Grantor Retained Annuity Trusts: What it is and How it Works?
One of the most powerful and tax efficient wealth transfer tools in use by the modern estate planner is the Grantor Retained Annuity Trust or GRAT. A GRAT allows a donor (usually a parent) to pass appreciated assets to his children and enjoy the future appreciation of those assets while paying little or no gift taxes.
WHO USES GRATS?
Successful professionals and business owners with sizeable estate tax and estate tax liability might consider a GRAT to shift assets to their children and reduce income and gift taxes. For example: let's say an individual owned a family business valued at $1 million. Let's also assume it is expected to appreciate to $1.3 million over the next two years. He's ready to retire and believes that one of his children is ready to take over running the business. Using a GRAT, the client can transfer this asset to his children and substantially eliminate his tax liability.
HOW IT WORKS
In step one the parent makes an initial gift (the family business from the above example) to a trust. For transfer tax valuation purposes, the amount of the taxable gift is the fair market value of the property transferred minus the value of the grantor's retained annuity interest. The trust is set up as an annuity and the Grantor retains an interest in the assets placed in the trust. The donor receives an annual payment from the annuity for a fixed period of time. At the end of the term, any assets that have not been distributed to the donor are gifted to the children as beneficiary of the trust. If the donor dies before the end of the term, his interest in the trust which is valued as of the date of his death, is distributed to his heirs.
The success of a GRAT is loosely tied to the fluctuations of the interest rate markets. They perform exceptionally well in low interest rate environments. Section 7520 of the Internal Revenue Code prescribes an assumed rate of return which must be used in determining the annuity payouts to the Grantor. Each month, the IRS announces what the rate will be and the rate is subject to change each month. For example: In June 2008, the Section 7520 Rate was 3.8%; In July 2003, it was as low as 3.0% and in May 1989, it was as high as 11.6%. The Section 7520 Rate represents a threshold beyond which the desired benefit of the GRAT is achieved. If the assets contributed to the GRAT appreciate at a rate higher than the 7520 rate, wealth will be transferred to the children tax-free. Below the 7520 rate and taxes will be imposed. For example: If the assets appreciate at a rate of 9%, when the Section 7520 Rate is 5%, the difference of 4% will be transferred tax free.
As the 7520 Rate increases so to must the Donor's annual annuity payment. As the 7520 Rate is decreased, the annuity payment is lowered. Therefore, when the 7520 Rate is higher, the likelihood of transferring assets to the children, is dampened.
As the 7520 Rate increases so to must the Donor's annual annuity payment. As the 7520 Rate is decreased, the annuity payment is lowered. Therefore, when the 7520 Rate is higher, the likelihood of transferring assets to the children, is dampened.
TAX BENEFITS OF USING A GRAT
Estate and Gift Tax
There are significant Estate and Gift tax benefits to be acheived, namely the extremely small gift tax. In the example above with the $1 Million family business, the annuity payments will be included in the Grantor's estate. If the Grantor dies during the term of the trust, all of the assets that are held in the GRAT are included in the Grantor's estate.
Of course, if the Grantor survives the two-year term, all of the appreciation during the term, in excess of the Section 7520 Rate, is transferred to the Grantor's children tax-free. At the expiration of the GRAT's term, the assets pass to the Grantor's children (or to a trust for their benefit) will not receive a step up in basis; rather they will have a carry over basis for tax purposes. Therefore, it may be prudent to select higher basis assets for contribution to the GRAT. In addition, it may be possible, in a properly structured GRAT, to "swap" out low basis assets for high basis assets, if appropriate.
Generation Skipping Transfer Tax
GRATs are not the preferred vehicle for transferring assets to grandchildren or great grandchildren because of the generation skipping transfer tax (GST). The tax liability of a GRAT may not be determinable until the end of the GRAT term. In other words, there's always the possibility that a successful GRAT will produce a GST tax when substantial assets are transferred to grandchildren but the extent of the tax can not be determined until after the GRAT term. Because of this uncertainty with regard to the GST tax, many estate planners shy away from creating GRATs when the donor's grandchildren are the desired beneficiary.
Income Tax
A GRAT is treated as a grantor trust for purposes of the Donor's income tax liability. All of the GRAT's income and expenses are taxed to the Grantor. The key here is that since the GRAT is not liable for taxes. Assets held by the GRAT intended for the beneficiary are not eroded by the payment of income taxes.
There are significant Estate and Gift tax benefits to be acheived, namely the extremely small gift tax. In the example above with the $1 Million family business, the annuity payments will be included in the Grantor's estate. If the Grantor dies during the term of the trust, all of the assets that are held in the GRAT are included in the Grantor's estate.
Of course, if the Grantor survives the two-year term, all of the appreciation during the term, in excess of the Section 7520 Rate, is transferred to the Grantor's children tax-free. At the expiration of the GRAT's term, the assets pass to the Grantor's children (or to a trust for their benefit) will not receive a step up in basis; rather they will have a carry over basis for tax purposes. Therefore, it may be prudent to select higher basis assets for contribution to the GRAT. In addition, it may be possible, in a properly structured GRAT, to "swap" out low basis assets for high basis assets, if appropriate.
Generation Skipping Transfer Tax
GRATs are not the preferred vehicle for transferring assets to grandchildren or great grandchildren because of the generation skipping transfer tax (GST). The tax liability of a GRAT may not be determinable until the end of the GRAT term. In other words, there's always the possibility that a successful GRAT will produce a GST tax when substantial assets are transferred to grandchildren but the extent of the tax can not be determined until after the GRAT term. Because of this uncertainty with regard to the GST tax, many estate planners shy away from creating GRATs when the donor's grandchildren are the desired beneficiary.
Income Tax
A GRAT is treated as a grantor trust for purposes of the Donor's income tax liability. All of the GRAT's income and expenses are taxed to the Grantor. The key here is that since the GRAT is not liable for taxes. Assets held by the GRAT intended for the beneficiary are not eroded by the payment of income taxes.
This short overview is a very simplified version of a complex planning strategy. GRATs can be excellent tools to pass assets from one generation to another while avoiding or mitigating estate and gift taxes. The potential tax advantages of a GRAT spring from the assumptions used to value the income and assets under Section 7520 of the tax code. The code assumes that the transferred property will produce income equal to a prescribed interest rate and the principal value of the property will not increase or decrease. If structured properly and managed well, a GRAT can produce significant benefits with very little risk and low costs.
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About the Author
C. W. Hankerson JD,EA
C. W. Hankerson JD EA is a tax adviser and financial planner in Washington DC. His practice, The Equity Financial Group, is devoted to.
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