A Grantor Retained Annuity Trust (GRAT) is an estate planning technique particularly attractive in a low interest rate environment such as we are experiencing. It allows an individual to make large gifts without paying gift tax or using any unified credit. Many families have used short-term GRATs to shift appreciation to beneficiaries with no estate or gift tax cost.
The technique is so successful that Congress has had this planning technique in its sights for a while, and it looks like the use of short-term GRATs will be curtailed soon. Legislation already passed the House July 1 and is expected to be considered soon by the Senate which would provide: (1) a GRAT must have a minimum 10 Year Term, (2) annuity payments paid back to the grantor can not decrease over the 10 year term, and (3) the remainder interest must have a value greater than zero at the time of the transfer to the GRAT.
The legislation that passed the House provides that the measure is effective for "transfers made after the date of the enactment of this Act." That means that there is still time to use this technique, but you must act quickly.
What is a GRAT?
A GRAT is an irrevocable trust. The creator of the trust, the Grantor, transfers assets to the trust. For a specified term of years, the GRAT must pay an annuity to the Grantor (hence, the "retained annuity"). At the end of the term, the balance remaining in the trust is paid to the beneficiaries. The term of the trust and the amount of the annuity are chosen to make the actuarial value of this gift to the beneficiaries very small. Here is an example:
Grantor transfers $3 million in assets to a 3-year GRAT. The asset transferred is expected to appreciate at the rate of 12% per year. To "zero out the GRAT," each year the GRAT is required to pay $1,056,523 to the Grantor. Since the Grantor can't make a gift to himself, the only gift made is the actuarial value of the remainder interest which is valued at zero. If we assume that the asset contributed to the GRAT grows at the rate of 2.8% per year (which is the current IRS §7520 rate for transfers to GRATs made this month), then at the end of the 3 year term, the Grantor would have received back all of the trust's property as annuity payments. The remaindermen would get nothing. The value of the gift that the Grantor made is thus zero.
However, if the asset in fact appreciated or earned income at the rate of 12% per year, then there would still be $649,650 remaining in the trust. This $649,650 is distributed to the beneficiaries at the end of the 3-year term completely free of gift and estate tax. The greater the growth of the assets inside the trust, the bigger the tax savings. In effect, all growth in excess of the IRS stated rate of 2.8% passes to the beneficiaries estate and gift tax free. If the Grantor can put $10 million in the GRAT the beneficiaries receive $2,165,500 free of estate tax.
For this tax saving technique to work, the Grantor must survive the chosen term of 3 years. If the Grantor dies during the 3-year term, the trust is included in his or her estate. That is one of the reasons why it is preferable to do shorter term GRATs.
If the GRAT asset does not outperform the IRS §7520 interest rate (now 2.8%), then there will be no tax savings. What is the downside? Only the transaction costs of setting the GRAT up and maintaining it . (Translation: attorney fees.)
It is not necessary for the annuity to be paid in cash. Let's say the Grantor transfers stock to the GRAT, perhaps even stock in his or her closely-held business. The annuity obligation can be satisfied by transferring shares of stock back to the Grantor, valued at the time of the payment.
The Grantor can be the Trustee of the GRAT. (Caution: The Grantor should not be the trustee if stock in a closely-held corporation is transferred to the GRAT.) Payment at the end of the term of years need not be outright to the beneficiaries. There could be a continuing trust for beneficiaries. With limited trustee powers, the Grantor could even be the Trustee of the trust after the expiration of the term.
There is an additional income tax advantage. Since all of the GRAT's income is paid to the Grantor, the GRAT is a Grantor trust for income tax purposes. The Grantor pays the income tax on any income earned by the trust. This is an additional estate planning advantage because this tax payment is really for the benefit of the remainder beneficiaries and, yet, it is not treated as a gift.
Because the GRAT allows the remainder beneficiaries to receive the appreciation on all of the trust property, it produces a much better tax result than an outright gift. Other gifts either use up the exemption or cause the payment of gift tax. A properly structured GRAT can shift very significant value to beneficiaries for no tax cost at all.
The important thing is that if a GRAT would be a good planning opportunity for you, act now. The days for GRATs are numbered.