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A Grantor Retained Annuity Trust (“GRAT”) is an irrevocable trust by which the grantor transfers property and retains a right to annuity payments during the term of the Trust. During periods of low interest rates, GRATs are a great tool to transfer wealth without being subject to the Federal Estate Tax or Federal Gift Tax.
A grantor creates an irrevocable Trust for a certain term. The grantor is typically the Trustee of the Trust. The grantor transfers assets to the Trust. During the term of the Trust, the grantor retains the right to an annuity payment equal to a certain percentage of the original value of the assets that were transferred to the Trust. At the end of the term of the Trust, any assets remaining inside the Trust will be transferred to beneficiaries identified by the grantor in the Trust agreement.
For purposes of the Federal Gift Tax, the IRS requires that the value of the gift be determined at the time that assets are transferred into the Grantor Retained Annuity Trust. Because there is no way to predict how assets may appreciate in the future, the IRS establishes an interest rate (“Section 7520 Interest Rate”) each month to be used to estimate how quickly the assets may appreciate. For November 2020, that interest rate is 0.4%. The taxable gift will be equal to the value of initial gift to the Trust, plus any appreciation based on the Section 7520 Rate, less the value of the annuity payment to the grantor.
If the grantor dies before the expiration of the GRAT term, then the value of the GRAT assets will be included in the grantor’s taxable Estate. Although there is no benefit for a grantor who dies during the term of a GRAT, the result is simply that the assets would be taxed the same way that they would be taxed if the grantor had done no planning at all, which means that the only negative impact on the grantor is the cost of establishing the Trust.
Additionally, if the assets of the GRAT grow at a rate that is less than the Section 7520 Interest Rate, then the GRAT simply transfers all of its assets to the grantor and will have no remaining assets to transfer to the beneficiaries of the Trust. Again, the only negative impact on the grantor is the cost of establishing the Trust.
The most common planning strategy with GRATs is the zeroed-out GRAT. With this strategy, the annuity payment from the GRAT is structured so that the actuarial value of the remaining gift is equal to $0. Because this is based on the Section 7520 Interest Rate, any growth and appreciation in excess of the Section 7520 Interest Rate can be transferred to beneficiaries without impacting the grantor’s basic exclusion amount for the Federal Gift Tax or Federal Estate Tax.
For example, assume a grantor transfers $1,000,000 to a GRAT in November 2020. The GRAT is structured to exist for two years. At the end of two years, the remaining assets will be transferred to grantor’s children. With a Section 7520 Interest Rate of 0.4%, the annuity payment from the GRAT to the grantor is $503,002 each year of the 2-year term. Based on these numbers, the IRS calculates that the grantor receives $1,006,004 from the GRAT and there is $0 left to give to the children. However, if the assets actually grow at a rate of 5% rather than 0.4%, the remaining assets in the GRAT will be $71,346. The $71,346 of remaining assets transferred to grantor’s children will have no impact on the grantor’s basic exclusion amount for purposes of the Federal Gift Tax and Federal Estate Tax.
Another fairly common strategy is the use of rolling GRATs or cascading GRATs. With this strategy, the annuity payment from each GRAT is continuously reinvested in new GRATs. The grantor establishes an initial GRAT (“GRAT #1”). After a year, the grantor takes the annuity payment from GRAT #1 plus any additional funds that grantor wishes to invest, and invests those assets into a new GRAT (“GRAT #2”). After the second year, the grantor takes the annuity payment from GRAT #1 and GRAT #2 plus any additional funds that grantor wishes to invest, and invests those assets into a new GRAT (“GRAT #3”).
A relatively new strategy is the 99-year GRAT. This strategy assumes that the grantor will not survive the 99-year term of the GRAT, and therefore the remaining value of the GRAT will be included in the grantor’s taxable Estate.
Treasury Regulation 20.2036-1(c)(2) states that the value of a GRAT, for purposes of the Federal Estate Tax, will be equal to the amount of Trust assets required to produce sufficient income to satisfy the annuity payment that the grantor would have been entitled to receive if the decedent was still alive. If such calculation results in a number that exceeds the actual value of the GRAT upon grantor’s date of death, then the actual value of GRAT will be used for purposes of the Federal Estate Tax.
Assume that grantor establishes a zeroed-out GRAT in November 2020 with a term of 99 years. If the GRAT is funded with $1,000,000, then the annuity amount will be $12,153 so that the value of the remaining GRAT assets is calculated to be $0 after 99 years. Regardless of whether grantor dies 1 year later or 30 years later, assume that the Section 7520 Interest Rate at such time is 6%. The GRAT would need to have assets worth $202,550 to produce an annuity payment of $12,153 when the interest rate is 6%. Therefore, the value of the GRAT for purposes of the Federal Estate Tax will be $202,550. To the extent that the actual value of the assets of the GRAT exceed $202,550, such excess value will not be subject to the Federal Estate Tax.
In summary, a Grantor Retained Annuity Trust is a great tool for individuals who may be subject to the Federal Gift Tax or Federal Estate Tax. This tool is extremely powerful when the value of the assets contributed to the GRAT can out-perform the Section 7520 Interest Rate that existed on the date when the assets were initially transferred into the GRAT.
Attorney R. Nicholas Nanovic is an Accredited Estate Planner®, serving as chair of Gross McGinley’s Wills, Trusts & Estates team and on the Tax Law team.