Tag Archives: Discount

Grantor Retained Annuity Trust (GRAT) Strategy

The acronym “GRAT” stands for the term “grantor retained annuity trust.”  As the name indicates, a GRAT is a trust (an irrevocable trust) to which the grantor (i.e., the person who creates the trust) transfers property but retains the right to receive a fixed annuity from the trust assets for a certain number of years.  The fixed annuity amount is a percentage of the initial value of the assets transferred to the GRAT.  At the end of the term of the GRAT, the remaining property in the trust (net of the annuity payments) passes to the remainder beneficiaries (e.g., the grantor’s children); provided, however, that the trust property will revert to the grantor’s estate if the grantor dies during the term of the GRAT.

Pursuant to IRS regulations, the value of the “gift” of the remainder interest is determined when the GRAT is created.  As described above, the remainder interest is the assets remaining in the GRAT, net of the annuity, when the term of the GRAT expires.  The value of the remainder interest for federal gift tax purposes is equal to (a) the value of the initial principal contribution to the GRAT, PLUS (b) a fluctuating theoretical interest rate earned on the principal (called the “section 7520 rate” after the Internal Revenue Code section which establishes the rate), MINUS (c) the value of the annuity payments to be made during the term of the GRAT.

GRATs are especially beneficial when, as is the case currently, interest rates (and the corresponding section 7520 rate) are low because the annuity paid to the grantor is less than it would otherwise be if the section 7520 rate were higher.  The section 7520 rate is currently only 2.0%.  If the rate of return on the GRAT assets during the term of the GRAT exceeds the applicable section 7520 rate, the remaining trust property after payment of the annuity amounts will be distributed tax-free to the remainder beneficiaries.  Therefore, the strategy with a GRAT is to contribute property to the GRAT which will either appreciate or produce income at a rate substantially in excess of the section 7520 rate.

We often use a “zeroed-out GRAT” to reduce the value of the remainder interest for federal gift tax purposes to zero at the time the grantor funds the trust.  Of course, if we reduce the remainder interest to zero, we must structure the zeroed-out GRAT so that the grantor’s retained interest is approximately equal to the value of the property transferred to the trust.  This results in an annuity equal to the value of the property transferred to the GRAT plus the assumed section 7520 rate.  If the trust property appreciates faster than the section 7520 rate any excess appreciation passes to the remainder beneficiaries free of gift and estate tax as long as the grantor survives the term of the trust.  Under the IRS Regulations, the annuity amount does not have to be the same amount for each year.  But, variations in the annuity amount from year to year may not exceed 120 percent of the amount payable in the previous year.

The length of a GRAT’s term is an important planning consideration.  The shorter the trust term, the more likely it is that the grantor will survive it.  The longer the term, the greater chance that the grantor will not survive it and the property will be included in the grantor’s estate.  However, with a long-term GRAT it is possible to lock in a low section 7520 rate for an extended period.  Also, if a trust’s term is too short, the chance that the property will appreciate diminishes and so does the amount of property passing to the remainder beneficiaries.  One solution to balance some of these risks is for the grantor to create a series of short-term GRATs and reinvest the annuity payments in the successive trusts.  This “rolling GRAT” approach manages the probability of failure by increasing the odds that the donor will survive the trust term and heightens the chance that the property will appreciate over the collective terms of the GRATs.  Note, however, that the rolling GRAT strategy still exposes the grantor to the risk of section 7520 rate increases.

A grantor should fund a short-term GRAT with property that he or she expects to appreciate rapidly.  For example, if a grantor owns a closely-held business and anticipates an initial public offering (IPO) in the near future, the grantor could contribute the stock of the company to the GRAT.  The remainder beneficiaries would then benefit from the appreciation resulting from the IPO during the term of the trust.

The grantor may also want to fund the GRAT with assets that the grantor can discount for gift tax purposes.  Examples include fractional interests in real estate, unmarketable assets such as stock in a closely-held company, and family limited partnership interests.  If the grantor can reduce the value of the asset at the time of funding, the taxable gift will also be lower.  If the business or property is sold at full value or even at a premium during the trust term then there will be substantial assets remaining in the GRAT for the remainder beneficiaries at the end of the trust term.

The fair market value of any non-cash assets initially transferred to a GRAT must be determined.  For example, real estate and unmarketable securities (such as stock or other interests in closely-held companies) must be appraised.  If the value of the asset is to be discounted, a second valuation is generally required to determine the amount of the discount.  Likewise, the trustee must determine the fair market value of any non-cash assets distributed to the grantor as part of an annuity payment.  Just as some assets may be discounted when they are contributed to the GRAT, they will likewise be discounted when they come out of the GRAT as part of an annuity payment.  Distributing discounted assets to the grantor as part of an annuity payment can substantially reduce the potential benefit of the GRAT and is generally discouraged.

In March 2010, a bill passed in the House of Representatives that would radically change some of the aforementioned GRAT strategies.  The bill would, among other things, require GRATs to have a minimum term of ten years and would prohibit zeroed-out GRATs.  Although the bill failed this time around, there is a strong likelihood that it will surface again.  Therefore, the window for establishing short-term GRATs may be closing in a matter of months.  If you have any interest in establishing a short-term GRAT, please contact Woodburn and Wedge.

by Don L. Ross, Esq.