A Time to Be GRATful

This article will explore the implementation of a Grantor Retained Annuity Trust (“GRAT”), in general, and provide specific examples of the estate and gift tax treatment of the transfer of assets to a GRAT. GRATs are a well-established estate planning strategy used to reduce the size of a client’s taxable estate.

A. What is a GRAT?

At a high-level, a GRAT is a wealth transfer technique in which an individual (the grantor) transfers assets to an irrevocable GRAT, while retaining the right to a fixed payment (an annuity) from the GRAT for a period of time (the term). At the end of the annuity term, the assets in the trust go to the remainder beneficiaries selected by the grantor.

The estate and gift tax treatment of the transfer of assets to a GRAT depends on the value of the annuity payments retained by the grantor.

• If the value of the payment stream that will be received by the grantor is less than the value of the property transferred to the GRAT in the first place, the difference will be a taxable gift by the grantor to the remainder beneficiaries. For example, if the value the grantor will receive for the term of the GRAT is worth $695,00, but the value of the property actually transferred to the GRAT is $1,000,000, then the difference of $305,000 ($1,000,000 – $695,000) is the taxable gift to the remainder beneficiaries.

• If the value of the payment stream that will be received by the grantor is equal to the value of the assets contributed to the GRAT, then there are no gift taxes on the transfer. This kind of GRAT is sometimes called “zeroed-out.”

While the payments from the GRAT back to the grantor can in theory be scheduled to last for the lifetime of the grantor, typically GRATs are structured for a term of years. Such a GRAT is sometimes called a “fixed GRAT” or a “fixed-term GRAT.”

B. Determining the Value of the “Gift” to the GRAT

The transfer of property to the GRAT typically involves a current gift to the remainder beneficiaries for gift tax purposes, even though the remainder beneficiaries don’t receive anything until after the end of the specified GRAT term. To determine if a gift is involved (and how much), first the grantor determines the current value of the fixed annuity payments (the “annuity interest”) and then subtracts that from the total value of the transfer to the trust. The difference, if any, is a gift to the remainder beneficiaries as of the date the GRAT is created and funded.

The Internal Revenue Service (“IRS”) publishes interest rates monthly that are used in valuing the annuity interest. With proper planning, GRATs can be designed so that the gift to the remainder beneficiaries is greatly reduced or entirely eliminated.

C. How Does a Typical GRAT Work?

Implementing a GRAT usually involves these steps:

1. The grantor creates a grantor trust.

This grantor trust is an irrevocable trust specially designed so that the trust assets are excluded from the grantor’s estate for estate tax purposes, but the assets are treated as belonging to the grantor for income tax purposes (discussed further below).

2. The grantor transfers assets to the trust in exchange for an annuity.

After creating the trust, the grantor transfers assets into the trust in exchange for an annuity – that is, a stream of payments. The initial contribution to the GRAT cannot be changed (however, the grantor is not prohibited from transferring or exchanging assets of equal value for assets of the GRAT). The grantor’s income tax basis in the property transferred to a GRAT carries over to the GRAT. Gain or loss will be recognized, and changes in basis will occur, if the trustee changes investments. Assets that are distributed to the remainder beneficiaries at the end of the term of a GRAT have a cost basis equal to the basis in the hands of the GRAT. So if the trustee retains the original property that was first transferred to the trust, the grantor’s original basis will carry over to the remainder beneficiaries.

3. The trust makes annuity payments to the grantor.

The third step is to have the trust make scheduled annual payments to the grantor. The IRS requires GRATs to make “fixed” annuity payments. The payments must be based on either a stated dollar amount (such as $50,000 per year), or a stated percentage of the initial value of the assets contributed to the trust (such as 5% of the trust’s initial value). Although the IRS calls the payments “fixed,” the IRS allows the scheduled payments to systematically increase or decrease by as much as 20% a year.

4. The grantor pays income taxes for the trust.

The grantor pays the income taxes on the GRAT’s income. If the grantor kept the assets, he or she would pay these taxes anyway. As a result the grantor will have to use a portion of the annuity payments, or other funds, to make the necessary income tax payments.

Obligating the grantor to pay the income tax on the GRAT’s income allows more funds to accumulate in the trust, free of tax burden, for ultimate distribution to the remainder beneficiaries at the end of the GRAT term. This payment of the GRAT’s tax burden can be viewed as another gift-tax-free transfer to the GRAT’s ultimate beneficiaries.

