Grantor Retained Annuity Trusts: An Estate Planning Strategy

In the current economic environment, IRS-prescribed monthly interest rates for certain intra-family transactions are at historic lows. As a result, an excellent opportunity exists to transfer wealth to lower generation family members while minimizing taxes. In Part Two of our three-part series on effective estate planning strategies in a low-interest-rate environment, we examine the technique known as “Grantor Retained Annuity Trusts” (GRATs), specifically “Zeroed-Out” GRATs. Like Intra-Family Loans described in Part One, a GRAT is an excellent strategy in a low-interest-rate environment to transfer wealth to a lower generation at reduced or no transfer tax costs.

A GRAT is a trust typically established by a parent, the trust’s “Grantor”, who transfers assets – such as stock or closely-held business interests – to the GRAT for a specific term of years, typically between two and ten years. The GRAT is often written to provide that the parent retains the right to receive back, in the form of annual fixed payments (that is, the “annuity”), 100% of the initial fair market value of the assets transferred to the GRAT, plus a rate of return on those assets based upon the IRS-prescribed interest rate known as the “7520 rate”, which references the Internal Revenue Code section detailing how this rate is to be calculated. The IRS’s 7520 rate for June 2015 is 2.0%. Any assets remaining in the GRAT at the end of the trust’s term of years pass to the named beneficiaries, typically the Grantor’s children, without additional gift tax. This type of GRAT is often referred to as a “Zeroed-Out GRAT” since it does not result in the Grantor making a taxable gift due to the retention of annuity equal to 100% of the assets contributed to the GRAT.

As an illustration, assume a parent contributes $1,000,000 of XYZ stock to a two-year Zeroed-Out GRAT during June 2015. Here, the parent will receive two annuity payments of $515,039 each from the GRAT at the end of the first and second years. If the XYZ stock appreciates at more than the 2.0% 7520 rate during the two-year GRAT, there will be a residual value left in the GRAT at the end of two years that would pass to the beneficiaries free of gift tax. So, if the initial GRAT value appreciated at 10% annually during the two years, there would be approximately $128,000 of value to pass to the beneficiaries gift tax-free at the end of two years, while if the initial GRAT value appreciated 7% annually, there would be approximately $78,000 left to pass to the beneficiaries gift tax-free at the end of the two-year GRAT.

The significant downside of this technique is that the Grantor must outlive the trust term for growth in excess of the 7520 rate, if any, to be distributed to the beneficiaries free of gift tax. If the Grantor dies during the trust term, the GRAT assets remain includible in the Grantor’s estate for estate tax purposes. Accordingly, it is vital to select a term for the GRAT that the Grantor is expected to survive.

To summarize, the GRAT technique presents somewhat of a “free shot” at attempting to shift future appreciation of assets to beneficiaries without any gift or estate tax. Under current law, there will be no taxable gift made assuming a Zeroed-Out GRAT is used. Further, if the Grantor survives the term of a GRAT created in June 2015 and the assets appreciate, a transfer to the trust beneficiaries will occur with respect to any appreciation over 2.0% on an annual basis. If such appreciation does not materialize, the Grantor will receive all of the trust assets back through receipt of the annuity payments. In other words, the Grantor will generally be no worse off from having tried the GRAT technique even if it does not work out as hoped. And in many instances, the Grantor can “roll over” the assets into a new GRAT and try again for the next two years.

If you have any questions or would like to discuss this planning opportunity or the others in this series in more detail, please let us know.