This is the fourth installment in a blog series on opportunities for tax planning in the current low-interest rate environment. Read our previous installments here. Future installments will cover family limited partnerships and limited liability companies, installment sales to defective grantor trusts, and charitable giving.

A popular method for transferring assets in a tax-efficient manner, particularly when interest rates are low and asset values are depressed, is by creating a grantor retained annuity trust (GRAT). A GRAT is a type of trust that allows the grantor of the trust to retain a stream of annuity payments for a fixed period of time. After the end of the term and the last annuity payment, the remaining assets in the trust, or the “remainder,” pass to the beneficiaries of the trust, potentially gift tax-free.

Creating a GRAT

To create a GRAT, the grantor transfers to the trust property that is expected to appreciate in value. Because the grantor retained the right to receive an annuity payment for a fixed period of time, the value of the remainder, or the gift, is reduced by the value of the annuity retained, as calculated for tax purposes. Consequently, depending on the structure of the GRAT, the remainder may have little to no value for gift tax purposes, thereby resulting in potentially no taxable gift upon creation. As mentioned above, at the conclusion of the annuity term, the remainder passes to the trust beneficiaries gift tax-free.

For income tax purposes, the grantor is considered the owner of the GRAT and is taxed on its income. The value of the retained annuity is determined by the IRS tables based on an interest rate known as the Section 7520 rate, which is based on the Applicable Federal Rate. As mentioned above, it is possible to structure the required annuity so that there is no gift for tax purposes upon the initial transfer to the GRAT (known as a “zeroed-out GRAT”).

Generally, it is preferable to fund a GRAT with assets that are going to increase in value. By using a zeroed-out GRAT, the grantor can essentially transfer all appreciation on the gifted property in excess of the 7520 rate to the beneficiaries of the GRAT free of gift tax, removing the value of such appreciation from his or her estate. Because many assets currently have depressed values that are hopefully going to increase at a later date, and the 7520 rate is historically low (0.4% for August 2020), this maximizes the value that can be transferred to family members in a tax-efficient manner.

Potential GRAT limitations

A drawback of the GRAT is that if the grantor dies before the end of the GRAT term, potentially all of the property in the GRAT will be included in the grantor’s taxable estate. A further limitation of the use of a GRAT is that the transferred assets, though excluded from the grantor’s taxable estate (assuming the grantor survives the term of the GRAT), may be included in the taxable estates of the beneficiaries of the GRAT, due to the inability to allocate GST exemption to the GRAT at the time of its creation.

The combination of today’s depressed asset values and historically low Section 7520 rate make the use of a GRAT potentially very advantageous, especially where the assets are likely to appreciate. Under these circumstances, the use of a GRAT may provide a method for transferring significant wealth tax-free or nearly tax-free.