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Grantor Retained Annuity Trust (GRAT)

A GRAT is an effective strategy to transfer assets to the client’s family or other loved ones with minimal to no gift tax. A GRAT is an estate planning technique that may be appropriate for that purpose.

DESCRIPTION OF THE GRANTOR RETAINED ANNUITY TRUST

Introduction. A grantor retained annuity trust (“GRAT”) is an estate planning technique which enables taxpayers to make gifts to family members or loved ones through the use of a trust. A GRAT involves a gift or transfer of property to a trust in which the creator of the trust (the “grantor”) retains the right to receive an annuity for a term of years, while the remainder interest in the trust passes to other family members/beneficiaries (such as children or grandchildren, or trusts for their benefit) upon the termination of the initial term of the GRAT. Because the grantor retains an annuity interest, the value of the gift or remainder interest is generally reduced, so there is little or no gift tax consequence upon creation of the GRAT and transfer of assets into the GRAT. When the grantor’s retained term interest ends, the GRAT terminates and all assets are distributed either outright to, or to a different trust for the benefit of, the remainder beneficiaries, generally the family members of the grantor.

If the property transferred to a GRAT has an overall investment performance that exceeds the Internal Revenue Code Section 7520 Rate in effect at the time of the creation of the GRAT, the return on the investment in excess of the Section 7520 Rate will be passed on to the remainder beneficiaries, generally free of gift tax. If the annual investment performance of the GRAT assets does not exceed the Section 7520 Rate, all of the GRAT assets will be returned to the grantor in satisfaction (or partial satisfaction) of the retained annuity interest, and the grantor will be in the same position economically, as if the GRAT had never been established. The Section 7520 rate is used for determining the present value of annuities, life estates, term estates, and remainder interests. It is determined by the Internal Revenue Service monthly. The Section 7520 Rate in effect for a given month is used in determining the present value of these kinds of interests in transactions that occur during that month.

In order for the GRAT to achieve its goal of shifting wealth to the remainder beneficiaries, the grantor must survive the trust term. If the grantor dies during the trust term, the assets of the GRAT will be included in the grantor’s gross estate and will be subjected to estate tax.

Income Tax Issues. A GRAT is a “grantor trust” for income tax purposes, during the initial term of the GRAT, the result of which is that the grantor will be taxed on the GRAT’s income. This is often viewed as an additional benefit from a wealth transfer perspective since the grantor will pay income tax on property that remains in trust, thereby enhancing the value of the property passing to the remainder beneficiaries without any additional gift tax.

Gift Tax Issues. The grantor will be deemed to have made a taxable gift to the remainder beneficiaries upon the creation of the GRAT. However, by properly structuring the term of the GRAT and the amount of the retained annuity, the grantor can minimize the actuarial value of the remainder interest to insure that the taxable gift will be nominal.

Estate Tax Issues. If the grantor does not outlive the retained annuity term, some or all of the GRAT assets may be included in his or her gross estate.

Rolling GRAT’s. As discussed above, the grantor will receive an annuity payment during each year of the GRAT term. If the grantor believes that the assets distributed in satisfaction of the annuity payment still have significant appreciation potential, he or she can transfer those assets to a new GRAT for the benefit of the remainder beneficiaries. This GRAT will simply be a mirror of the initial GRAT, although the annuity rate might differ depending upon the Section 7520 Rate then in effect. This technique is designed to ensure that the assets remain in the leveraging technique for as long as it is economically feasible. Practitioners commonly refer to this strategy as a “rolling GRAT” or a “cascading GRAT” because the grantor “rolls” his or her annuity payments into another GRAT year after year. In addition to the annuity payments, the grantor may make more transfers into the GRAT if desired.

Primary Advantages and Disadvantages of the GRAT. The primary advantages and disadvantages of the GRAT are as follows:

Primary Advantages

  • The GRAT does not typically result in a large taxable gift.
  • The GRAT is specifically authorized by the Internal Revenue Code and is a relatively conservative estate planning technique.
  • If the assets depreciate in value, all of the assets are returned to the grantor in the form of annuity payments and the grantor is no worse off than had he or she done nothing (except for any associated transaction costs).
  • To the extent that the assets possess additional appreciation potential, the grantor can “roll” an annuity payment (or additional assets) into a new GRAT in an attempt to shift that additional appreciation to descendants.
  • Since the GRAT is a grantor trust for income tax purposes, the GRAT is not required to file a separate income tax return.  The grantor reports the income from the GRAT on his/her income tax return.  This again is a “good” planning strategy, as assets are paid from the grantor’s estate, and not from the trust assets. In essence, it is like an additional gift to the trust without the imposition of the gift tax rules.

Primary Disadvantages

  • The trust assets must generate a rate of return in excess of the Section 7520 Rate in order for the GRAT to be successful and transfer assets to the remainder beneficiaries.
  • The GRAT is not an effective tool for generation-skipping transfer tax planning (absent a sale of the remainder interest to a GST-exempt trust).
  • Although the annuity can be “back-end loaded” by up to 20% (i.e., the early annuity payments are smaller than the later annuity payments), assets must be returned to the grantor on a more rapid basis than under other types of wealth-shifting transactions.
  • The grantor must survive the term of the GRAT. The IRS takes the position that all GRAT assets are included in the grantor’s gross estate if the grantor dies during the GRAT term.
  •  If the GRAT assets do not generate sufficient cash flow to satisfy the annual annuity payments, the trustee must either borrow funds from a third-party lender or make an in-kind distribution of assets in order to satisfy those payments. If the assets are difficult to value, a formal appraisal will be required.

Contact the Majors Law Firm, P.C. to learn more about the benefits of setting up Grantor Retained Annuity Trust.

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