5. At end of GRAT’s term, any remaining assets pass to the grantor’s beneficiaries, tax free.

If the grantor outlives the term of the GRAT, the trust assets will pass to his or her identified beneficiaries free of any estate taxes. But if the grantor dies before the GRAT term has expired, then all of the trust assets are brought back into the grantor’s estate for estate tax purposes. [Some grantors hedge against the tax cost of an untimely death by purchasing term life insurance that will not be included in their estate if they die during the term of a GRAT, such as a 5-year term life insurance policy to match a 5-year GRAT].

In summary, using a GRAT provides significant benefits for an individual, at virtually no risk, except for the following:

• Death During the Term of the GRAT: As described, if the grantor dies before the GRAT term has finished, all of the assets may be brought back into his or her estate – but this is what would have occurred if the grantor had not created the GRAT in the first place. Only the legal and accounting costs of establishing the GRAT are at risk.

Investment Risk: When the assets in the trust are invested in such a way that the return on the invested funds exceeds the amount of the annual distributions to the grantor, then value of the assets in trust at the end of the term of the GRAT can be transferred to the remainder beneficiaries estate tax free. However, if the overall return on the invested assets in the GRAT property does not exceed the annual distributions to the grantor, the distributions to the grantor may well completely exhaust the trust, and nothing will remain for distribution to the remainder beneficiaries. Again, the only downside risk to the strategy is the initial cost of establishing it. It is for this reason that assets likely to appreciate in value significantly during the term of the GRAT are the best choice for funding the GRAT.

D. Examples

The foregoing concepts can be better understood with the following examples:

Example A: Assume that a grantor who is 75 years old funds a GRAT with $500,000 in November, 2015. Under the terms of the trust, the grantor receives a $50,000 annuity for 10 years paid quarterly (a 10% payout). If the IRS interest rate in November 2015 was 2%, the grantor’s retained interest would be valued at $452,498.48, and the remainder interest would be valued at $47,501.52 (that is, the initial gift of $500,000, less the value of the retained annuity of $452,498.48).

Thus, the present value of the right to receive a $50,000 each year for 10 years is worth $452,498.48 on the date the GRAT is created, and the present value of the right to receive the remainder at the end of the term, 10 years later, is worth $47,501.52. The value of the remainder interest, $47,501.52, is subject to gift tax upon creation of the GRAT.

Let’s consider how the GRAT actually performs. If the assets in the GRAT return 5% per year in principal appreciation and 2% in income, then at the end of the GRAT term, there should be about $276,394.30 in assets remaining to distribute to the beneficiaries of the GRAT, as demonstrated in the schedule below:

In this case, the grantor ends up transferring $276,394.30 in value to the beneficiaries at a gift tax “cost” of only $47,501.52.

The example below illustrates the gift tax impact where the value of the annuity to the grantor equals the value of the asset contributed to the GRAT. In the example below of a “zeroed-out” GRAT, there are no gift taxes:

Example B. Assume that a grantor who is 60 years old funds a GRAT with $1,000,000 in in November, 2015. Under the terms of the trust, the grantor receives an annual annuity for 10 years of $115,000 (an 11.5% payout). If the IRS interest rate in November 2015 was 2%, the grantor’s retained interest would be valued at $1,000,000, and the remainder interest would be valued at $0 (since the value of the remainder is equal to the amount transferred to the GRAT). Therefore, because the value of the remainder interest is $0, the GRAT is “zeroed out” and no gift tax is due.

Here’s how that GRAT might perform under the same financial conditions as the GRAT in Example A:

In this case, the grantor transfers over $383,000 in value to the beneficiaries entirely gift tax free and without the use of any lifetime gift tax exemption.

The example above was designed to reflect a wildly successful GRAT – it assumes a very low Section 7520 interest rate, an annuity amount calculated to “zero-out” gift tax, a grantor who survives the terms of the GRAT. Therefore, the greater the appreciation on the assets in the GRAT after creation, the greater the transfer tax benefit achieved.

Choosing the right GRAT structure comprises determining the grantor’s need for the annuity payments, the grantor’s health and anticipated longevity, and the likelihood of appreciation of the assets transferred to the GRAT.

E. Some Other Tax Issues

There are some other important tax consequences grantors should be sensitive to when approaching this wealth-shifting strategy.

