The generational transfer of wealth is a complex issue facing many high net worth individuals that requires meticulous planning and the balancing of competing interests. On one hand, wealthy individuals desire to protect their wealth and reduce transfer taxes to the greatest degree possible. On the other, these same individuals are understandably reluctant to cede present control and interest in their assets. Often times these objectives are in conflict with one another, and the individual is forced to prioritize his or her objectives. However, there is at least one wealth transfer vehicle that permits an individual to pass significant property to his or her desired beneficiary while maintaining control and the beneficial enjoyment of same: the Grantor Retained Annuity Trust, or “GRAT.”

A GRAT is a trust in which an individual (“client”) funds a trust with assets and the GRAT pays the client an annuity for a number of years. If structured properly, at the end of the term of the GRAT, the GRAT terminates and any remaining assets (including appreciation on these assets) are distributed to the named beneficiary with minimal to no gift tax cost. The strength of the GRAT is that the client maintains control of his or her assets while passing on any appreciation of these assets tax-free to his or her intended beneficiary. While the potential tax-savings are substantial, there are several risks to this planning technique, which fortunately can be mitigated through careful planning and periodic adjustment as needed.

How a GRAT Works

A client initially funds a GRAT with assets, typically those with appreciation potential, and selects a term of years for the GRAT. Over this term, the client will be paid an annuity on an annual basis, which can either be a fixed dollar amount or a percentage of the initial fair market value of the property.

The value of the interest the client retains in the annuity (“retained annuity interest”) when the GRAT is initially funded (as determined by IRS guidelines) will be the value used when calculating the gift of the assets passing to the beneficiaries for gift tax purposes at the end of the term. However, the investment performance of the GRAT in excess of the client’s retained annuity interest passes to the beneficiaries tax-free at the end of the term.

So long as the annuity paid to the grantor does not exceed the GRAT’s annual return, there should be significant transfer tax savings. The income from the GRAT is taxed to the client during its term, which makes for an “additional” non-counted gift to the GRAT. Also, the creator of the GRAT can be his or her own trustee.

To illustrate, assume that the client initially funds the GRAT with marketable securities valued at $950,000 and his or her retained annuity interest based on IRS guidelines is $1,000,000. Upon the termination of the GRAT, any of the initial assets remaining (after all annuity payments) pass to the beneficiary and may be subject to gift tax depending on the annuity structure. However, any appreciation of the initial assets in excess of the retained annuity interest (i.e., $1,000,000) is not part of the gift tax computation. Thus, for example, if the appreciation over the client’s retained annuity interest is $250,000, that $250,000 passes to the beneficiaries tax-free. If the initial assets do not appreciate over the value of the client’s retained annuity interest (i.e., $1,000,000), the assets are returned to the client at the end of the term in satisfaction of the annuity and there are no tax repercussions. The client is essentially left in the same position economically as he or she would have been had the client not created the GRAT.

GRAT Requirements

In order to take advantage of this wealth transfer technique, the GRAT must be structured properly to comply with the IRS regulations. A few of the more relevant provisions include the following:

  1. The annuity payment must be made to the client at least once a year;
  2. No person may make additional contributions to the GRAT after it is initially funded;
  3. The annuity payments may increase or decrease every year of the term, but the annuity can never exceed 120% of the value of the annuity payment from the prior year;
  4. The GRAT cannot permit distributions from the GRAT to anyone other than the client during the term of the GRAT; and
  5. The annuity payment must be made in cash or in-kind – it cannot be paid by note or a debt instrument.

Note that any income earned on GRAT assets in excess of the amount required to pay the annuity may be paid to the client and this does not affect the value of the client’s retained annuity interest.

Asset Types

As noted, the GRAT is the ideal instrument to pass on wealth created by appreciating assets, specifically discounted assets (e.g., assets with a discount for a minority interest). However, certain types of assets require special consideration.

For example, care must be taken in valuing certain interests in corporations or partnerships, specifically those that must be valued under the IRS’ special valuation rules. When funding the GRAT, if the fair market value of such an interest is used rather than the value of the interest calculated under the IRS’ special valuation rules, the client could inadvertently make a substantial gift to the intended beneficiary that will be subject to gift tax if the fair market value is lower than the actual value of the interest calculated under the IRS rules.

