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A grantor retained annuity trust (GRAT) is an irrevocable
trust into which you make a one-time transfer of property, and from which you
receive a fixed amount annually for a specified number of years (the annuity
period). At the end of the annuity period, the payments to you stop, and any
property remaining in the trust passes to the persons you’ve named in the trust
document as the remainder beneficiaries (e.g., your children), or the property
can remain in trust for their benefit.
A GRAT is generally used to transfer rapidly appreciating or
high income-producing property to heirs with the main goal of transferring,
free of federal gift tax, a portion of any appreciation in (or income earned
by) the trust property during the annuity period.
With a GRAT, you generally receive a fixed
dollar amount that does not change even if the value of the trust property
increases or decreases. Alternatively, you may retain the right to receive a
fixed percentage of the trust property determined annually. This is known as a
grantor retained unitrust (GRUT). A GRUT provides more income, but less tax
savings, than a GRAT.
How a GRAT works
Because a GRAT is an irrevocable trust, when you transfer
property to the GRAT, you’re making a taxable gift to the remainder
beneficiaries. The value of the gift is discounted because of your retained
interest. The amount of the discount is calculated using IRS valuation tables
that assume the property in the trust will realize a certain rate of return
during the annuity period. This assumed rate of return is known as the Section
7520 rate, discount rate, or hurdle rate. If the property in the trust grows
more than the IRS assumes it will, the excess growth will pass to the remainder
beneficiaries gift tax free.
For example, say you transfer your high yield investment
portfolio worth $1 million to a GRAT that will pay you $117,000 at the end of
each year for 10 years. Also say that the current Section 7520 rate is 3.0%.
According to the IRS tables, your retained interest is valued at $998,033, and
the taxable gift to the remainder beneficiaries is valued at $1,967. You pay
federal gift tax on $1,967 or offset this amount with your
gift and estate tax applicable exclusion, to the extent it has not already been used.
If the investment portfolio actually earns a 3.0% annual
return over the 10-year term, about $1,967 will be left in the trust to
distribute to the remainder beneficiaries. If, however, the investment
portfolio actually earns a 5.0% annual return, about $157,281 will pass to the
remainder beneficiaries (but the taxable gift will have been only $1,967). And,
if the investment portfolio actually earns a 10.0% annual return, about
$729,064 will pass to the remainder beneficiaries (but the taxable gift will
have been only $1,967).
Because the transfer to the remainder
beneficiaries is not a present interest gift, it does not qualify for the annual gift tax exclusion.
You may fail to outlive the annuity term
If you die during the GRAT term, all of the property in the trust
will be included in your gross estate for federal estate tax purposes.
The advantages of the GRAT will be lost, and you will
have incurred the costs of creating and maintaining the GRAT
for nothing.
The remainder beneficiaries may want to buy
life insurance on your life to potentially cover any taxes that may result from the
inclusion of the GRAT property in your gross estate.
The GRAT may fail to outperform the Section 7520 rate
If the GRAT property does not produce a return that exceeds
the Section 7520 rate, there will be no excess to transfer and no tax savings
will be achieved (the trust may even be depleted), defeating the purpose of the
GRAT. This outcome puts the grantor in the same position he or she would have
been in had the GRAT not been created; however, the costs of creating and
maintaining the GRAT will have been wasted.
The Section 7520 rate is generally based on
current risk-free interest rates. Thus, a GRAT can be especially attractive in
a low interest rate environment.
GRAT generally not appropriate for generation-skipping
transfers
The federal generation-skipping transfer tax (GSTT) (and
perhaps state GSTT as well) will apply to transfers of property made to a GRAT
if some or all of the remainder beneficiaries are two or more generations below
the grantor (these are known as skip persons). However, the transfer does not
actually occur until the grantor’s retained interest terminates. Thus, the
grantor cannot allocate his or her GSTT exemption to the transfer until the end
of his or her retained interest (or estate tax inclusion) period (this is known
as the estate tax inclusion period or “ETIP” rule). Allocating the GSTT
exemption when the trust property has already appreciated fails to leverage the
exemption. Therefore, a GRAT may not be an appropriate device for making
transfers to skip persons.
A grantor may be able to circumvent these
generation-skipping transfer limitations using sophisticated estate planning
techniques. An experienced estate planning attorney should be consulted.
Remainder beneficiaries do not receive a step-up in
basis
Unlike property received because of the death of the
transferor, property transferred to the remainder beneficiaries does not
receive a step-up in basis.
This situation may be averted if the grantor
buys the trust property at the end of the retained interest period. The
remainder beneficiaries get the cash instead, and the property will receive the
step-up in basis at the grantor’s death.
GRAT is considered a grantor trust for income tax
purposes
For income tax purposes, a GRAT should be a grantor trust.
Being classified as a grantor trust means that all items of income and
deductions flow through to the grantor. This is the case even if all of the
income earned by the trust property is not distributed to the grantor. The
grantor should have other property available to meet this liability.
While trusts offer numerous advantages, they incur up-front costs and often have ongoing administrative fees. The use of trusts involves a complex web of tax rules and regulations. You should consider the counsel of experienced estate planning, legal, and tax professionals before implementing trust strategies.
All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy will be successful. Investments offering the potential for higher rates of return involve higher risk.
The cost and availability of life insurance depend on factors such as age, health, and the type and amount of insurance purchased.