Grantor Retained Annuity Trusts (GRATs) and Grantor Retained UniTrusts (GRUTs) can present excellent estate planning opportunities in today's environment of low interest rates and low asset values.
The idea behind these special kinds of trusts is for a donor to remove highly appreciated assets from his/her estate and indirectly to his/her designated beneficiaries (usually children) at a low gift tax cost. Simply put, a GRAT or GRUT is a trust under whose terms the donor irrevocably gifts appreciated assets into a trust but retains the right to receive back from the trust either (1) a fixed annuity amount each year (GRAT) or (2) a fixed percentage of the fair market value of trust assets each year (GRUT). The annuity or unitrust amount is payable back to the grantor monthly, quarterly or annually (at least annually) for life or for a specific number of years.
Some differences between GRATs and GRUTs are: (1) Additional contributions can be made to a GRUT after its creation while no additional contributions may be made to a GRAT after its creation, and (2) the annual payment to the grantor is fixed with a GRAT while the payment with a GRUT varies with the annual change in the fair market value of the trust's assets.
Gift Tax Implications
Assuming the trust meets the requirements of a qualified annuity or unitrust interest, a value for the grantor's right to receive the annuity amount or unitrust amount is computed by discounting these amounts to the present which is computed using 120 percent of the applicable federal mid-term rate during the month in which the GRAT or GRUT is funded. The computed present value of the grantor's retained interest is then subtracted from the fair market value of the gifted assets and the remainder constitutes the taxable gift.
Therefore a lower taxable gift can be achieved by (1) a reduced fair market value of assets gifted and/or (2) a higher present value of the donor's retained interest.
Assets in today's economy are depreciated already, which satisfies condition one. For condition two, going back to the basics of present value computations, a lower discount rate results in a higher present value, and vice versa. Therefore, the low interest rates we encounter today offer another opportunity to produce a higher present value for the donor's retained interest. Note that the taxable gift is computed only once - when the grantor transfers property to the trust - therefore, even with rising interest rates, any future hikes in the §7520 rate will have no adverse effects on the success of the trust. On the other hand, rising interest rates will positively affect the rate of return on trust assets and, when coupled with rising asset values, will increase the chances of a successful GRAT or GRUT. With a successful GRAT/ GRUT, all appreciation in trust assets subsequent to the original gifting completely escapes the donor's estate tax and passes directly to the trust's beneficiaries.
For closely held businesses, the prospects are even higher when combining these valuation techniques with valuation discounts that could be taken when minority or partial interests are transferred to a GRAT/GRUT. Lack of control and lack of marketability discounts along with the already-reduced values of assets can enable a grantor to transfer more to the beneficiaries at much less transfer tax cost than ever.
It should be noted here that since the gift is that of a remainder (i.e., future) interest in the assets, the gift is not eligible for the gift tax annual exclusion. As such, any resulting taxable gift from the above equation will either (1) need to be offset by use of the donor's lifetime gift tax exemption ($1,000,000 as of 2009) or (2) result in the donor's paying a gift tax immediately.
Special kinds of GRATs, known as "zeroed-out GRATs," are designed so that the present value of the grantor's retained interest is equal to the fair market value of the property gifted to the trust, therefore resulting in a no taxable value for gift tax purposes. Use of a zeroed-out GRAT, therefore, results in neither gift tax being paid nor use of the donor's lifetime exemption.
Income Tax Implications
From an income tax perspective, a GRAT or GRUT is a grantor trust.As such, income of the trust is taxed to the grantor using an individual's more favorable tax bracket. Other advantages of grantor trust status include the trust's ability to hold S Corporation stock during the grantor's retained interest term and the nonrecognition of transactions between the grantor and the trust (e.g., funding of the trust is not a taxable transaction for income tax purposes).
In general, grantor trusts file a fiduciary income tax return. However, income and expenses of the trust are not reported on that return but rather on a separate statement attached to the return detailing the items of income, deductions and credits to be reported on the grantor's personal income tax return. If certain conditions are met, the grantor can report the items of income, deductions and credits directly on his/her personal tax return without even the need to file a fiduciary income tax return.
Estate Tax Implications
For a GRAT or GRUT to be successful, the grantor must survive the term of the trust. If this occurs, the assets in the trust (including any appreciation) completely escape the grantor's estate upon his/her eventual death and pass directly from the GRAT or GRUT to the designated beneficiaries. On the other hand, if the grantor dies during the term of the trust, a portion or all of the trust property will be included in the grantor's gross estate at its date of death value. The amount includible in the grantor's gross estate requires a complex computation of an amount required to support the balance of the annuity payments. If a portion or all of the trust property is included in the grantor's gross estate, the estate gets a credit for any gift tax that was paid at the time the trust was created. These rules evidence the need for grantors to be realistic in selecting a term for their trusts. Generally, the grantor's age and lifestyle must be considered in determining the appropriate term for the trust. In other words, the grantor should select a term that he or she is "likely to survive."
Generation-Skipping Transfer Taxation
Generally, GRATs and GRUTs are not good planning vehicles for the GST tax. This is because of the Estate Tax Inclusion Period (ETIP) rule. The ETIP rule provides that no allocation of a donor's GST exemption can be made to a trust so long as there's a possibility that the trust's assets will be included in the donor's estate. As mentioned above, if the donor dies during the trust term, a portion or all of the trust assets will be included in the donor's estate. With a GRAT or GRUT, the ETIP ends when the grantor's retained income interest terminates and the property passes to its intended beneficiaries. At that time (presumably when the property has appreciated in value), the GST exemption can be allocated to the trust based on the then-existing fair market value which consumes more of the grantor's GST exemption. Whenever possible, it's better to have children (rather than grandchildren) as remainder beneficiaries of GRATs and GRUTs for the reasons mentioned above.
Laddered GRATs Or GRUTs
To minimize the risk that assets of a GRAT or GRUT will be included in the donor's gross estate should he or she die within the term of the trust, a technique sometimes referred to as "Laddered GRAT/GRUT" could be used where multiple GRATs or GRUTs are created with various terms (e.g., one with two-year term, another with four-year term, and so on), with each funded with a portion of the grantor's assets required to be transferred. This way, each time the grantor survives the term of one trust, this trust becomes successful and its assets are removed from the grantor's estate. When additional time passes and the grantor survives the next trust, this in turn gets removed from the estate, and so forth.
What If It Fails?
A GRAT or GRUT could potentially fail if assets in the trust decline in value or grow at a rate of return equal to or less than the §7520 rate. What happens then? The answer is straightforward: The amounts paid back to the grantor each year will completely deplete the assets of the trust and there will be no remainder. These amounts are now part of the grantor's assets and will be included in his/her gross estate at their date of death value, the same result that would have been reached had the grantor never formed the GRAT or GRUT in the first place. Another scenario where a trust could fail is if the grantor dies during the term of the trust and the trust assets are brought back into the grantor's estate. Again, the result would be the same as if the trust was never created at all. Therefore, the only cost of an unsuccessful GRAT/GRUT is the transaction cost in terms of professional fees for setting up the trust and so forth.
Conclusion
In summary, the success of a GRAT or GRUT depends on assets in the trust growing at a rate in excess of the §7520 rate. Today's low rate presents an opportunity for this to occur. Although recent trends show a climb in the §7520 rates, the current rates are still lower than the rates that prevailed before the economic crisis began.
Wealthy taxpayers should consider creating a GRAT/GRUT now rather than later to transfer wealth to a lower generation at a lower transfer tax cost.
Published March 2, 2010.