In order to avoid this type of situation, an official appraisal should be conducted in advance showing the actual value of the interest calculated under the IRS’ special valuation rules, and that value should be the value used for GRAT purposes. Other issues can arise if the client funds the GRAT with certain types of voting stock of a controlled corporation, including accidental inclusion of the value of this stock in the client’s taxable estate, which completely defeats the wealth-shifting objective of the GRAT. Similarly, a GRAT should never be funded with community property assets. Fortunately, there are numerous ways for a professional advisor to “correct” a GRAT if it is funded with problem assets.

Mortality

The single most important factor in the success of the GRAT from a wealth-shifting perspective is the mortality of the client. The client must survive through the term of the GRAT, or some or all of the GRAT assets will be includable in his or her estate. A change in the client’s life expectancy, due to injury or illness, could also cause complications, and the GRAT provides flexibility to accommodate these changing realities.

In the event of a known reduction in life expectancy, the client can purchase the beneficiary’s interest in the GRAT (known as the remainder interest). As the client would then own both the annuity interest and the remainder interest, the GRAT would terminate, putting the GRAT assets back into the client’s hands where they could be utilized in a different estate planning technique.

Performance

The wealth shifting power of the GRAT is only made possible by the performance of the assets. Underperforming, as well as overperforming, GRATs can be problematic for the client. However, the GRAT is very flexible and can be adjusted to respond to market conditions.

If a GRAT is performing poorly and has little wealth shifting potential, the client has the ability to swap the GRAT assets with assets of equal value. Typically, the grantor would swap the GRAT assets for cash and transfer the initial GRAT assets to a new GRAT to restart the process. A separate issue arises where the GRAT performs well but perhaps too early during the term. Some clients may wish to avoid the potential market risks and lock in the gains before the GRAT term has concluded.

As with an underperforming GRAT, the client has the ability to swap the assets for assets of equivalent value with less market risk (such as cash). After locking in the appreciation in the first GRAT, the client could then transfer the appreciated asset to a new GRAT if he or she feels it has further appreciation potential. The GRAT could also vastly outperform client expectations, creating an issue where the named beneficiary is receiving more wealth than the client intended. In this situation, the client could swap the asset as described above, locking in the appreciation, and re-GRAT to a GRAT with a different beneficiary, or he or she could add other beneficiaries to the original GRAT, thus spreading out the wealth transfer among multiple beneficiaries.

Other Risks

“Locking in” assets for a set period of time can be understandably daunting to some, but the flexibility of the GRAT permits the client to retain significant access to those assets to meet his or her needs. For example, if the client experiences a liquidity crisis and had initially funded the GRAT with liquid assets, he or she can re-acquire these liquid assets by swapping them for a promissory note or other illiquid asset of equal value. The client also has the power to borrow against the GRAT by virtue of a properly structured promissory note.

A client may likewise experience a beneficiary problem – that is, the client may no longer wish to provide for a beneficiary by virtue of divorce or otherwise, or may wish to provide for more beneficiaries than are currently named in the GRAT. In the case of disfavored beneficiaries, the client can utilize his or her swap power and freeze the appreciation (if any) passing to the named beneficiaries. With respect to new beneficiaries, the trustee of the GRAT could sell the assets to a separate trust with new beneficiaries. If structured properly, the GRAT could also include a power to change the named beneficiary.

Ideal GRAT Term

A series of rolling short-term GRATs is generally deemed the best opportunity to achieve the wealth-shifting goals of the client while minimizing the aforementioned risks. The annuity payments of the initial GRAT can be used to fund additional GRATs and continually transfer the appreciation potential to the remainder beneficiaries.

Current GRAT Developments

On Feb. 9, 2016, President Obama released his proposals for the 2017 federal budget, which included proposals concerning the estate and gift tax laws. Several of these proposals call for a minimum GRAT term of 10 years and a maximum term equal to the life expectancy of the client plus 10 years.

In addition, President Obama proposes that the remainder interest must have a value greater than 25 percent of the value of the assets contributed to the GRAT or $500,000, and any decrease in the annuity during the GRAT term and any tax-free exchange of any asset (e.g, asset swap) held by the GRAT would be prohibited. These proposals, if they ever became law, could severely reduce the effectiveness and flexibility of the GRAT as a wealth-shifting technique.

Conclusion

When drafted and funded properly, the GRAT can transfer a significant amount of wealth tax-free to the client’s intended beneficiaries while allowing the client to maintain control and enjoyment of these assets throughout his or her lifetime. Unlike many estate planning techniques, the client has significant access to GRAT assets and can substitute assets, change beneficiaries, and otherwise modify the GRAT to suit his or her changing needs. Accordingly, the GRAT is one of the most powerful wealth-shifting tools available for high net worth families.