Grantor Retained Annuity Trust: A Tax-Efficient Way to Pass the Fruit of the Tree to the Next Generation
 
October 23, 2003
 
Nancy T. Hegarty- Boston

Millions of homeowners have taken advantage of the current low interest rate environment by refinancing their home mortgages. Low interest rates also make certain estate planning vehicles particularly attractive. A Grantor Retained Annuity Trust (GRAT) is one such vehicle that may facilitate the transfer of wealth to the next generation with little or no transfer tax cost.

A GRAT is an irrevocable trust funded with a single contribution of assets, which pays a percentage of the initial contribution, either fixed or with a predetermined increase (the annuity), back to the donor for a term of years, and then distributes the assets remaining at the end of the term to beneficiaries other than the donor. 

The objective of a GRAT is to shift future appreciation on the assets contributed to the GRAT to others at a minimal gift tax cost.  For the strategy to be successful, the assets transferred to the GRAT must appreciate at a rate greater than the IRS assumed rate of return.  The difference between the actual rate of return on the investment and the IRS assumed rate of return will pass, gift tax free, to the beneficiaries at the end of the GRAT term. 

With this estate planning vehicle, a donor transfers assets to a trust from which the donor retains the right to receive an annuity for a set period of time (for example, four years), after which time the remainder passes to the donor’s children or other beneficiaries, either outright or in trust.  Under the terms of the GRAT, the donor retains the right to receive an amount equal to the value he or she  transferred to the GRAT plus interest, and the remainder beneficiaries receive everything in excess of that value. 

By way of illustration, assume a donor transfers $1,000,000 of assets to a four-year GRAT in a month in which the IRS assumed rate of return, determined monthly, is four percent.  The GRAT will provide for four annual annuity payments of 27.5 percent of the value of the assets initially contributed to the GRAT ($275,489).  If the assets in the GRAT do not yield sufficient income to fund the annuity payments, principal of the trust will be distributed back to the donor to satisfy the payments.  At the end of the four- year period, the beneficiaries will receive the remainder of the trust.  

The taxable gift resulting from the transfer of property to the GRAT is the present value of the remainder interest, determined using the four-percent, IRS-assumed rate of return.  Under the facts in the example, the taxable gift is minimal because, given the high annuity payout level, the donor will receive back almost all of the trust assets if they earn the assumed four-percent-investment return, and the gift tax is based on the anticipated  remainder value of the GRAT at the end of the annuity period.  Based on the IRS’ computation method, under the above example the donor’s taxable gift would be de minimis, and would use a negligible amount of the donor’s exemption from federal gift tax.  A so-called “zeroed out GRAT” is a GRAT in which the annuity payment is calculated to produce no taxable gift.

Assuming the GRAT in the example had an actual annual investment return of 20 percent, at the end of the four-year term, $594,771 of assets would be left in the GRAT for the benefit of the donor’s children after the required annuity payments are made to the donor.  Measured against the use of a negligible amount of exemption from federal gift tax at the creation of the GRAT, this is an outstanding result from a gift tax standpoint. 

If the trust assets do not appreciate as expected and the GRAT has a rate of return of, say two percent, the donor will receive back all of the trust assets through the annuity payments, and nothing will be left for the benefit of the remainder beneficiaries; but the donor will not have wasted an appreciable amount of his or her exemption from federal gift tax.  Comparing the favorable result in the preceding paragraph against the unfavorable scenario highlights a key tax benefit of the GRAT – when it works, the results are excellent, and when it does not work, the loss is minimal.  Based on this characteristic, a GRAT would be an excellent vehicle to hold a highly speculative investment that has the potential for significant appreciation – but also substantial downside risk – or equity investments that are less risky, but still have potential for double-digit appreciation.

There are a few other material tax points to consider regarding the GRAT:

• If the donor dies before the end of the annuity period, the trust assets will be includible in the donor’s estate, and the advantages of the GRAT strategy will be lost.  This favors use of a relatively short annuity period.  In addition, it is generally easier to “beat” the IRS rate of return over a short period than a long period (for example, a 20-percent, annualized rate of return on an investment over a two-year period happens more frequently than a 20-percent, annualized rate of return on an investment over a 10-year period).  Recognizing this fact, the IRS has become sensitive to the use of short-term GRATs, and a two-year annuity term is considered an aggressive strategy.  A four- or five-year term is less aggressive.
   
• A GRAT should be taxed as a “grantor trust” for income tax purposes, and this has several benefits.  First, the donor will report the GRAT income (during the annuity period) on the donor’s individual income tax return and pay the resulting taxes from the donor’s own funds.  Therefore, the GRAT strategy generally will produce gifts to the ultimate beneficiaries if the pre-tax return on its assets exceeds the IRS assumed rate.  Second, as a grantor trust, the GRAT can pay the donor the annuity using appreciated property without the distribution being treated as a taxable sale of the property.  Thus, if the donor funds the GRAT with illiquid stock, the GRAT can make annual annuity payments to the donor in kind, using the stock.
   
• Funding a GRAT with hard-to-value property, such as real estate, partnership interests or shares of a closely held business, poses valuation challenges.  For example, if the donor funds the GRAT with illiquid assets and plans to have the annual annuity payments made from the GRAT by distributing back to the donor assets in kind, rather than selling assets to make the payment, the donor will need to value the assets on the date they are contributed to the GRAT
  and on each annuity payment date thereafter.
   
• It is better to have multiple GRATs, each holding a different investment, than a single GRAT with a diversified portfolio.  This will prevent investments that do not appreciate substantially from diminishing the overall return of the GRAT.  There is no limit on the number of GRATs a person can create.

With a stock market on the rebound and interest rates remarkably low, the GRAT is an exceptional estate planning option deserving of your consideration.

For more information, e-mail Nancy Hegarty at nancy.hegarty@hklaw.com or call toll free, 1-888-688-8500.