Grantor Retained Annuity Trust

This handout is designed to illustrate the use of a Grantor Retained Annuity Trust (“GRAT”) in an estate planning context and answer some questions you may have with regard to its use.

1.0 WHAT IS A GRAT?

A GRAT is a form of irrevocable trust. The trust is structured to allow the grantor of the trust the ability to transfer assets to the grantor’s heirs with minimal gift tax by having the grantor retain an interest in the trust.

2.0 HOW DOES A GRAT WORK?

An individual transfers assets to a GRAT and retains an interest in the trust. The retained interest is structured as the right to receive certain predetermined payments (“annuity payments”) from the trust over time. By including such retained interest in the trust, the grantor substantially reduces the value of the asset transferred for gift tax purposes. Once the annuity payments have been made to the grantor from the GRAT, the remainder passes to the grantor’s heirs without additional gift tax. The value of the asset transferred to the GRAT, including appreciation, is also excluded from the grantor’s net worth for estate tax purposes.

3.0 HOW DOES A GRAT SAVE GIFT AND ESTATE TAXES?

By transferring property to a GRAT, the grantor:

(a) Reduces his or her estate immediately through minority and marketability discounts taken on the property transferred to the GRAT;

(b) Freezes the value of the property transferred to the GRAT and allows all appreciation in the property to pass to the trust beneficiaries without gift or estate tax;

(c) Will make gift tax-free transfers to the trust’s beneficiaries equal to the annual income tax liability of trust (during the retained interest period and possibly longer);

(d) May retain control of the underlying property transferred to the GRAT without causing inclusion in the grantor’s gross estate; and

(e) May have the opportunity to obtain the stepped-up basis that s/he would otherwise receive for holding the property until death.

4.0 HOW DOES A GRAT DIFFER FROM AN OUTRIGHT GIFT?

(a) Rather than transferring an asset to one’s heirs at full fair market value, the grantor of the trust can reduce the amount of the asset for gift tax purposes by the assumed value of the retained interest. The amount of the reduction is determined by several factors, including the amount of the annuity payments, the number of years the annuity payments will be made to the grantor, the age of the grantor, and the assumed rate of return from the asset on the date of the gift. The assumed return is typically between 6-8% and is determined by the IRS. If structured correctly, the GRAT may effectively “zero-out” the gift so no taxable gift is created by the transfer to the GRAT.

(b) The statutory language allowing a GRAT specifically includes an automatic adjustment clause that eliminates the possibility any additional gift tax will be created to the extent the IRS successfully challenges any valuation discounts taken on the original transfer to the GRAT.

5.0 WHO IS A GOOD CANDIDATE FOR A GRAT?

5.1 Family Business Owners. If you would like to pass a family business to a child (rather than taking on Uncle Sam as a partner when you die), a GRAT can make that possible with minimal gift and estate tax. It also allows you to retain control over the business until you die without causing inclusion of the value of the business in your estate.

5.2 Clients Holding Income Producing Property. If you currently hold property that produces substantial annual income, a GRAT can produce substantial estate tax savings.

(a) Real Property. Income producing property is especially good property to use with a GRAT because the discounts for transfers of the property to the trust are typically high and the income can be used to make the required annuity payments.

(b) Property Expected to Appreciate. Because a transfer to a GRAT effectively “freezes” the value of the property at the date of transfer, property that is likely to rise in value is an excellent candidate for a GRAT.

5.3 Clients Who Anticipate Selling Non-income Producing Property at a Premium in the Future. If you anticipate selling company stock or other non-income producing in the near future at a value higher than its current fair market value, a GRAT allows you to lock in the lower value for gift tax purposes at a minimal gift tax cost. The value of such property is often less than a proportional share of its fair market value due to minority and marketability discounts available for such property. Until the property is sold, the GRAT may make the required annuity payments in-kind with the property originally gifted to the GRAT. When the property is sold, any interest remaining in the GRAT then passes to the trust beneficiaries (after the annuity payments have been made to the grantor).

