Strategies & Techniques for Estate Planning


Grantor Retained Annuity Trust (GRAT)

A Grantor Retained Annuity Trust ("GRAT") is one of the estate planning techniques based primarily on interest rate assumptions. Clients create GRATs using assets that are likely to earn more than the Internal Revenue Service's measuring standard (the section 7520 interest rate) during the GRAT term in an effort to pass the appreciation in the assets to the beneficiaries of the trust free of gift and estate tax.

A Description of the GRAT Technique
A grantor creates a GRAT by transferring assets to an irrevocable trust for the benefit of one or more non-charitable beneficiaries and retains an annuity interest for a term of years. For transfer tax valuation purposes, the amount of the taxable gift is the fair market value of the property transferred minus the value of the grantor's retained annuity interest.
At the end of the term reserved by the grantor, the trust assets are distributed to the beneficiaries selected by the grantor. If the grantor dies during the GRAT term, the value of the remainder interest in the trust is included in the grantor's taxable estate under either section 2036 (retained income, possession, or enjoyment of property) or 2039 (retained right to receive annuity in transferred property).

If the trust instrument meets the requirements of section 2702 of the Internal Revenue Code, the IRS assumes that the trust assets will produce a return equal to the section 7520 rate applicable to the month of transfer. The annuity amount is paid to the grantor during the term of the GRAT, and any property remaining in the trust at the end of the GRAT term passes to the beneficiaries with no further gift tax consequences. Thus, if the GRAT assets produce a return in excess of the 7520 rate, the increase in value above the section 7520 rate is passed to the beneficiaries free of gift tax. The actuarial value of the amount of the remainder interest passing to the beneficiaries of the GRAT upon its termination is a gift to the remainder beneficiaries subject to gift tax.

If the GRAT is structured so that the retained annuity's actuarial value is almost equal to the value of the property transferred, there is little gift tax consequence. If the grantor lives out the term, the remainder passes to the beneficiaries without any additional transfer tax. If the grantor receives annuity payments in an amount equal or almost equal to the value of the property transferred, the only value removed from the grantor's taxable estate is the growth, if any, in the value of the transferred property in excess of the section 7520 rate.

The following is an example of the valuation rules of a GRAT. Assume that a parent funds an irrevocable trust with $1,000,000. Under the terms of the trust, parent receives an annual annuity for 10 years of $50,000. If the section 7520 rate is 8.0 percent, the value of parent's retained interest is valued at $313,940 and the remainder interest is valued at $686,060. Thus, the right to receive a $50,000 annuity for 10 years is worth $313,940 and the right to receive the remainder at the end of 10 years is worth $686,060. The value of the remainder interest, $686,060, would be subject to gift tax upon creation of the GRAT.

The purpose of the rules applicable to GRATs promulgated by the Internal Revenue Service is to prevent the shifting of economic enjoyment between income and remainder beneficiaries based on investment decisions made by the trustee. The grantor is entitled to receive the annuity regardless of the income produced by the trust assets. Accordingly, a trustee would have no incentive to maximize principal growth at the expense of income. The trustee=s objective is to maximize the total return of the trust assets regardless whether it is from income or appreciation.

Governing Instrument Requirements of a GRAT.
The most important element in structuring a GRAT is to make sure that the governing instrument (irrevocable trust) meets the requirements of section 2702 so that the grantor’s retained interest may be subtracted in determining the grantor=s gift to the remainder beneficiaries. Otherwise, the grantor's retained interest is valued at zero and the gift made by the grantor to the remainder beneficiaries is the entire value of the trust assets.

Under section 2702, a qualified interest is valued under section 7520. If the grantor retains an interest that is not a qualified interest or does not meet one of the exceptions to section 2702, the retained interest is valued at zero. Thus, if the requirements of section 2702 are not met, a GRAT could result in a taxable gift equal to the entire value of the trust assets regardless of the interest retained by the grantor.

Section 2702(b) defines a qualified interest to be:

1. Any interest which consists of the right to receive fixed amounts payable not less frequently than annually, and
2. Any interest which consists of the right to receive amounts which are payable not less frequently than annually and are a fixed percentage of the fair market value of the property in the trust (determined annually).
The term of the annuity in a GRAT must be a fixed amount of time equal to the life of the annuitant, a specified term of years, or the shorter of those two periods