JMBM Tax Newsletter: A Good Time To GRAT! Trust Transfers Asset Appreciation With Little Or No Gift Tax

JMBM Tax Newsletter

Historically low interest rates have created an opportunity to take advantage of a special estate planning vehicle: a Grantor Retained Annuity Trust (a “GRAT”). A GRAT allows for a grantor to pass to its beneficiaries the appreciation of assets in the trust with little or no gift tax.

A GRAT may be formed to hold assets expected to appreciate at a rate in excess of a certain stated federal interest rate (the “§ 7520 rate”). To the extent that the property contributed to the GRAT appreciates at a rate in excess of the § 7520 rate on the date the GRAT is formed, the appreciation will pass to the grantor’s children (or other beneficiaries) for little or no gift tax (depending on how the annuity payments are structured). With the § 7520 rate for June 2008 set at 3.8%, the GRAT provides an excellent opportunity for estate and gift tax planning.

How does a GRAT work? The Internal Revenue Code provides that the value of gifts of property to a GRAT may be valued for gift tax purposes by reducing the value of the property transferred by any interest retained by the grantor. Thus, the value of the right to receive annuity payments from the trust reduces the value of the gifted remainder interest. If the retained annuity is properly structured, the remainder interest will have little or no value for gift tax purposes.

What is a “zeroed out” GRAT? A “zeroed-out” GRAT is structured to require annuity payments to the grantor equal to 100% of the value of the property transferred to the GRAT, plus interest at the § 7520 rate, with both the value of the property and the § 7520 rate determined as of the date of transfer. As a result, the value of the gift of the remainder interest is “zeroed out” and thus no gift tax is due. The property is revalued when each annuity payment comes due to determine the portion of the property required to make the annuity payment. To the extent that the property transferred to the GRAT appreciates at a rate in excess of the § 7520 rate, there will be value remaining in the GRAT net of the annuity payments at the end of the annuity term which will pass gift tax free to the remainder beneficiaries.

A GRAT example. The following example illustrates the benefit when stock transferred to a two-year GRAT doubles in value each year for two years:

  • On January 1, 2008, a GRAT is funded with 10,000 shares of XYZ nonvoting stock, valued at $500 per share at the time of transfer (total value of property transferred to the GRAT = $5,000,000). Assume that the GRAT is required to pay the Grantor an annuity for two years, each annuity payment in an amount equal to 53% of the value of the property transferred to the GRAT ($2,650,000)
  • On January 1, 2009, the XYZ nonvoting stock is worth $1,000 per share. The 2009 annuity payment due is $2,650,000, and can be paid with 2,650 shares of XYZ stock [$1,000/share x 2,650 shares = $2,650,000], leaving 7,350 shares of stock in the GRAT
  • On January 1, 2010, the XYZ nonvoting stock is worth $2,000/share. The 2010 annuity payment of $2,650,000 can be made with 1,325 shares of XYZ stock [$2,000/share x 1,325 shares = $2,650,000]. At the end of the annuity period, a total of 3,975 shares of XYZ stock has been used to fund the annuity payments, and the GRAT holds the balance of 6,025 shares of XYZ nonvoting stock with a total value (as of January 1, 2010) of $12,050,000

Assuming that the grantor survives the two-year annuity term, those 6,025 shares valued at $12,050,000 have been transferred out of the Grantor’s estate, to the Grantor’s beneficiaries, without incurring any gift taxes!

What types of assets should I consider transferring to a GRAT? Generally, any asset appreciating at a rate higher than the Section 7520 rate can be used, including a diversified stock portfolio. Annuity payments may be made “in kind” from GRAT property. Property which you expect to increase significantly in value before the first annuity comes due would yield the best results from a GRAT insofar as (1) annuity payments based on a percentage of the value of the GRAT property at transfer can be satisfied with appreciated property, which (2) maximizes the amount of property left in the GRAT as the remainder for your children.

What if the assets used to fund the GRAT fail to appreciate? Even if the assets used to fund the GRAT fail to perform as expected, there is virtually no downside. The assets would simply come back to the Grantor as annuity payments.

How long should the annuity term be? Ideally the annuity term should be designed to capture the appreciation expected in the property used to fund the GRAT. However, since in general the death of the Grantor during the annuity term will cause all of the GRAT assets to be brought back into the Grantor’s taxable estate, it is advisable to keep the annuity term as short as possible. Under current law, two years is the shortest annuity term acceptable.

Does transferring appreciated assets to the GRAT trigger an income tax liability? Generally, a GRAT will be structured as a “grantor trust” for income tax purposes at least during the annuity term. A transfer of appreciated property to a grantor trust is not treated as a taxable event since the grantor is simply transferring property to himself/herself and not to an independent taxable entity. Moreover, depending on how the GRAT is structured, the grantor may continue to pay the GRAT’s income taxes without having such benefit treated as a taxable gift to the GRAT’s remainder beneficiaries.

In summary, historically low interest rates create an opportunity to take advantage of this special estate planning vehicle. If properly structured, and assuming the property transferred appreciates at a rate in excess of the § 7520 rate at funding (3.8% for transfers which occur in June 2008), a GRAT could allow you to transfer a substantial portion of appreciating assets to your beneficiaries free of transfer taxes. As with all trusts, you will need to consider issues such as who to name as the trustee of the GRAT, and how to time distributions from the GRAT to your beneficiaries.