What You Should Know About Grantor Retained Annuity Trusts
1. What is a Grantor Retained Annuity Trust?
A Grantor Retained Annuity Trust (“GRAT”) is created when property is transferred to an irrevocable trust, and the grantor retains the right to receive an annuity payment from the trust for a fixed term of years, usually between 2 and 20 years. At the end of the term, the remaining trust property will pass to the beneficiaries, usually the grantor’s children, free of estate tax.
When establishing a GRAT, the grantor must report a taxable gift equal to the present value of the remainder interest. However, the GRAT is so powerful that it may be possible to establish one without having to report a taxable gift at all. By configuring the annuity to equal the value of the transferred property, the taxable gift can be reduced to almost nothing. This is referred to as a “zeroed-out GRAT.”
The power of a zeroed-out GRAT will be most evident if the trust property can outperform a special interest rate called the Section 7520 rate over the trust term. In effect, the initial value of the trust property is paid back in full to the grantor (in the form of an annuity), but all appreciation in excess of the Section 7520 rate is transferred free of estate and gift tax to the beneficiaries.
2. How does a Grantor Retained Annuity Trust work?
For example, assume Parent transfers property valued at $1,000,000 into a GRAT and retains a right to receive annuity payments back from the trust for 10 years. The selected annuity payout rate is 12.45%, which is large enough to reduce the remainder interest to zero. Thus, Parent would report a zero or nominal taxable gift. Assuming Parent lives for at least 10 years, the entire value of the trust – perhaps now worth $1,750,000 – is excluded from Parent’s estate for estate tax purposes. Effectively, the “cost” of transferring the $1,750,000 property to the grantor’s children was $0.
After the 10 year term expires, the trust could distribute its property outright to the grantor’s children, or to trusts for their benefit.
3. What could go wrong with a GRAT?
A Grantor Retained Annuity Trust is almost a no-risk technique, but plans might go wrong:
4. Can LLC or partnership interests be used to fund a Grantor Retained Annuity Trust?
Yes, this is an excellent strategy. If the GRAT is funded with LLC or partnership interests, they will likely qualify for a valuation discount. The term “discount” means that a LLC or partnership interest will be valued less for tax purposes than the actual value of the underlying assets. A qualified appraisal is needed to substantiate the discount, which is usually for lack of control and/or lack of marketability. The size of the discount depends on many factors, but may range as high as about 50%.
A valuation discount can be leveraged to make the GRAT even more powerful. A lower initial value for the trust means the annuity payments back to the grantor will be lower. This makes it much easier for the trust to exceed the minimum growth rate it needs to succeed.
5. What are the disadvantages of using a Grantor Retained Annuity Trust?
The GRAT is not a good option for people who do not want to relinquish control of their property during their lifetime. The trust is irrevocable and cannot be amended.
By transferring property into a GRAT, the grantor acquires peace of mind knowing that the property will definitely be distributed to the intended beneficiary. This is especially important in second marriages when, perhaps, the grantor wants the property to be distributed ultimately to the grantor’s child, not the spouse’s family.
About the Author
Thomas J. Bouman provides legal counsel in the areas of estate planning, estate settlement, and asset protection. He brings a highly systematic approach to the practice of law, which is critically important when wading through the complex, and often bizarre, legal requirements associated with estate and trust law. Mr. Bouman is author of the Arizona Estate Administration Answer Book and a prominent member of Wealth Counsel, LLC, the nation’s premiere organization of estate planning attorneys.
A Grantor Retained Annuity Trust (“GRAT”) is created when property is transferred to an irrevocable trust, and the grantor retains the right to receive an annuity payment from the trust for a fixed term of years, usually between 2 and 20 years. At the end of the term, the remaining trust property will pass to the beneficiaries, usually the grantor’s children, free of estate tax.
When establishing a GRAT, the grantor must report a taxable gift equal to the present value of the remainder interest. However, the GRAT is so powerful that it may be possible to establish one without having to report a taxable gift at all. By configuring the annuity to equal the value of the transferred property, the taxable gift can be reduced to almost nothing. This is referred to as a “zeroed-out GRAT.”
The power of a zeroed-out GRAT will be most evident if the trust property can outperform a special interest rate called the Section 7520 rate over the trust term. In effect, the initial value of the trust property is paid back in full to the grantor (in the form of an annuity), but all appreciation in excess of the Section 7520 rate is transferred free of estate and gift tax to the beneficiaries.
2. How does a Grantor Retained Annuity Trust work?
For example, assume Parent transfers property valued at $1,000,000 into a GRAT and retains a right to receive annuity payments back from the trust for 10 years. The selected annuity payout rate is 12.45%, which is large enough to reduce the remainder interest to zero. Thus, Parent would report a zero or nominal taxable gift. Assuming Parent lives for at least 10 years, the entire value of the trust – perhaps now worth $1,750,000 – is excluded from Parent’s estate for estate tax purposes. Effectively, the “cost” of transferring the $1,750,000 property to the grantor’s children was $0.
After the 10 year term expires, the trust could distribute its property outright to the grantor’s children, or to trusts for their benefit.
3. What could go wrong with a GRAT?
A Grantor Retained Annuity Trust is almost a no-risk technique, but plans might go wrong:
- Increase in property value fails to exceed the Section 7520 rate. If the combined earnings and appreciation of the trust property are less than the Section 7520 rate, the potential estate tax savings is lost.
- Grantor dies before end of term. If the grantor dies before the annuity payments end, the full value of the trust property will be included in the grantor’s taxable estate. This emphasizes the importance of selecting a term of years that the grantor is likely to outlive; however, the grantor is no worse off for trying to use the GRAT.
- Property fails to produce enough income to fund the annuity. If the trust property fails to produce enough income, some trust principal will have to be liquidated in order to fund the annuity. Therefore, it is important to fund the GRAT with assets that are likely to produce sufficient income.
4. Can LLC or partnership interests be used to fund a Grantor Retained Annuity Trust?
Yes, this is an excellent strategy. If the GRAT is funded with LLC or partnership interests, they will likely qualify for a valuation discount. The term “discount” means that a LLC or partnership interest will be valued less for tax purposes than the actual value of the underlying assets. A qualified appraisal is needed to substantiate the discount, which is usually for lack of control and/or lack of marketability. The size of the discount depends on many factors, but may range as high as about 50%.
A valuation discount can be leveraged to make the GRAT even more powerful. A lower initial value for the trust means the annuity payments back to the grantor will be lower. This makes it much easier for the trust to exceed the minimum growth rate it needs to succeed.
5. What are the disadvantages of using a Grantor Retained Annuity Trust?
The GRAT is not a good option for people who do not want to relinquish control of their property during their lifetime. The trust is irrevocable and cannot be amended.
By transferring property into a GRAT, the grantor acquires peace of mind knowing that the property will definitely be distributed to the intended beneficiary. This is especially important in second marriages when, perhaps, the grantor wants the property to be distributed ultimately to the grantor’s child, not the spouse’s family.
About the Author
Thomas J. Bouman provides legal counsel in the areas of estate planning, estate settlement, and asset protection. He brings a highly systematic approach to the practice of law, which is critically important when wading through the complex, and often bizarre, legal requirements associated with estate and trust law. Mr. Bouman is author of the Arizona Estate Administration Answer Book and a prominent member of Wealth Counsel, LLC, the nation’s premiere organization of estate planning attorneys.