Grantor Retained Annuity Trusts (GRATs), or, How to Make Gifts at Little or No Gift Tax Cost Another Tax Advantaged Way to Give Property
I. GRATs Defined
GRATs are a special type of trust, first authorized by Congress in 1990, that can greatly reduce the tax cost of making gifts. Importantly, recent developments confirm that GRATs can be planned that entirely eliminate gift tax costs. GRATs are particularly attractive because they have essentially no downside risk.
A GRAT is a trust created by a person (the grantor), who retains the right to receive fixed annual payments for a specified term of years. At the end of the specified term the property of the GRAT is either distributed outright to the designated beneficiaries (the "remaindermen" of the trust) or retained in trust for their benefit. The transfer of property to a GRAT may involve a gift to the remainderman for gift tax purposes. Whether there is a gift is determined by deducting the actuarially determined value of the grantor's retained term interest from the total value of the property transferred to the trust. The difference, if any, is a gift to the remaindermen. The method of determining whether a gift is involved allows GRATs to be planned so the gift to the remaindermen is greatly reduced or entirely eliminated. The gift element is entirely eliminated if the gift is "zeroed-out" (i.e. there is no gift if the actuarial value of the grantor's interest equals the full value of the property transferred to the trust).
The potential of a zeroed-out GRAT is illustrated by the following example. As the example indicates, there is almost no downside tax risk to creating a GRAT.
Example 1. Grantor (G) transfers property worth $1 million to a GRAT that will pay G $129,500 per year for a term of 10 years at the end of which the GRAT will terminate and the property will be distributed to G's children. If the IRS prescribed interest rate was 5.0% at the time the GRAT is created (the applicable rate, which changes monthly, has fluctuated between 1.8% and 8% since 2000), the value of the annuity that G retained interest will be roughly equal to the full value of the property that G transferred to the GRAT. (i.e., the GRAT is "zeroed out".) Accordingly, for gift tax purposes, the creation of the GRAT does not involve a gift.
Note that if the grantor survives the term of a zeroed-out GRAT, the GRAT will have property available for distribution only to the extent the property in the GRAT appreciates at a rate greater than the rate (5.0% in this example) that was assumed when the GRAT was created. Thus, if G survives the retained term, his children will receive the property (if any) then held in the GRAT. Thus, if the property generates an annual return of at least 12.95%, G's children will receive the entire principal of the trust—which itself may have increased dramatically in value over the term of the GRAT.
If G dies before the retained interest expires (ten years), the IRS contends that the entire value of the trust is includible in the G's estate. Although the IRS position is currently being challenged, one should plan with the IRS position in mind. Note, however, the downside risk for a grantor such as G is very limited. If G dies during the retained term and the IRS succeeds, the GRAT property will be included in G's estate, which is what would occur if G had not created the GRAT. Essentially only the costs of creating the GRAT are at risk.
Elements of a Successful GRAT. As indicated by the example, a GRAT unquestionably succeeds in transferring property to the remaindermen at little or no tax cost if the grantor survives the retained term and the total return generated by the property exceeds the interest rate greater than the rate that applied in valuing the remainder interest when the GRAT was created. If the grantor does not survive the term of the GRAT, the IRS contends that the GRAT property is all includible in the grantor's estate. If the overall return on the GRAT property does not exceed the assumed rate, distributions to the grantor will completely exhaust the property—nothing will remain for distribution to the remaindermen. As illustrated by the following example, a prime candidate for transfer to a GRAT might be property that generates an annual income that exceeds the amount of the annual annuity payments. Thus, if a GRAT is funded with stock that pays annual dividends that are sufficient to make the annuity payments, at the end of the term the beneficiaries will receive the entire principal of the trust.
Example 2. If G transfers $1 million in stock that pays an annual 12.95% dividend to the GRAT described in Example 1, the dividend itself will be sufficient to fund the annual annuity payments. At the end of the 10 year term of the GRAT G will have received payments of $1,295,000 and the stock will remain on hand to be distributed to G's children. The payments to G will, of course, be includible in G's estate unless they are disposed of before G dies. Most important, the stock, which might be worth $4 or $5 million, will be distributed to G's children without the payment of any gift or estate tax.
The property that will be transferred to a GRAT and the key terms of the GRAT must be carefully selected. If the grantor believes that the assets placed in the GRAT will have a total return (dividends and appreciation) that exceeds the IRS prescribed rate, the grantor will have transferred property to his or her children to the extent of the difference, almost entirely free of the estate and gift tax.
II. Tax Issues
Whether a GRAT is an appropriate estate planning technique must be determined in light of several important tax issues.
Income Tax Issues. The income received by the GRAT, even amounts in excess of the required annuity payments to the grantor, will all be taxed to the grantor. That is, the grantor will have to use a portion of the annuity payments, or other funds, to make the necessary income tax payments. As explained below, being required to pay the income tax on the entire income of a GRAT can be an overall estate planning advantage.
