With IRS-prescribed interest rates at historic lows and much like Intra-Family Loans described in a previous blog, a Grantor Retained Annuity Trust (GRAT) presents an excellent opportunity to transfer wealth to lower generation family members with reduced (or no) federal transfer tax costs.
A GRAT is a trust often established by a parent, the trust’s “grantor,” who transfers assets — such as stock or closely held business interests — to the trust for a specific term, typically between two and 10 years. GRATs often provide that the parent retains the right to receive back, in the form of annual fixed payments (the “annuity”), 100% of the initial value of the assets transferred to the trust, 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 November 2016 is 1.6%. Any assets remaining in the GRAT at the end of the term 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 making a taxable gift due to the retention of an annuity equal to 100% of the assets contributed to the GRAT.
As an illustration, assume the grantor contributes $1 million of XYZ stock to a two-year zeroed-out GRAT during November 2016. Here, the grantor will receive two payments of $512,033 each from the GRAT at the end of the first and second years. If the XYZ stock appreciates at more than the 1.6% 7520 rate during the trust’s two-year term, 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 trust assets appreciate at 10% annually during the two years, there would be approximately $135,000 of value to pass to the beneficiaries transfer tax-free. If the trust assets appreciate at 7% annually, there would be approximately $85,000 left to pass to the beneficiaries transfer tax-free.
A downside of this technique is that the grantor must outlive the selected trust term for growth in excess of the 7520 rate to be distributed to the beneficiaries free of transfer 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” 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 GRAT term and the assets appreciate, a transfer to the trust beneficiaries will occur with respect to any appreciation over the 7520 rate on an annual basis. If such appreciation does not materialize, the grantor will receive all of the trust assets back through 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 annuity payments into a new GRAT and try again.