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Grantor-Retained Annuity Trust – GRAT

January 1, 2010

The Grantor Retained Annuity Trust (GRAT) is a popular method of transferring wealth to children without incurring gift or estate taxes. The Grantor Retained Annuity Trust is an opportunity with tremendous potential advantages and minimal risk to transfer wealth to children without incurring gift or estate taxes.

What Is a GRAT?

In its most basic form, you transfer assets to a trust (GRAT) and retain the right to receive an annuity payment for a term of years. At the end of the term, the assets remaining in the GRAT are distributed to your children (or other beneficiaries). The transfer to the GRAT will trigger a gift tax event. However, the value of the taxable gift is not the value of the assets transferred to the GRAT. Instead, the gift is reduced by the actuarial value of the annuity you retain. If the annuity is structured properly, it equals the value of the assets, and there is no gift. This is referred to as a “zeroed-out” GRAT.

Advantages of the GRAT

A GRAT can be funded with virtually any kind of asset. One popular option is to transfer non-voting stock in a closely-held business to the GRAT while retaining all (or a controlling interest in) the voting shares. This works particularly well with S Corporation stock.

You may select the annuity’s payout rate, and the payout rate can be increased each year by as much as 20%. This flexibility allows you to determine the value of the taxable transfer.

To the extent the trust outperforms the discount factor applied by the Internal Revenue Code when determining the present value of the annuity (i.e. the percentage the I.R.S. assumes you can earn on your investments), assets will be transferred to the next generation without being exposed to gift or estate tax.

The GRAT is considered a “grantor-type trust” by the IRS. The tax on any income generated on such a trust is your responsibility. This can be a real advantage because the performance of the Trust is not hampered by having to use trust income to pay tax.

Possible Disadvantages of the GRAT

Since the taxable portion of the transfer is not a “present interest,” the gift to a GRAT can never be sheltered from gift tax by the $11,000 annual exclusion. Therefore, some unified credit may have to be consumed when the GRAT is created, unless the GRAT is zeroed-out.

What Are Ideal GRAT Assets?

What types of assets suggest planning with a GRAT? A person who establishes a GRAT, particularly a zeroed-out GRAT, is going to get back 100% of the present value of the property transferred to the GRAT, plus whatever interest rate the I.R.S. assumes can be earned on an investment. Therefore, if you have assets that you believe will outperform the I.R.S.’s assumed interest rate, use of a GRAT will allow you to shift the benefits of this better-than-expected performance to your beneficiaries without gift tax.

Examples would include a business owner who expects rapid growth in his or her business, a business owner who foresees a sale at a premium price in the next few years, an owner of an interest in a closely-held business who believes that his stock might be offered to the public, or the owner of a portfolio of marketable securities who believes that the market is poised for a rapid recovery. Another possibility is the owner of rental real estate which generates a reliable and better than average income stream.

Use in Combination with a Spousal Gift Trust

Many clients are nervous that if the GRAT is successful, they will shift more wealth to their descendants than they want to transfer. The answer is to name a Spousal Gift Trust (which is explained in a separate handout) as the remainder beneficiary. Any amount that remains in the GRAT at the end of the term selected will be held for the benefit of the grantor’s spouse, and the spouse is given a power of appointment which can be exercised to continue the assets in trust for the grantor’s benefit if the spouse dies first. Assets pass to descendants only after both spouses are deceased.

A “No-Lose” Proposition

The risks with this planning are minimal. There are two possible negative outcomes: You could die during the term of the trust, wiping out all potential tax advantages; or the assets transferred to the GRAT could lose value and no transfer would occur at the end of the term even though you have used some tax credit. In either event, the overall estate plan is not harmed by having attempted the GRAT because the GRAT assets would have been included in your estate if you had never established the GRAT in the first place. On the other hand, if the GRAT performs appropriately, you will have transferred assets with as little transfer tax exposure as possible.

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