Current Economic Environment Represents a Prime Time for Grantor Retained Annuity Trusts

In light of the recent stock market downturn and the current low interest rate environment, now may be an ideal time to consider using marketable securities to fund a Grantor Retained Annuity Trust (GRAT). This article will describe the basic characteristics and benefits of a GRAT strategy.

A GRAT is an irrevocable trust funded with a single contribution of assets which pays back to the grantor a percentage of the initial contribution, either fixed or with a predetermined increase (the “annuity”), for a term of years, and then distributes the assets remaining at the end of the term to beneficiaries, such as the grantor’s children or trusts for their benefit.

GRAT Overview

The objective of a GRAT is to shift future appreciation on the assets contributed to the GRAT to others at a minimal gift tax cost. For the GRAT strategy to be successful, the assets contributed to the GRAT must appreciate (or otherwise generate a return) at a rate greater than the IRS assumed rate of return (also known as the Section 7520 rate or the hurdle rate). This IRS assumed rate of return is published monthly, so the rate in effect for the month the GRAT is created will apply. For example, the IRS assumed rate of return for May, 2009, is 2.4 percent. The difference between the actual rate of return of the assets contributed to the GRAT and the IRS assumed rate of return will pass, gift tax free, to the beneficiaries at the end of the GRAT term.

After the grantor contributes assets to the GRAT, the grantor retains the right to receive annuity payments for a set period of time (for example, two or three years), after which time the assets remaining in the GRAT pass to the grantor’s children (or other beneficiaries), either outright or in trust. A GRAT is not a good vehicle for making transfers to grandchildren or more remote descendants due to unfavorable consequences under the generation-skipping transfer tax.

Under the terms of the GRAT, the grantor retains the right to receive annual annuity payments, which are determined as a percentage of the value of the assets contributed to the GRAT. In order to minimize the gift tax consequences to the grantor upon funding the GRAT, this percentage is typically set very high as is illustrated below.

Illustration of a GRAT

By way of illustration, assume a grantor transfers $1 million of marketable securities to a three-year GRAT in May 2009, when the IRS assumed rate of return is 2.4 percent. The GRAT will provide for three annual annuity payments of 34.945 percent of the value of the assets initially contributed to the GRAT ($349,450). If the assets in the GRAT do not yield sufficient income to fund the annuity payments, principal of the trust will be distributed back to the grantor to satisfy the payments. At the end of the three-year period, the grantor’s children (or a trust for their benefit) will become the beneficiaries of whatever assets remain in the GRAT after the annuity payments to the grantor have been satisfied.

The taxable gift resulting from the transfer of property to the GRAT is the present value of the remainder interest, determined using the 2.4 percent IRS assumed rate of return. Under the facts in this example, the taxable gift is minimal because (a) given the high annuity payout percentage, the grantor will receive back almost all of the GRAT assets if they earn the assumed 2.4 percent investment return, and (b) the gift tax is based on the anticipated remainder value of the GRAT at the end of the term of the GRAT. Based on the IRS’s computation method, the amount of the grantor’s taxable gift in this example would be approximately $14, so it would use a negligible amount of the grantor’s exemption from federal gift tax. The taxable gift could be made even smaller (for example, under $1), but many practitioners prefer to choose an annuity payout percentage that yields a more substantial taxable gift for gift tax reporting purposes.

Assuming the marketable securities transferred to the GRAT had an actual annual investment return of 10 percent, at the end of the three-year term, there would be approximately $174,321 of assets left in the GRAT for the benefit of the grantor’s children after the required annuity payments are made to the grantor. Measured against the use of a negligible amount of exemption from federal gift tax at the creation of the GRAT, this is an outstanding result from a gift tax standpoint.

If there is adverse investment performance and the GRAT has a rate of return of 2 percent, for example, the grantor will receive back all of the GRAT assets through the annuity payments, and nothing will be left for the benefit of the children, but the grantor will not have wasted an appreciable amount of his or her exemption from federal gift tax. Comparing the favorable result in the preceding paragraph against this unfavorable scenario highlights a key tax benefit of the GRAT – when it works, the results are excellent, and when it does not work, the loss is minimal. Based on this characteristic, a GRAT is traditionally viewed as an excellent vehicle to hold highly speculative investments that have the potential for significant appreciation. Given the current depressed value of the stock market, however, equity investments may have a potential for double digit appreciation as a result of a rebound. This growth potential, combined with a relatively low IRS assumed rate of return, makes this an extremely attractive time to establish one or more GRATs.

