California Probate - Law Offices of Janet Brewer Blog

Grantor Retained Annuity Trusts (GRAT)

Innovative technique may eliminate a GRAT’s mortality risk

One of the most tax-efficient vehicles for transferring wealth to your family is a grantor retained annuity trust (GRAT). Plus it provides you, the grantor, with an income stream. But there’s a major drawback to this estate planning strategy: If you don’t survive the trust’s term, the assets are included in your estate and taxed as if you had never created the trust.

Over the last few years, a number of estate planners have begun using an innovative new technique — the guaranteed GRAT — in an effort to eliminate this mortality risk. This strategy is designed to let your family take advantage of a GRAT’s substantial tax benefits without worrying the benefits will be lost if you die unexpectedly.

Keep in mind, however, that guaranteed GRATs have not yet been accepted by the IRS or the courts. Before using this strategy, be sure to discuss the pros and cons with your estate planning advisor.

GRAT basics

A GRAT is an irrevocable trust you fund with a one-time contribution of assets. The trust pays you an annuity for a specified number of years, and at the end of the term any remaining assets are transferred tax-free to your children or other beneficiaries.

The annuity can be a fixed percentage of the initial contribution’s value or a fixed dollar amount. You also may design it with predetermined increases. You must report the annuity payments on your individual income tax return.

Gift tax savings

A GRAT’s tax-saving power lies in its ability to minimize or eliminate gift tax. The present value of the heirs’ remainder interest in the trust assets is subject to gift tax. That value is determined using the Section 7520 interest rate, published monthly by the IRS.

The annuity amount can be designed to minimize the value of the remainder interest — or even eliminate it altogether (a so-called “zeroed-out GRAT”) — for gift tax purposes. Then any actual appreciation beyond the IRS’s “assumed rate of return” passes to the heirs tax-free. (See the sidebar “GRATs are great in a low interest rate environment” for an illustration.)

The key to reducing gift tax with a GRAT is to fund the trust with assets you expect to outperform the Sec. 7520 interest rate, such as real estate or securities with great appreciation potential. A GRAT also can be a viable strategy for transferring assets that are subject to valuation discounts, such as limited partnership interests or closely held business interests (especially if the company may be sold or go public in the future).

The guarantee

As discussed earlier, if you don’t outlive its term, assets remaining in the trust will be included in your taxable estate. To avoid this downside, consider creating a guaranteed GRAT. How?

First, you establish a GRAT and retain a contingent reversion interest, which means that if you don’t survive the term, the remaining trust assets will be paid to your estate. Shortly after you form the GRAT, you and your children enter into an agreement for them to purchase the equivalent of your contingent reversion interest at fair market value. Because the purchase price is set at the time you draft the GRAT, it should be only a fraction of the value of the assets your children ultimately receive.

If you die before the end of the trust’s term, the remaining assets are distributed to your estate, but under the purchase agreement, the estate is contractually obligated to pay an equal amount to your children. Even though the assets are included in your estate, the estate is entitled to an offsetting estate tax deduction for the amount it’s required to pay to the children. In effect, the children receive the remaining trust assets tax-free as if you had outlived the trust.

Exercising caution

Properly structured, this strategy lets your family take advantage of a GRAT’s substantial tax benefits without worrying the benefits will be lost if you die unexpectedly.

A guaranteed GRAT can give you peace of mind that your family will be able to take advantage of your GRAT’s tax benefits if you die suddenly. But like any new estate planning technique, the guaranteed GRAT is relatively untested, so it’s important to consider potential risks of an IRS challenge. And keep in mind that traditional GRATs also are subject to complex rules and regulations, so careful planning is necessary.

GRATs are great in a low interest rate environment

Grantor retained annuity trusts (GRATs) can be especially attractive when interest rates are low. Let’s take a closer look at an example that illustrates why.

Susan, age 60, transfers $2 million in assets to a five-year GRAT that provides for five annual annuity payments of $449,000 (22.45% of the value of the initial contribution). At the end of the term, the remaining assets pass to Susan’s daughter, Caroline. Assume that the Section 7520 rate for the month the GRAT is established is 4%, and the actual rate of return on the assets is 10%.

Based on the assumptions, the gift tax value of the transfer is $65,484 even though nearly $500,000 is transferred to Caroline. The gift is potentially significantly less in light of a recent decision involving the Sam Walton family. It’s still too early, though, to rely on that decision. Please contact your professional advisor to help you determine how this decision may affect your estate plan.

When is a Home Not a Home? Change of Domicile and Estate Planning

Your domicile — your home or permanent residence state — will control where your estate is probated and which state’s rules apply at your death. State estate tax rates can vary significantly. So your domicile can dramatically affect how much of your estate goes to taxes vs. your heirs. Your domicile also may have other important ramifications during your life, such as determining how (and if) your income will be taxed. State income tax rates vary widely.

As a result, it’s important that it’s as obvious as possible and not overly subject to interpretation. If you have homes in multiple states, you may be inadvertently adding confusion to your eventual estate administration. Why? Because more than one state may lay claim to your estate and the accompanying tax.

Even though your intent with respect to domicile is important, your actions are more important. To demonstrate that you consider a particular place to be your domicile:

• Use the address for correspondence, particularly with respect to the IRS or state tax authorities with whom you may have to argue your position,

• Register to vote there,

• Register and insure your vehicles there,

• Have your driver’s license and, if relevant, other licenses issued there, and

• License or register your pets there.

