“Grantor Retained Annuity Trusts: A Silver Lining” by Emily Bell

It’s difficult to avoid–the depressed economy and crumbling of Wall Street has taken over the news media. All of us can feel the impact of these difficult times with higher gas prices, a stalled real estate market and decline in our investments. There is, however, a silver lining in the dark cloud of the current economy: an estate planning and tax savings technique that is perfect for times like this.
Grantor Retained Annuity Trusts (or GRAT’s, as they are commonly known) are successful when the IRS assumed rate
of growth (“IRS rate”) is lower than the actual growth rate of assets. The premise behind GRAT’s is relatively simple. The taxpayer (also called the “Grantor”) transfers assets that he or she expects to grow in value into a trust. For a specified term of years, the trust pays an annuity to the Grantor based on the IRS rate. If all goes
as planned, the trust assets will appreciate at a faster rate than the IRS rate and there will be assets left in trust after the annuity term has ended. At the end of the annuity term, the remaining trust assets are distributed
to the beneficiaries named in the trust, such as the Grantor’s descendants, and removed from the Grantor’s estate for estate tax purposes. If done correctly, there is no gift involved and hence no gift tax. The GRAT allows a portion of the Grantor’s assets to be successfully removed from his or her estate and passed down to his or her descendants without incurring any gift tax.
The best assets to put into a GRAT are those that are expected to grow in value in a relatively short amount of time (although the term can vary). For example, if you are a small business owner with shares of stock or LLC interests that currently have a low fair market value, but you expect these assets to grow dramatically in value over the next few years, these assets are the perfect candidate to fund a GRAT. This is especially true when
the IRS rate is at a historic low, as this makes it easier to “beat” the IRS rate and have assets left over for descendants at the end of the annuity term. The IRS rate used for this purpose is determined by the IRS on a monthly basis and is based on interest rates and the economy.
To illustrate the mechanics and benefits of a GRAT, consider this example: A 60 year old taxpayer contributes $500,000 worth of LLC interests into a GRAT on October 15, 2008. The annuity term of the GRAT is five years. In order to “zero out” the GRAT to avoid gift taxes, the Grantor will receive an annual annuity payment of $111,684 (which can be paid in kind by distribution of LLC interests). If the trust earns income at a rate of 5% and trust
principal grows at a modest 5% per year, almost $126,300 will be left at the end of the five year term to distribute to the Grantor’s descendants free of gift tax. The Grantor has decreased the value of his estate by $126,300 without incurring a gift tax.
Another way a GRAT may help to reduce the value of the Grantor’s estate is by virtue of the GRAT being treated as a
“grantor trust” for income tax purposes. This means that the Grantor is responsible for paying income taxes on the GRAT’s income. It’s a win-win situation: the Grantor is reducing the value of his estate and the assets in the GRAT are allowed to grow rather than being distributed to pay taxes.
If the assets decrease in value so much so that the annuity payment to the Grantor is less than what is required to be paid based on the IRS rate, then all of the assets will be paid to the Grantor during the term of the trust, and there is nothing left to pass to descendants at the end of the annuity. This merely puts the Grantor in the same position he or she would have been had no GRAT been created. The same is true if the Grantor dies during the
annuity term. All or part of the assets will be included in his or her estate for estate tax purposes, but this is what would have happened had the GRAT not been created. Therefore, there is truly only a potential upside and no downside to creating a GRAT.
There is a silver lining to this dark cloud we are under – you can take advantage of historically low IRS rates in order to decrease estate taxes and pass on wealth to future generations. If you would like to discuss the potential use of GRAT’s in your particular circumstances, please contact a member of the CECB Estate Planning Practice Group.