Material Tax Considerations

If the grantor dies before the end of the term of the GRAT, then, in most cases, the GRAT assets will be includible in the grantor’s estate, and the advantages of the GRAT strategy will be lost. This favors the use of a relatively short term for a GRAT. In addition, it is generally easier to “beat” the IRS assumed rate of return over a short period of time. For example, a 10 percent annualized rate of return on an investment over a two-year period occurs more frequently than a 10 percent annualized rate of return on an investment over a 10-year period. Recognizing this fact, the Treasury Department has set forth a proposal that GRATs must have a minimum term of 10 years. The proposal comes at an interesting time, given that many practitioners are currently suggesting that it is advisable to create longer term GRATs to lock-in the historically low interest rates.

A grantor may also choose to establish new GRATs each year to be funded with the annuity payments received from the GRATs established in prior years. This strategy of “rolling” GRATs can be helpful to capture a sharp increase in value that occurs after the GRAT has already made one or more annuity payments to the grantor.

To defer the estate tax consequences of a married grantor if the grantor dies during the GRAT term, it is advisable to amend his or her estate plan to make sure that the GRAT assets that are includible in his or her estate qualify for the marital deduction or otherwise pass in a tax efficient manner. Since the GRAT assets are divided between annuity payments and a remainder interest, GRAT property passing via a traditional estate plan might not qualify for the marital deduction.

A GRAT should be taxed as a “grantor trust” for income tax purposes which has several benefits. First, since it is a grantor trust, the grantor will report the GRAT income (during the annuity period) on the grantor’s individual income tax return and pay the resulting taxes from the grantor’s own funds. Accordingly, the GRAT strategy generally will yield benefits to the ultimate beneficiaries if the pre-tax return on its assets exceeds the IRS assumed rate of return. Second, as a grantor trust, the GRAT can pay the grantor the annuity using appreciated assets without the distribution being treated as a taxable sale of the assets. Thus, if the grantor funds the GRAT with stock, the GRAT can make annual annuity payments to the grantor in kind, using the stock.

Other Considerations

1. It is often preferable to have multiple GRATs, each holding a different investment, as compared to a single GRAT with a diversified portfolio. For example, if a grantor wanted to fund a GRAT with Exxon stock and Microsoft stock, then it may be better to have an Exxon GRAT and a Microsoft GRAT (rather than transferring both to the same GRAT). This will prevent investments that do not appreciate substantially from offsetting the gain on investments that do increase in value. There is no limit on the number of GRATs a person can create.
2. Often, a grantor prefers to provide that the annuity payments from the GRAT increase over time. By making the earlier annuity payments less, and the later annuity payments more, the grantor allows more of the assets to remain in the GRAT to grow. A GRAT may be structured so that the annuity payments increase by as much as 20 percent per year.
3. Grantors often prefer to make the remainder beneficiary of a GRAT an irrevocable trust(s) for the benefit of children (rather than the children outright). By keeping a child’s share in trust, the grantor can provide some creditor protection for the child. Also, the irrevocable trust could be structured as a grantor trust, which would mean the grantor (rather than the trust or the child) would be taxable on the income generated by the trust assets, which, in effect, allows the grantor to make additional tax-free transfers to the trust due to the income tax savings of the trust.
4. If the grantor is a reporting person with respect to public company stock transferred to a GRAT, the transfer should not be made during a “black out” period during which trading is prohibited, and the identity of the trustee of the GRAT will determine what reporting is required for purposes of Securities and Exchange Commission disclosure requirements.

Conclusion

The use of GRATs can be an effective strategy for passing appreciation on investments to children (or trusts for their benefit) at a minimal transfer tax cost. The current economic environment, including a depressed stock market and relatively low interest rates, enhances the ability of GRATs funded with marketable securities to outperform the IRS assumed rate of return, which may result in significant transfers to children.

The beauty of the GRAT strategy is that if it does not work, then the grantor receives back all of the GRAT assets in the form of annuity payments, and very little gift tax exemption has been wasted. If it does work, however, then significant value can be transferred to the next generation. For these reasons, a GRAT strategy can play an important role in a gift giving program.