6.0 WHAT STEPS ARE INVOLVED IN USING A GRAT?

6.1 Transformation of Property.

(a) Closely-held Stock. If the grantor wishes to transfer stock in a closely-held corporation to the GRAT, the corporation should be recapitalized into voting stock and nonvoting stock. This will allow the grantor to transfer the majority of the value of the corporation to the GRAT without relinquishing control. If the Corporation is currently a C-Corporation, the grantor may consider making an S election so that all income from the Corporation passes to the GRAT without an additional level of income taxation and the GRAT has sufficient income to make the required annuity payments.

(b) Other Property. If the grantor holds real property or other property outside a corporate entity, these assets can be contributed to a limited liability company (“LLC”). As with closely-held stock, the membership units of the LLC would also be capitalized as voting and nonvoting interests. A family limited partnership (“FLP”) could also be used to conduct the transfer of the property to the GRAT through the transfer of limited partnership interests.

6.2 Transfer of Property to GRAT.

(a) The nonvoting shares or LLC interests would be transferred to the GRAT in exchange for the right to receive the annuity payments for a predetermined number of years. The value of the property transferred may be entitled to a discount for lack of marketability and lack of control. Depending upon the underlying property, the discounts could be between 20-50% of the fair market value of the underlying property. Thus, the value of annuity payments payable to the grantor from the GRAT would be substantially less than the value attributed to such retained interest for gift tax purposes.

(b) Because the grantor and GRAT are treated as a single taxable entity for income tax purposes during the period the annuity payments are being repaid to the grantor, no additional income tax returns need to be filed for the GRAT and all income of the GRAT will be attributed to the grantor.

6.3 Repayment of Annuity Payments. As income is generated by the property held in the GRAT, the GRAT could distribute a portion of the income to the grantor to satisfy the annuity payments. Because the GRAT receives these funds income tax-free (because the income tax is attributed solely to the grantor), the income will typically be more than sufficient to repay the annuity. If the property held in the GRAT is not income producing, the property can be distributed in-kind to satisfy the annuity payments until the property is sold.

6.4 Payment of Income Tax Attributable Property. The grantor can use a portion of the annuity payments paid by the GRAT to pay the grantor’s income tax liability from the earnings of the property held in the GRAT.

6.5 Conclusion of Annuity Payments. Once the annuity payments have been repaid to the grantor, the remaining value of the GRAT can pass outright to the grantor’s heirs or be held in continuing trust for the benefit of the grantor’s heirs.

6.6 Example. Assume you (age 55) hold S-Corporation stock with a fair market value of $3,000,000 and transfer a percentage (e.g., 50%) of the shares of the company (all nonvoting shares) to a GRAT in exchange for the right to receive $116,675 per year for 12 years. If the nonvoting shares transferred received a combined 33% minority and marketability discount, the value of the transfer to the GRAT would first be reduced from $1,500,000 to $1,000,000. Then, due to the twelve year retained interest, the value would be reduced to less than $1. Assuming the S-Corporation stock produced 8% income per year and appreciated in value at 2% per year, the income from the S-Corporation could be used to pay the annuity payments to you and you could use these payments to pay the income tax obligations arising from the corporation. As a result, after the annuity payments were fully repaid in year 12, the remaining value in the GRAT would be approximately $1,973,465 (beginning value plus growth) and this would pass to your heirs without additional tax. Therefore, by making a nominal gift of $1, you effectively are able to transfer almost $1,973,465 to your heirs in 12 years using the GRAT.

7.0 WHY WOULD I WANT TO KEEP THE PROPERTY IN TRUST?

Rather than passing the assets remaining in the GRAT to the grantor’s heirs outright after the annuity payments have been repaid, the grantor may wish to keep the property in continuing trust for the following reasons:

7.1 Continued Control over Property. By keeping the property in trust, the Trustee of the trust controls the property as well as a beneficiary’s right to distributions of income and principal. Because the Trustee is selected by the grantor and can be removed or replaced by the grantor, the grantor can effectively retain continued control over the property without causing inclusion of the property in the grantor’s estate upon death.