Income Tax Issues. GRATs are considered “grantor trusts” for income tax purposes. This means that the income received by the GRAT, even amounts in excess of the required annual payments to the grantor, will all be taxed to the grantor. As a result the grantor will have to use a portion of the annuity payments, or other funds, to make the necessary income tax payments. However, being required to pay the income tax on the entire income of a GRAT can be an overall estate planning advantage, as discussed below.

In Example B, above, the GRAT makes annuity payments of $115,000 to the grantor in the first year, which assumes the GRAT increased in value by $70,500. In the first year, the grantor will be taxed on $20,500 in income received (and possibly the $50,000 in capital appreciation if that is “realized” for tax purposes), even though the GRAT paid the grantor $115,000. This is because all tax items such as income and capital gain realized by the GRAT during the annuity term are taxed to the grantor on his or her personal income tax return. And since the grantor is considered the owner of the trust assets for income tax purposes, the actual annuity distributions are not taxable to the grantor because the passing of assets between the grantor and the trust does not constitute a taxable event.

But the upside from a wealth transfer standpoint is that obligating the grantor to pay the income tax on all GRAT income allows more funds to accumulate in the trust, free of tax burden, for ultimate distribution to the remainder beneficiaries at the end of the GRAT term. That is, the grantor’s payment of income tax on GRAT income is not considered a gift by the grantor to the GRAT remainder beneficiaries. This payment of the GRAT’s tax burden can be viewed as another gift-tax-free transfer to the GRAT’s ultimate beneficiaries.

Income Tax Basis. The grantor’s income tax 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 remainder beneficiaries 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, as discussed above, the grantor’s original basis will carry over to the remainder beneficiaries.

If the grantor dies during the term of a GRAT, the GRAT’s assets will receive a new basis to the extent they are included in the grantor’s estate. Generally, 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 gross estate—usually its fair market value on the date of the decedent’s death. This rule has resulted in a “free” step-up in basis.

Estate Tax. As noted above, if the grantor dies prior to the expiration of the GRAT term, the IRS takes the position that the value of the property in the trust will be included in the grantor’s estate at the property’s fair market value on the date of the grantor’s death. Some grantors hedge against the tax cost of an untimely death by purchasing term life insurance that will not be included in the estate if the grantor dies during the term of a GRAT (e.g., a 5-year term life insurance policy to match a 5-year GRAT).

F. What If There Isn’t Enough Income to Pay the Annuity?

The GRAT has the legal obligation to make the annuity payments for the term of the GRAT. If the assets in the GRAT do not earn enough interest or 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 make the required payment. Or the trustee might make distributions “in kind” to the grantor.

Even though the transfer of the original property back to the grantor does not require the recognition of any capital gain, returning property back to the grantor may defeat the purpose of the plan in the first place. If the grantor receives back the property she was trying to dispose of in the first place (such as stock in a closely held business), the failure of the assets in the GRAT to generate sufficient income to make the annuity payments can thwart the estate planning goals of the grantor.

G. The IRS and GRATs

In 2015, the IRS issued its “General Explanations of the Administration’s Fiscal Year 2016 Revenue Proposals” – occasionally less formally called the “Green Book.” This document explains some of the assumptions that are built into the President’s budget. While the Green Book is not the law, it represents the current Administration’s thinking on various tax topics, puts taxpayers on notice that certain changes in tax law might be coming, and could also impact the above discussion of GRATS:

• First, the proposal in the Green Book would require that taxpayers shoulder some real downside risk when using GRATs. The Administration suggested that GRATs should have a minimum ten year term and a maximum term equal to the life expectancy of the grantor plus ten years. This would increase the risk of the grantor’s death during the GRAT term, resulting in the loss of anticipated transfer tax benefits. It would also eliminate some of the perceived abuse with so-called 2-year “rolling” GRATs.

• The concept that GRATs could be used to transfer substantial amounts of value at no tax cost whatsoever, while actuarially sound, has long been disturbing to the IRS. The Administration’s proposal would therefore mandate that the remainder interest in the GRAT at the time of creation have a minimum value equal to the greater of: (a) 25% of the value of the assets contributed to the GRAT or (b) $500,000 (but not more than the value of the assets contributed). A GRAT funded with $1,000,000 would therefore require a remainder interest of $500,000 (the greater of $250,000 and $500,000).

H. Conclusion

The current environment of low IRS interest rates has created a favorable environment for GRATs. GRATs can be a powerful estate planning tool in the right circumstances, and as noted above, can be deployed at very minimal tax risk with substantial tax savings.