Creating a grantor retained annuity trust (commonly referred to as a "GRAT") is a relatively simple way to transfer property to your children at virtually no gift tax cost. In addition, because of the low interest rate environment and down markets, the advantages of creating a GRAT are magnified. When properly structured, a GRAT can pass to your children all of the future appreciation of the transferred property and reduce the value of the gift to virtually zero.
Trust Pays an Annuity to You
In a typical GRAT, you contribute assets to a trust which provides that you are to receive an annuity annually for a fixed number of years. The annuity amount is typically a stated percentage of the initial fair market value of the trust. It can be stated as a fixed percentage or as a percentage that can increase as much as 20% a year over the trust's term.
At all times during the term of the trust, you will receive the predetermined annuity amount, regardless of how much income the trust actually generates or whether its value rises or falls. To the extent that the income is insufficient to cover the annuity payments, trust principal will be paid to you to make up any shortfall.
At the end of the period, the property remaining in the trust passes to the ultimate beneficiaries of the trust, typically your children or other family members, in further trust or outright, depending upon your preference. Alternatively, you can delay the transfer of assets to your children by naming a trust for your spouse and your descendants as the beneficiary until the spouse's death, at which time your children (or other family members) become the beneficiaries.
Gift Tax Is Minimized
The creation of a GRAT constitutes a gift to the ultimate beneficiaries for gift tax purposes, but the value of that gift is only the initial value of the trust assets reduced by the present value of the annuity you have retained. The calculation of the present value of your retained annuity is based, in part, upon the current interest rates promulgated by the IRS, commonly referred to as the "hurdle" rate (i.e., the 7520 rate). In order for a GRAT to be successful, the assets used to fund the GRAT must appreciate faster than the IRS hurdle rate. At the hurdle rate for September 2011 of 2.00%, it is easier to have a successful GRAT. Since interest rates are near historic lows, the potential tax savings are maximized.
The most popular use of this device in sophisticated estate plans has been the short-term, "zeroed-out" GRAT, in which the term is limited to two or three years and the annuity amount is maximized in order to produce as small a taxable gift as possible. In this way, anticipated short-term growth in the trust assets can be availed of without risking longer-term uncertainty, and the risk of depreciation is neutralized by virtually eliminating the gift tax cost. With this short-term GRAT, the gift to your children can be nearly "zeroed-out."
Suppose you create a GRAT with $5,000,000 to pay yourself an annuity of $2,575,195.50 per year for two years. Applying September's hurdle rate, the value of your retained interest is approximately $4,999,999.58 and the taxable gift is only $.42. If the principal of the trust appreciates over the two-year period, so that, after receiving your annuity payments, there are assets remaining in the GRAT – whether one dollar or millions of dollars – your children will receive that amount at virtually no gift tax cost. If the value of the trust goes down, you will simply get back everything you put in, and you will have lost nothing. Distributions may be made in-kind so there is no need to sell any property in order to receive your annuity payments.
In a two-year zeroed-out GRAT, your children or other named beneficiaries will receive the remaining principal in the trust at the end of two years at no gift tax cost to you or them.
No Extra Cost If You Die Prematurely
If you die prior to the end of the annuity period, the annuity will continue to be paid to your estate and the value of the assets in the GRAT at your death will be included in your gross estate for estate tax purposes. Your estate will receive credit for any gift tax already paid, however. Thus, although you will have lost the tax advantage the GRAT was designed to achieve, your estate will be in the same position had you not created it.
Gift of Stock in a Closely-Held Business
You may be able to achieve substantial benefits by transferring a closely-held business interest or depressed real estate, which you anticipate will increase in value, to your GRAT. In fact, this may be the ideal estate planning device for such a transfer to your children, because you may be in a much better position to predict the future growth of your own business than that of other property.
Of particular appeal is the fact that the GRAT also removes the risk of undervaluing a closely-held business interest or real estate for gift tax purposes. With an outright gift, there is no way to guard against a substantial gift tax deficiency if the value of the property is increased by the Internal Revenue Service. But if instead the gift is the remainder interest in a "zeroed-out" GRAT, and if the annuity amount is expressed as a percentage of the initial value of the trust principal (rather than a dollar figure), any increase in the value of the business (or real estate) determined on an audit of the gift tax return would result almost entirely in an increase in the value of the retained interest and, in turn, in only a nominal gift tax increase.
In the previous example, if the IRS successfully asserts that the value of your company's stock transferred to the trust is $6,000,000 instead of $5,000,000, because your annuity is defined as a percentage of the value of the stock, your annuity is now worth $5,999,999.50 and the value of the resulting gift to your children, is $.50 instead of $.42.
Income Tax Considerations
Since the GRAT is a "grantor trust" for income tax purposes, all of its income and deductions are included on your personal return, as if there had been no transfer at all, until the property passes to the ultimate beneficiaries of the GRAT. Therefore, the GRAT is generally income tax-neutral, meaning that your income taxes should be the same whether or not you create the GRAT. If you choose to keep the property in trust for your children (or your spouse and children) after the two-year GRAT period, the continuing trust or trusts also can be structured as grantor trusts so that you can continue to pay the income tax attributable to the trusts' income each year until you choose otherwise. Your payment of the trust's income tax essentially is an additional tax-free gift to your children.
When properly structured, a GRAT can truly have a "heads you win, tails you break even" result. By adjusting the terms of your trust, you can nearly eliminate the gift tax associated with the transfer of property to your children.
Upon termination of the GRAT, all the appreciation on the assets in excess of the hurdle rate will pass to your children free of gift tax. But if the appreciation is not as expected, or if you do not survive the term of the trust, there are no adverse tax consequences.
Finally, in designing the manner in which the ultimate beneficiaries of the GRAT are to receive the trust assets at the end of the GRAT period, you may choose among many options available to achieve the result most consistent with your family and financial objectives.