Example 3. If the GRAT makes annuity payments of $129,500 per year to G, but receives a total of $150,000 of dividends and interest, G will be taxed on the full $150,000. This occurs even though the GRAT pays G only $129,500. The excess of $20,500 remains in the trust and is added to principal.
Requiring the grantor to pay the income tax on the excess income of a GRAT allows more funds to accumulate in the trust for distribution to the remaindermen (or trusts for their benefit) at the end of the GRAT term. On the other hand, the requirement subjects the grantor to an additional income tax burden if the income earned by the GRAT should exceed the annuity payment. Flexibility can be added by allowing the trustee of a GRAT to distribute additional funds to the grantor equal to the income tax on the extra income.
Estate Tax. If the grantor dies prior to the expiration of the GRAT term, the IRS takes the position that the entire value of the property in the trust will likely be included in the grantor's estate at its fair market value on the date of the grantor's death. Some grantors hedge against the tax cost of an untimely death by making funds available to purchase term life insurance that will not be included in their estate if they die during the term of a GRAT. Again, if the grantor lives until the end of the GRAT term, the property in the GRAT will be distributed to the remaindermen completely tax free (i.e., the property will not be included in the grantor's estate).
Income Tax Basis. The grantor's basis in the property transferred to a GRAT carries over to the trustee. Gain or loss will be recognized and changes in basis will occur if the trustees change investments. Assets that are distributed to the remaindermen at the end of the term of a GRAT have a cost basis equal to the basis in the hands of the trustee of the GRAT. Thus, if the trustee retains the original property that was transferred to the trust, the grantor's original basis will carry over to the remaindermen.
If the grantor dies during the term of a GRAT the assets will receive a new basis to the extent they are included in the grantor's estate. Under general principles the basis of an asset that is included in a decedent's gross estate is the value at which it was included in the decedent's estate—usually its fair market value on the date of the decedent's death. Historically the application of this rule has resulted in a "free" step-up in basis.
Authority for GRATs Continues. GRATs are explicitly authorized by federal statute. Several bills have been introduced in Congress that would limit the benefits of gifting through the use of GRATs, but none of them have been passed. To date, the IRS has ruled favorably on a wide range of issues involving GRATs. IRS inquiries regarding GRATs tend to focus on the propriety of the valuations used for the properties contributed to GRATs.
III. Operational Issues
A variety of issues bear on the operation of the GRATs once they are established.
Payment of Annuity Amount. The GRAT will have the obligation to make annuity payments throughout the term of the GRAT. If the assets in the GRAT do not earn enough dividends to make the required annuity payment, the trustee of the GRAT will have to satisfy the obligation in other ways. For example, a trustee might borrow funds to the extent required, secured by the property of the trust. Alternatively, the trustee might make distributions in kind to the grantor. The IRS has, helpfully, approved satisfying the annuity payments by making distributions to the grantor of property in kind, including interests in the property originally transferred to the trust. Such distributions in kind can be made without the recognition of gain or loss by the trustee or the grantor.
Example 4. If the GRAT requires annuity payments of $129,500 per year, and the GRAT only earns $50,000 in a year, the trustee of the GRAT would have to make up the other $79,500. The amount could be satisfied by transferring to the grantor property in kind that is worth $79,500. In some cases the trustee may borrow funds for the purpose of making the payments—which can help preserve the benefits of a GRAT.
Even though the transfer of the original property back to the grantor does not require the recognition of any capital gain, returning the property to the grantor defeats the purpose of the plan: Instead of making cash annuity payments back to the grantor, the grantor receives back the property that he or she was trying to dispose of in the first instance. Thus, the failure of the assets in the GRAT to generate sufficient income to make annuity payments can have an adverse impact on the estate planning goals of a GRAT.
IV. Other Estate Planning Options
The issue really is how much should one rely upon GRATs as the ultimate estate planning tool. Property that is transferred to a GRAT is not available for other planning options, such as outright gifts or installment sales to family members. Those, and other options, should be considered and, perhaps, utilized along with, or in place of, a GRAT. Other popular options include acquiring life insurance policies through irrevocable trusts and the establishment of family limited partnership or limited liability companies in order to facilitate the transfer of wealth among family members in a coordinated manner that accomplishes a number of business and planning objectives. While GRATs are only one option, they are often a very good one, particularly in a low interest rate environment.
There is little doubt that a GRAT can be a highly effective and valuable tool for the transfer of wealth. However, GRATs are not for everyone. The suitability of a GRAT depends upon the circumstances of each client and the thoughtful consideration of a wide range of tax and nontax factors.
© 2011 Perkins Coie LLP