Facebook Billionaires Use GRATs for Estate Plan
We can take a lesson from Mark Zuckerberg and Dustin Moskowitz, the founders of Facebook. Both young, unmarried and with no children, they still did estate planning to save a bundle n estate and gift taxes for their beneficiaries – maybe their as yet unborn children and grandchildren. They used a technique called a Grantor Retained Annuity Trust (GRAT).
GRATs are trust arrangements that seek to make a gift of something to somebody with a greatly reduced gift tax. It is designed for giving someone assets that are going to appreciate much faster than current interest rates. The ideal situation is a transfer of private stock just before it goes public with an initial public offering (IPO) or for the transfer of a company that is going to be bought out by a larger company at a high price.
Gift tax is levied on present interest gifts to people in excess of the exclusion rate of $13,000 per recipient per year. “Present interest” means the recipients get delivery and full control of the gift immediately, not sometime in the future. If a gift is not of a present interest, then there is no exclusion and the donor must use some of his exemption ($5 million this year).
A GRAT works like this. The Grantor creates an irrevocable trust and funds it with assets. He commits to take an annuity payment annually (or more frequently) from it for a number of years. Interest at the then-current rate is assumed to accrue throughout the term of the annuity. At the end of the term of the trust, what is left is either distributed to beneficiaries or to another trust which might include the Trustee’s discretion to pay income and principal to a class of beneficiaries.
If a high enough annuity payment is specified then theoretically there will be little or no money left at the end of the term of the annuity and the gift will be insignificant and therefore the gift tax will be insignificant.
If there is more left than interest rates predicted, then the principal distributions to the remainder beneficiaries will be transfer-tax-free. If a person funds a GRAT with $1,000 with a current interest rate of two percent and receives an annuity of 51 percent per year, then there should be $9.78 left after two years. This would be what is called a (nearly) zeroed out GRAT. If there happens to be $1,000 left after the term is up because of outstanding performance of the assets, that $1,000 can be distributed to the remainder beneficiaries with no transfer tax.
Now pretend you’re one of the inventors of Facebook, Mark Zuckerberg or Dustin Moskovitz. Its 2008, you are 24 years old and your company is still private. Mark owns $3,023,128 worth of the private stock and Dustin owns $11,955,748 worth of stock. You each put your shares into your own GRAT. Then you take the company public with an IPO. After taking their annuities for the terms of their trusts, Mark’s beneficiaries were left, according to current Forbes estimates, with $27, 315,513 and Dustin’s beneficiaries with $147,573,190. The transfer tax (if any) having already been paid, these huge values in the trust pass to beneficiaries or a trust for beneficiaries with no transfer tax, that is, in the case of Mark Zuckerberg $27,315,513 to his beneficiaries with no gift tax and no estate tax.
The trusts must still pay income tax on what it earns in a year unless it distributes the income to individuals. The individuals then have to pay the income tax on what they are given of the GRAT income. The trust issues K-1s to the individuals to tell them how much trust income to add to their 1040s and also to tell the IRS how much of a distribution deduction the trust can claim.
Trusts have tax brackets just like people do, but the brackets are much more compressed. A single individual reaches the top rate of 35 percent only when his income reaches $388,350. A trust gets there when its income reaches a mere $11,650. Needless to say, it’s preferable to distribute all of a trust’s income to individuals. Once all the income is distributed, any further distributions are income tax free distributions of principal. Remember, the transfer tax, if any, was paid when the trust was funded.
Because this offers such great tax leverage, there is a move afoot in Congress to make the annuity term a minimum of ten years. This would increase the chance that the Grantor would die before the end of the annuity term and all the assets would be included in his federally taxable estate. So far, this provision has not been passed.