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.
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).
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.
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.