BY ANDREW T. WOLFE, ESQ., CPA
Grantor retained annuity trusts (GRATs) have become quite popular as a tax-advantaged wealth transfer technique. The “zeroed-out” GRAT has been used by the wealthy to avoid estate tax on the growth of rapidly appreciating assets, without incurring a gift tax or even utilizing their lifetime gift tax exemption.
Under a GRAT, an individual (grantor) transfers appreciating property to an irrevocable trust and retains the right to receive a fixed annual payment during the trust’s term. At the end of the annuity term, the balance of property remaining in the trust typically passes to the grantor’s children or other beneficiaries. The annuity amount – expressed as a percentage of the initial fair market value of the property transferred to the GRAT – is frequently set so that the present value of the amount to be paid to the grantor over the annuity term equals the amount transferred to the GRAT, plus an assumed rate of return. This results in the grantor being treated as having made no taxable gift to the ultimate beneficiaries of the GRAT because, in a present value sense, the grantor will receive back everything he or she puts in. This is known as zeroing out the GRAT for gift tax purposes.
The result is that any appreciation in the value of the GRAT property in excess of the Internal Revenue Service (IRS) hurdle rate can be distributed to the beneficiaries at the end of the annuity term without any gift tax. If the property doesn’t appreciate, or appreciates at a rate lower than the (IRS) hurdle rate, then all of the property placed in the GRAT will be returned to the grantor during the annuity term and nothing will be left for the intended beneficiaries. Although no transfer tax advantage will have been gained in such event, there is no real downside, since the grantor has made no taxable gift in establishing the GRAT. Moreover, the chances of “winning” are greatly enhanced when the GRAT property consists of marketable securities that have been beaten down in today’s volatile market or a minority interest in a family business that is subject to favorable valuation discounts. This is because a depressed-value asset has a better chance of outperforming the IRS hurdle rate, which remains quite low due to today’s historically low interest rates.
Should the grantor die before the end of the annuity term, the trust property is included in his or her estate for estate tax purposes. This mortality risk should be considered when selecting the GRAT annuity term. If the grantor is insurable at reasonable rates, the mortality risk can often be managed by purchasing inexpensive term insurance.
The grantor’s establishment of a series of short-term (e.g., two-year) zeroed-out GRATs, often referred to as “rolling GRATs,” has become a popular technique for attempting to avoid transfer taxes on the growth of marketable securities in excess of the IRS hurdle rate. Separate GRATs are often established to hold different securities or different classes of investment assets so the poor performance of any individual security or asset class won’t adversely impact the GRAT holding the better performing security or asset class. The use of longer-term GRATs has also become a popular way to transfer minority interests in a family business to children, while allowing the parents to retain a continuing income stream during the annuity term.
Legislation was recently proposed that would restrict the benefit of GRATs by requiring a minimum annuity term of 10 years and requiring that a GRAT remainder interest has a value greater than zero. The 10-year minimum annuity term would undoubtedly diminish the appeal of GRATs to older and infirmed individuals due to the mortality risk associated with longer-term GRATs. This legislation would be effective for transfers occurring after the date of enactment. Therefore, GRATs that are established and funded before the proposal becomes law should avoid these troublesome restrictions.
Andrew T. Wolfe, CPA, Esq., is of counsel to the law firm of Hartman & Winnicki, P.C. He is also a member of the New Jersey Society of CPAs Estate, Trust & Gift Taxation and Federal Taxation interest groups. Contact Wolfe at firstname.lastname@example.org