What is a Grantor Retained Annuity Trust?
A grantor retained annuity trust (GRAT) is a special type of irrevocable trust that allows the trustmaker/grantor to gamble against the odds. If the trustmaker/grantor plays his cards right, then a significant amount of wealth can move down to the next generation with virtually no estate or gift tax ramifications.
How Does a GRAT Work?
Here is a general overview of how a GRAT works:
1: The trustmaker/grantor transfers specific assets into the name of the GRAT and, as the name suggests, retains the right to receive an annual annuity payment for a certain number of years. When the term of the GRAT ends, what is left in the GRAT is distributed to the trust beneficiaries (children or other beneficiaries of the trustmaker/grantor’s choice).
2: The amount of the annuity payment that is required to be paid to the trustmaker/grantor during the term of the GRAT is calculated by using an interest rate the IRS determines monthly called the section 7520 rate. The section 7520 rate for August 2018 is 3.4 percent. For a chart showing historical and current section 7520 rates, refer to Key Rates / Valuation on the Leimberg.com website.
3: The trustmaker/grantor can set the annuity payment so that it will be exactly equal to the section 7520 interest rate, meaning that all of the assets that have been transferred into the GRAT will theoretically be returned to the trustmaker/grantor in the form of the annuity payments and nothing will be left for distribution to the children or other beneficiaries when the GRAT ends. The transfer of assets owned by someone into an irrevocable trust for the benefit of someone else would ordinarily be deemed a gift for federal gift tax purposes, but with a GRAT, since theoretically all of the assets transferred in could come back to the trustmaker/grantor, the value of the gift to the beneficiaries of the GRAT will be at or close to $0. This is called a “zeroed-out GRAT.”
4: So why would someone set up a trust for the benefit of someone else but get all of the assets back in the form of annuity payments? This is where gambling against the odds comes into the picture. The trustmaker/grantor is really betting on the fact that the assets transferred into the GRAT will appreciate in value above and beyond the section 7520 interest rate. So while the trustmaker/grantor will receive the annuity payments, the beneficiaries of the GRAT will receive the underlying GRAT assets at their value. It’s the value of those assets that will appreciate over and above the section 7520 rate.
The Drawbacks of Using a GRAT
1: Assets that are expected to appreciate greatly in value above can be transferred into a GRAT and in turn move a significant amount of property down to the beneficiaries of the GRAT when the term ends. There are, however, two downsides to using a GRAT:
2: The assets transferred into the GRAT could grow at a rate lower than the section 7520 rate. If this is the case, then the trustmaker/grantor will simply receive back the trust property at its depreciated value and will only be out the legal fees that were paid to set up the GRAT.
The trustmaker/grantor could die during the term of the GRAT. If this is the case, then all of the property transferred into the GRAT would revert back into the estate of the trustmaker/grantor and be taxable for estate tax purposes, and the trustmaker/grantor will also be out the legal fees that were paid to set up the GRAT.
The downside of the GRAT structure discussed above is that gift tax is determined at the start of the GRAT term. If the assets in the GRAT fail to appreciate at the Sec. 7520 rate, the grantor would have paid gift tax (or used a portion of his or her lifetime credit) on the present value of the remainder interest while transferring few assets to the beneficiaries.
A second alternative GRAT structure uses a zeroed-out, or Walton, GRAT. This structure was made possible as a result of the holding in Walton, 115 T.C. 589 (2000). With it, the grantor sets the annuity payment such that the present value of the annuity stream is equal to the value of the property transferred into the trust. This results in a valuation of zero (or close to zero) for gift tax purposes. A zeroed-out GRAT allows the grantor to transfer any appreciation in excess of the Sec. 7520 rate without using any of the grantor’s lifetime exemption. If the assets fail to appreciate at the Sec. 7520 rate, the only cost to the grantor will have been the legal and administrative costs of setting up the GRAT.
A 10-year GRAT term comes with some risk. The assets need to appreciate faster than the Sec. 7520 rate over the term, and the grantor needs to live past the last payment in the term. To reduce the risk of the grantor’s dying during the GRAT term, he or she can set up a series of rolling, shorter-term zeroed-out GRATs. Without the rolling GRATs, if the grantor dies during the trust term, nothing will pass to the beneficiaries, and the remaining assets are included in his or her estate. However, if the grantor establishes rolling GRATs and dies before the end of the 10-year term, only the value remaining in the active GRATs will be included in his or her estate.
Possible GRAT Changes Ahead
GRATs are excellent vehicles for transferring appreciation to beneficiaries with little to no gift tax cost. They work especially well when interest rates are low. The trusts can be structured with substantial upside and little downside. As a result, GRATs have been the target of potential legislative changes. Specifically, former President Barack Obama, in his fiscal 2010 and 2011 budgets, proposed requiring GRATs to have a minimum term of 10 years and a residual value greater than zero (eliminating zeroed-out GRATs). Similar restrictions were contained in the Small Business and Infrastructure Jobs Tax Act of 2010, H.R. 4849, which was passed by the House of Representatives. Several similar proposals have been made by candidates in the 2020 presidential election. With interest rates expected to rise in the future and a GRAT-friendly Code that could be subject to changes in the next several years, now may be the time to speak with your clients about GRATs in their estate plans.
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