If you change your domicile, be sure to update your estate plan to reflect your new state as your state of domicile and, as appropriate, as the controlling law.

Regardless of the steps you take, more than the intended state may try to claim that you are domiciled there. Determine where you want your domicile to be and take as many steps as necessary to strengthen your argument. After all, just because you have a home in a state, it doesn’t necessarily mean that the state is your home state.

Three Reasons to Keep Assets In Trust for Your Child

Many years ago the prevailing estate planning philosophy was that keeping assets in trust for a child’s lifetime was administering from the grave. Today, more people view it as providing security for children and grandchildren in a more unsettled world.

Sometimes, you may want to deny your child complete access to your funds. So let’s examine three reasons to keep assets in trust for your child.

1. Insulates assets from creditor claims and divorce proceedings

Money held in trusts is off-limits to the beneficiary’s creditors and from a divorcing spouse during divorce proceedings. For example, if your child starts a business and he or she guarantees a loan and the business fails, the bank can’t attach the assets in his or her trust. If your child gets divorced, the divorce court isn’t permitted to give his or her spouse trust property.

If a child received all trust assets on reaching a specified age and kept the assets solely in his or her name, almost all states would not consider this property marital property. Thus, the spouse would not be entitled to any of the trust assets after a divorce. But if your child puts the money in joint tenancy with his or her spouse, the assets would be considered marital property in most states, and the divorce court could give the spouse a percentage of the assets.

2. Keeps property in the family

If your child has the right to withdraw his or her entire trust after reaching a specified age, he or she is free to dispose of those assets any way he or she desires. If your child decides to put the money in joint tenancy with his or her spouse and predeceases the spouse, the assets will go to the spouse as a surviving joint tenant.

This should not be problematic because the spouse will, in all likelihood, take care of any children (your grandchildren) she has with your deceased child. But if the spouse remarries, puts all the trust’s property in joint tenancy with a new spouse, and then predeceases that spouse, all the assets would pass to the new spouse and your grandchildren would receive nothing.

Keeping the funds in trust for your child ensures that, on his or her death, the trust’s assets will either be distributed to or continued to be held in trust for your grandchildren rather than being bequeathed to your child’s spouse.  

3. Provides for a trustee to control asset distribution

By keeping your assets in trust you may name a trustee to invest the money and control distribution of trust income and principal to your child. If you’re concerned that your child may not be capable of correctly investing the trust’s assets, you may choose an individual as a trustee who either knows how to invest or would hire someone who does. You also may hire a bank or a trust company to act as trustee.

If you believe your child may spend the money irresponsibly, you can authorize the trustee to make asset distributions according to the trust’s terms. You also may direct the trustee to distribute property only when your child reaches specific incentives, such as graduating from high school or earning a college degree.

Finally, you may name your child as a co-trustee when he or she reaches a specific age. As a co-trustee, your child can learn the ins and outs of investing assets from the trust’s trustee.

Many more benefits

These are but three reasons to consider leaving assets in trust for your child. Many more benefits may exist depending on your situation. To learn more about these versatile estate planning vehicles, please give us a call.

QTIP Trusts and Blended Families

With the rate of divorce so high in the country today, it is not unusual to end up in what is referred to as a "blended family."

Do you remember the old movie--"Yours, Mine and Ours?" Now, fast-forward that same idea about 30 years down the road. They were in an unusual situation for that time period but today it is commonplace to have a blended family. In order to keep everything straight, there are a few items you can put in place to keep the peace.

A QTIP Trust Can Keep Everyone Happy

If you’re getting married for the second (or later) time, before the big day it’s wise to review your estate plan — especially if you have children.

Why? Because financial conflicts between your future spouse and children from previous marriages may arise. To head these problems off at the pass and maintain family harmony, consider a Qualified Terminable Interest Property (QTIP) trust.

QTIP as a Family Peacekeeper

A QTIP trust gives you the peace of mind that assets you leave to your spouse won’t eventually be distributed in a way that’s against your wishes. In other words, it provides lifetime security for your surviving spouse while protecting your children from a previous marriage from disinheritance by your spouse.

How does this work? You designate your new spouse as the current trust beneficiary and your children from your previous marriage as the remainder beneficiaries. Your spouse receives all income from the trust, and you can allow your spouse as much or as little access to the principal as you choose — though giving him or her too much access to the principal would defeat the trust’s purpose.

Bear in mind that, even with a QTIP trust, squabbles can erupt between spouses and children about investment decisions that affect how much income the trust will generate for distribution. Some states have total return trust legislation, which allows the surviving spouse to annually receive a fixed percentage of the trust assets in lieu of income.

A Balancing Act

When creating a QTIP trust, you must choose a trustee and successor trustee. Your trustees must balance the needs of both your surviving spouse and the children. Often, a corporate trustee is the best choice because he or she provides neutrality. QTIP trust beneficiaries often have the option of removing a trustee.

To ensure that a trustee who favors one beneficiary over another isn’t put in place, require both the surviving spouse and the children to agree on any successor trustees. In some circumstances it may be appropriate to form a contingency plan.

For example, let’s say your new spouse is considerably younger than you. Under a QTIP trust, your children won’t receive their inheritance until your spouse dies, which may be many years after your death. Thus, consider making an immediate distribution of part of your estate to the children in a separate trust, and place only a fraction of the total estate in trust for the surviving spouse.

A Clean Start for your Family

A second or third marriage can be both a joyous and contentious time for you and your family. To smooth over conflicts, consider setting up a QTIP trust to help meet everyone’s needs.

All the best,