Understanding Your Wealth: An Introduction to Grantor Retained Annuity Trusts

Posted on 09.05.17

Understanding Your Wealth: An Introduction to Grantor Retained Annuity Trusts

By Michael J. Mariani, Tax Associate | Family, Executive & Entrepreneur Advisory Services Team

A Grantor Retained Annuity Trust, or “GRAT,” is a commonly used estate planning technique that allows families to transfer wealth to their children with little or no gift tax consequences.

Specifically, a GRAT is an irrevocable trust established by a grantor, who transfers assets in trust and retains the right to receive a fixed dollar amount annually for a specified term of years.  At the expiration of the GRAT’s term, any remaining assets are distributed to the grantor’s named beneficiaries either outright or further in trust.

Such arrangements are sometimes referred to as “split interest” trusts, namely for the two types of interests that comprise a GRAT: (i) the retained interest, paid to the grantor in the form of an annuity; and (ii) the remainder interest that is the remaining GRAT assets, if any, distributed to the grantor’s beneficiaries at the expiration of the GRAT’s term.

The grantor’s fixed annuity payment, which is determined at the outset of the trust, is based in part on the fair market value of the assets transferred to the trust plus interest at the Internal Revenue Service’s assumed rate of return. The IRS assumed rate of return, as prescribed under Internal Revenue Code Section 7520, is published monthly and set at 120 percent of the applicable federal midterm rate, rounded to the nearest two-tenths of a percent.  The Section 7520 rate has ranged from as high as 11.6 percent in May 1989 to as low as 1 percent, most recently in January 2013.[1]  Since May 2011, the Section 7520 rate has remained at or below 3 percent.[2]  For September 2017, the Section 7520 rate is 2.4 percent.[3]

Scenarios

In order for a GRAT to be successful, the GRAT assets must appreciate at a rate that exceeds or outperforms the Section 7520 rate.  For example, assume $1,000,000 of marketable securities are transferred to a two-year GRAT and appreciate at a rate of 12 percent over the GRAT term.  If the Section 7520 rate was 2 percent at the time the GRAT was created, $100,000 or 10 percent, i.e., the appreciation in excess of the Section 7520 rate, would be distributed to the beneficiaries free of any gift tax.  As this example illustrates, when the Section 7520 rate remains low, the amount of wealth that can be transferred to successive generations is only limited by the appreciation of the assets contributed to the GRAT.

If, however, the GRAT assets fail to appreciate at a rate that exceeds the Section 7520 rate, all of the assets transferred to the GRAT will be returned to the grantor, in kind, during the annuity term and no assets will be distributed to the remainder beneficiaries. Thus, even when a GRAT is unsuccessful, the grantor is in no worse a tax position for having established the GRAT. The grantor is always free to try again and can either re-contribute the assets to a new GRAT or contribute different assets to a new GRAT with the objective that the assets in the new GRAT will outperform the Section 7520 rate.

Risk

Perhaps the biggest risk associated with establishing a GRAT is the grantor’s mortality. If the grantor dies during the GRAT’s term, all of the assets held in the GRAT, including any appreciation, will be taxable as part of the grantor’s estate. To hedge against such risk, GRATs are often structured for the shortest term possible (i.e., two years), and in the case of married taxpayers, both spouses can fund separate GRATs.

Gift Taxes

For gift tax purposes, the grantor’s transfer of assets to the GRAT is treated as a completed gift at the time the GRAT is funded.  The taxable amount of the grantor’s gift is calculated as the fair market value of the assets transferred to the GRAT, less the present value of the grantor’s retained annuity interest.  Note here that although the grantor is treated as having made a gift when the GRAT is funded, the taxable amount of the gift is only a fraction of the fair market value of the assets transferred because it represents a future interest to the remainder beneficiaries.

"Zeroed out" GRAT

In a “zeroed out” GRAT, the grantor’s retained annuity interest is calculated so that the present value of the fixed annuity payments equals the fair market value of the assets transferred to the GRAT, plus interest at the Section 7520 rate.  Under this arrangement, the grantor is treated as having made a tax-free gift to the remainder beneficiaries.  Moreover, the grantor is not required to use any of his or her lifetime estate and gift tax exemption[4] to execute the zeroed out GRAT.  

Income Tax

For income tax purposes, a GRAT is considered a grantor trust. This means that all of the GRAT’s income, gain, loss, and credit that accumulates during the GRAT’s term will be taxed to the grantor. However, the grantor’s payment of the income tax liability associated with the GRAT is not considered an additional gift to the GRAT. This provides an additional benefit to the remainder beneficiaries, since the GRAT assets are not reduced by any income taxes.

Conclusion

As the Section 7520 rate hovers around a record low, and the stock market continues along its bullish trend, GRATs provide an excellent opportunity for families to transfer significant amounts of wealth to their children with little or no gift tax consequences and minimal downside risk. 

Is a GRAT right for you? Contact your professional advisor. Questions on this topic? Call or email our Family, Executive & Entrepreneur Advisory Services team | 804.747.0000 | Email

 

[2] Id.

[3] Section 7520 Rates, www.irs.gov/businesses/small-businesses-self-employed/section-7520-interest-rates (site last visited Sep. 2, 2017).

[4] Beginning in 2011, the estate and gift tax was unified with a lifetime exemption amount.  For 2017, the amount of the lifetime estate and gift tax exemption is $5.49 million per taxpayer or $10.98 million for married taxpayers.  Accordingly, gifts made during a taxpayer’s lifetime will reduce a taxpayer’s taxable estate; however, gifts in excess of the annual gift tax exclusion (i.e., $14,000 for individual taxpayers or $28,000 for married taxpayers) will also reduce a taxpayer’s lifetime estate and gift tax exemption.