Viewpoints on Financial Planning
Historically, wealthy families have strived to reduce transfer taxes while retaining a continuing interest in the underlying property without running afoul of changing tax laws. While there is no legal difficulty in establishing an annual gifting program and the Internal Revenue Code permits each individual to gift up to $14,000 annually ($28,000 for spouses consenting to split the gift) with no impact on the $5,250,000 (2013 limit) gift/estate tax exemption amount, the donor of such gifts must give up control and access to both underlying principal and income. For those individuals wishing to maintain control and a right to distributions from the property for a period of years, a Grantor Retained Annuity Trust (GRAT) can be a viable alternative.
A GRAT entails a lifetime transfer of cash or property into a trust in exchange for an annuity payable to the grantor for a fixed term of years. Any property remaining in trust upon expiration of the annuity term passes to the remainder beneficiary (presumably the grantor’s children) at no additional gift tax cost. As a creation of the Internal Revenue Code, a GRAT offers predictable tax results. In the right circumstances, a grantor can exclude property from their estate with minimal to no gift tax costs, yet still retain control and benefit from the trust property during the trust term. Accordingly, there is virtually no downside estate planning risk.
FREQUENTLY ASKED QUESTIONS
1. When should one utilize a GRAT?
A GRAT is an effective estate freeze technique and is most applicable with taxable estates that would exceed the applicable exclusion ($5.25 million in 2013). It is a tax efficient means for a grantor with an appreciating estate and potential significant tax exposure to maximize his or her family wealth transfer desires. It works best in a low interest rate environment as a lower interest rate increases the value of the annuity retained by the grantor and therefore reduces the value of the gift of the remainder interest. Other factors that come into play in terms of valuing the gift include the term of the trust, life expectancy of the grantor, as well as the aforementioned interest rate. For illustrative purposes, the higher the payout to the grantor during the trust term, the smaller deemed gift value to the grantor. This is logical as the higher the payout to the grantor, the less value that will potentially be available to pass to the remainder beneficiary.
The interest rate utilized is called the §7520 rate. This rate, which is based on the Applicable Federal Rate (AFR), is published monthly and is established in the month of the transfer. Since 2009, this rate has ranged from a high of 3.40% to a low of 1.00%. The rate for January 2013 is 1.00%. The taxable gift on inception is equal to the value transferred less the retained interest.
2. How is a GRAT taxed?
A GRAT is deemed to be a grantor trust. Therefore, any income generated or capital gains realized within the GRAT during the GRAT term would be income taxed to the grantor—just as if the asset remained in the grantor’s name. This would be the case even in situations where the income tax liability exceeds the annual annuity payable to the grantor.
From a wealth transfer perspective, the payment of taxes by the grantor on property that will ultimately inure to the benefit of his or her remainder beneficiaries can be viewed as an additional tax-free gift to those beneficiaries.
3. What requirements must be met for favorable GRAT tax treatment?
- The transfer to the GRAT must be irrevocable
- Annuity payments to the grantor must be made at least annually
- Payments may be in cash or in kind
- No additional contributions to the GRAT may be made during the trust term
- Payments from the trust must be fixed but increases of up to 20% per annum are permissible
4. What impact does the length of the trust term and/or the grantor’s death during the trust term have on a GRAT?
To realize the full benefit of a GRAT, the grantor must outlive the trust term. The longer the trust term, the smaller the taxable gift as the remainder beneficiaries must wait longer to receive the property. Conversely, the longer the GRAT term, the greater the risk the grantor will not survive the trust term. Where the grantor does not survive the GRAT term, all or a portion of the GRAT property will be includable in the grantor’s estate. The exact amount includable in the grantor’s estate will be equal to the amount of capital necessary to fund the annuity amount for the balance of the trust term.
The discount rate to be used to calculate this amount is equal to the §7520 rate for the month of the grantor’s death or on the alternate valuation date, if applicable. In a worst-case scenario, the family is generally no worse off from a transfer tax perspective absent the cost of the legal document and valuation costs, if any, to establish and fund the GRAT.
5. In what situations is a GRAT most effective as a wealth transfer tool?
Some examples of situations where a GRAT can prove particularly beneficial include but are not limited to the following:
- Rapid appreciation during GRAT term
- Trust property generates sizable cash flow (this may allow the cash flow to meet the required annual annuity payments and enable the trust corpus to remain in the GRAT and ultimately pass to remainder beneficiaries)
- Gift tax valuation discounts may be available
- Sequential or cascading GRATs can enhance gift tax leverage (see FAQ #8)
6. What are some situations where a GRAT may require additional care and consideration?
- Mortality risk
- Under-performing investment returns (a GRAT must outperform the AFR during the GRAT term to be beneficial)
- Carryover basis for trust beneficiaries can be manipulated
- Transfers to third or fourth generation beneficiaries are atypical (a GRAT is generally an inefficient tool for generation-skipping transfers)
7. How can one reduce or eliminate the initial gift tax consequences associated with a GRAT?
It is possible to combine a trust term with a high annual payout to reduce the gift tax value of a GRAT to zero or close to zero so there will be minimal, if any, gift tax consequences upon trust inception. For example, in January 2013 with a §7520 rate of 1.0%, the required payout for a five-year GRAT would be about 20.60411% to zero out the gift. A two-year GRAT would require a payment of about 50.75112%.
Example: Mary has $2,000,000 in a concentrated stock portfolio that she does not want to sell. Mary gifts the stock to a two-year GRAT. She expects the stock to appreciate by 10% annually over the next two years. Additionally, for this example, the stock does not pay any dividends. The §7520 rate is 1.0%. Therefore, Mary would receive, in two installments, value equal to her contribution plus the 1.0% assumed annual return. At the end of the two years, if the stock does in fact grow by 10% annually, the remainder beneficiaries (children) will be left with the excess without any tax ramifications.
The actual numbers, including compounding, are as follows:
|Term of GRAT:||2 Years|
|Anticipated Growth Rate:||10% per Year|
|1st Annual Distribution:||$1,015,022|
|2nd Annual Distribution:||$1,015,022|
|Excess Remaining for Heirs:||$288,054|
Mary would receive the initial $2,000,000 plus $30,044—in the form of two pre-established annual payments of $1,015,022. Then the beneficiaries are left with the excess appreciation that remains in the trust, $288,054, without any tax ramifications! As with any gift, the beneficiaries retain the basis of the grantor (Mary).
8. How can one maximize the benefits of a GRAT?
One tool that can work well to more effectively leverage the gifting potential for a GRAT is to set up sequential or cascading GRATs. Essentially, a grantor establishes an initial GRAT for a set term and as the annuity payments are received from the initial GRAT, those dollars are transferred to a second GRAT for a stated term. In the following year, the distributions from both GRATs 1 and 2 are paid into GRAT 3. Assuming the grantor survives the full term of each GRAT, not only is the initial property potentially transferred to heirs, but the income is as well.
A GRAT can be a very effective and predictable tool to transfer significant wealth to one’s heirs. The best results come where the expected return on the trust assets exceed the §7520 rate that is established in the month of transfer and the grantor survives the trust term. If both variables are satisfied, the result is that appreciation above the §7520 rate will be transferred and this appreciation will neither be includable in the grantor’s estate nor subject to additional transfer tax thereon. This technique, therefore, has the capacity to transfer significant wealth in an extremely tax efficient manner to the next generation.