools available today. A GRAT allows a person to transfer the future appreciation of an asset to his/her children with little or no gift tax.
The Basics
A GRAT is a trust with a specific term (i.e., 2 years or longer). The grantor transfers assets to the GRAT and retains the right to receive a fixed annual payment during the specified term. The annual payment or annuity is a percentage of the initial fair market value of the original assets transferred to the GRAT. At the end of the GRAT term, any remaining assets will be distributed to the named beneficiary or beneficiaries, usually the grantor’s children.
The amount of the gift is calculated using the subtraction method. The present value of the annuity payments to the grantor are subtracted from the original value of the assets placed into the GRAT. The IRS requires the grantor to assume that the assets transferred to the GRAT will grow at the rate published by the IRS for the month the GRAT is created. Generally, the lower the interest rate, the larger the annuity and the longer the term, the smaller the gift. Moreover, if the assets transferred to the GRAT qualify for valuation discounts (for lack of control and lack of marketability) such as non-voting interests in a Family LLC or Subchapter S corporation, the annuity can be set at a higher rate resulting in a smaller gift.
Example
The following example illustrates how a GRAT works. Assume the grantor (age 60) owns a building with a fair market value of $2 million. The building is generating $200,000/year in rent and is expected to appreciate at 5% per year. The grantor then transfers the building to a limited liability company and takes back a 1% Class A voting interest and a 99% Class B non-voting interest. The grantor also names himself/herself as the manager of the LLC.
Then, the grantor obtains an independent appraisal of the 99% Class B membership interest which reports – after taking a 40% discount for lack of control and marketability – a value of $1,188,000 (i.e., $2 million x 99% = $1,980,000, less 40%). Next, the grantor transfers the 99% Class B membership interest in the LLC to a GRAT with a 6 year term, paying a 16.8% annuity to the grantor. The annuity is equal to the annual rent (i.e., 16.8% x $1,188,000 = $199,584). Assuming the IRS’s published interest rate for the month of transfer is 3%, the value of the gift to the GRAT remainder beneficiaries (the grantor’s children) is only $143,956.
This gift does not quality for the $13,000 ($26,000 for married couples) annual gift tax exclusion. Thus, the grantor must use part of his/her $1,000,000 lifetime gift tax exemption to cover this gift. Finally, by the end of the 6 year term, the grantor will have received $1,197,504 ($199,584 per year x 6 years). The 99% Class B membership interest will have grown to $2,881,757 (without regard to any valuation discounts). Thus, the grantor’s children will have received $2,881,757, from a gift of only $143,956! Moreover, the grantor remains in control over the LLC through the 1% Class A voting interest not given away.
More Basics
If the grantor dies during the GRAT term, the IRS’s position is that a portion of the GRAT assets are included in the grantor’s estate. The portion so included is the amount necessary to produce the retained annuity in perpetuity (as if the annuity amount were the annual income of the GRATs assets) using the IRS’s assumed interest rate in effect on the date of death. Generally, if a GRAT’s assets have substantially appreciated, there will be a significant tax-free transfer of wealth even if the grantor dies during the term. For this reason, the term of the GRAT should be set at a length the grantor is likely to survive. If the GRAT term is shortened, the annuity payout rate must be increased or a larger gift will occur.
It is possible to “bullet proof” a GRAT by purchasing a life insurance policy on the grantor’s life for the benefit of the beneficiaries of the GRAT. This policy would be held in an irrevocable trust to prevent it from being included in the grantor’s taxable estate. Therefore, if the grantor does not survive the set term, the life insurance proceeds – which will be both income and estate tax free – can be used to pay the “additional” estate taxes that will be due because the GRAT failed. Of course, this would be no more than the tax that would have been due on the building had the GRAT not been attempted. It is important to note that the GRAT annuity payment does not have to be made from income. The annuity payment can be satisfied with principal or from the assets that were originally transferred into the GRAT.
Benefits
First, if the assets transferred to the GRAT grow (both in accumulated income and appreciation) at a rate higher than the IRS’s published interest rate, the value of the assets remaining in the GRAT when the term ends will be greater than the amount that was taxed. This growth passes to the named beneficiaries gift tax free. Thus, if the grantor has assets which he/she expects will substantially appreciate in the next few years (e.g., stock in an income producing closely held business that is expected to grow in value), a GRAT is an ideal way for the grantor to get the greatest benefit for his/her $1 million gift tax exemption by transferring those assets now at their lower value.
Second, the grantor can eliminate the gift tax due upon creation of the GRAT if the GRAT provides that in the event the grantor dies before the term ends, the remaining annuity payments will be paid to the grantor’s estate. Depending upon the IRS interest rate at the time the GRAT is created, by selecting the proper term and annuity percentage, it is possible to create a “zeroed-out GRAT” because the value of the assets passing the named beneficiaries at the end of the term is zero for gift tax purposes. If the grantor dies during the term, the value of the annuity payments paid to the grantor’s estate will be included in his/her estate for estate tax purposes. The estate tax exposure can be reduced if the payments received by the grantor’s estate are paid to his/her spouse, because then the estate will receive an offsetting marital deduction. The concept of a “zeroed-out GRAT” was allowed in a case involving the Walton family of Wal-Mart fame. A zeroed-out GRAT offers a virtually risk-free way to shift any excess income and appreciation on the assets contributed to the GRAT to the grantor’s family. As mentioned above, if the GRAT assets produce a return in excess of the IRS interest rate and the grantor outlives the term, the extra appreciation passes gift tax-free to the grantor’s family. If the GRAT assets under perform, the assets will be returned to the grantor to satisfy the annuity payments, but the grantor is in no worse a position than when he/she started.
Third, if the IRS were to successfully claim (upon a gift tax audit) that the value of the property transferred to the GRAT was greater than the amount reported on the gift tax return (Form 709), the annuity amount, expressed as a percentage of the (now higher) initial amount transferred to the GRAT, would automatically adjust upward. This adjustment would minimize the additional gift. Thus, a GRAT is particularly useful for hard-to-value assets.
Finally, a GRAT can be designed as a so-called “grantor” trust. If so, the grantor will not be taxed separately on the annuity payments. Instead, the grantor will be taxed on all of the GRAT’s income and capital gains. These tax payments are essentially tax-free gifts from the grantor to the beneficiaries of the GRAT.
Summary
While there is a present lapse in the estate and generation-skipping transfer taxes, it’s likely that Congress will reinstate both taxes (perhaps even retroactively) some time during 2010. If not, on January 1, 2011, the estate tax exemption (which was $3.5 million in 2009) becomes $1 million, and the top estate tax rate (which was 45% in 2009) becomes 55%. But, the gift tax was not repealed. The gift tax exemption is fixed at $1,000,000. Thus, GRATs will continue to be useful to leverage the amount a grantor can give.
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Julius Giarmarco, J.D., LL.M, is an estate planning attorney and chairs the Trusts and Estates Practice Group of Giarmarco, Mullins & Horton, P.C., in Troy, Michigan.
For more articles on estate and business succession planning, please visit the author’s website, www.disinherit-irs.com, and click on “Advisor Resources”.
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