7.2 Ability to Pay Income Tax of Trust. If provisions are included in the GRAT that cause the trust to treated as a “grantor trust” even after the annuity payments have been repaid, all income of the trust will continue to be taxed to the grantor even though the income passes to the trust beneficiaries. While this may not seem like a good result, it effectively allows the grantor to make tax-free gifts (of the income tax payable) each year the grantor pays the tax of the GRAT. However, such provisions can provide the grantor the ability to cancel the “grantor trust provisions” and cause the income to be attributed to the trust if the grantor no longer wishes to make these tax-free gifts to the trust in the future.

7.3 Creditor Protection. By keeping the property in trust for your heirs, the property will not be subject to the creditors of the trust beneficiaries while held in trust. Additional provisions can also be included to further protect the property from a divorcing spouse of a trust beneficiary, prevent distributions from being made to a trust beneficiary who is physically or mentally incapable of handling the funds (e.g., a drug addict), and possibly prevent a trust beneficiary from being disqualified for state and federal aid in case the trust beneficiary becomes incapacitated.

7.4 Possible Stepped-up Basis of Assets at Death of Grantor.

(a) Typically, the heirs of any person who dies holding appreciated property will receive a new income tax basis equal to the fair market value basis in those assets of those assets at death and will not have to recognize gain to that extent upon later sale of the property. For this reason, many clients hold their property until death. While their heirs receive the stepped-up basis, the assets are then subject to estate tax at a rate of up to 45%.

(b) With a transfer to a GRAT, the grantor’s basis in the transferred property will carry-over to the trust. If the GRAT were then to sell the property to a third party, capital gain would have to be recognized. Even if this could not be avoided, the transfer to the GRAT would still produce tax savings because of the great disparity between capital gain and estate tax rates (e.g., maximum 25% combined state & federal capital gains rate vs. maximum 40% estate tax rate).

(c) However, even the loss of the stepped-up basis can be avoided where the grantor has sufficient liquidity outside the trust and the trust has assets for which it makes economic sense for the grantor to reacquire. An advantage of keeping the property in trust (with the necessary provisions to ensure the trust is taxed as a grantor trust) is that the grantor retains the ability to replace the trust property from the trust for other property of equivalent value at any time. Using this power, the grantor can exercise, at some point prior to death, his or her replacement right by transferring cash or other non-appreciated assets to the trust in exchange for the trust property. This exchange is completed at the then fair market value of the trust property, so the grantor has effectively removed all appreciation in the property from his or her estate. Then when the grantor dies, the property reclaimed from the trust will receive a stepped-up basis equal to its fair market value.

8.0 WHAT ARE THE POSSIBLE DISADVANTAGES TO A GRAT?

8.1 Death During Term of Annuity Repayments. If the grantor survives until after the annuity payments have been repaid, the property remaining in the trust (including all appreciation) will be excluded from the grantor’s net worth for estate tax purposes. However, if the grantor dies during the repayment term, the entire value of the trust property including appreciation will be subject to estate tax in the grantor’s estate. As a result, it is important to choose a repayment term the grantor is likely to survive so the anticipated estate tax benefit is achieved.

8.2 No Transfers to Grandchildren. Because certain IRS rules prevent a grantor from allocating GST exemption to a GRAT until the end of the retained term (after the property has appreciated), it is typically not possible to pass the GRAT property to the grantor’s grandchildren. If one has a strong desire to have the GRAT property pass to the grantor’s grandchildren without tax at the children’s death, they may want to consider using a similar estate planning technique entitled “Sales to Defective Grantor Trusts.”

Clay R. Stevens © 2011