Grantor
Retained Annuity Trusts (GRATs)
A Grantor Retained
Annuity Trust or “GRAT” is one of the most powerful and tax
efficient wealth transfer tools available today. A GRAT allows a person to share the
future appreciation of an asset with the next generation with virtually no gift
tax.
The Basics
A GRAT is a trust
with a specific life or term, i.e., 5 years, 8 years, etc. The grantor transfers assets to the GRAT
and retains an interest in the trust.
This income interest will be stated as an annuity percentage of the
original assets transferred to the GRAT.
Each year the GRAT will pay the grantor the required
payment.
At the end of the GRAT
term, any remaining assets will be distributed to the named beneficiary or
beneficiaries. The gift will be
calculated using the subtraction method. The present value of the annuity payments to
the grantor will be subtracted from the original value of the assets placed
into the GRAT.
Example #1
Dad holds $1,000,000 of a
stock that pays a 10% dividend. Dad
establishes a GRAT with a 13 year term and transfers the $1,000,000 of stock to
this GRAT. Each year the $100,000
dividend is paid to the GRAT and the GRAT then pays the required $100,000
annuity to Dad/grantor. The value of the
gift may be as low as $13,710. This is a
gift of the future interest and does not qualify for the annual exclusion. Dad/grantor must use part of his $1,000,000
lifetime gift exemption or pay a gift tax.
At the end of the GRAT
term or 13 years, Dad would have received $1,300,000 ($100,000 per year x 13
years) in annuity payments. The
remainder value in the GRAT is the stock and would still be valued at
$1,000,000 assuming no appreciation. The
stock would then be distributed to the remainder beneficiaries, usually Dad’s
children. In this case, the children
will have received an asset worth $1,000,000 but Dad only had to report a gift
of $13,710.
More Basics
The term of a GRAT
can be as short as two years or as long as the grantor chooses. However, if the grantor dies during the GRAT
term, the IRS says “the technique fails and the assets inside the GRAT are
included in the taxable estate”. For
this reason, most GRATs are kept to shorter term.
If the GRAT term is
shortened, the annuity payout rate must be increased or a larger reportable
gift will occur. It is important to note
that the GRAT annuity payment does not have to be made from income. The annuity payment can be satisfied with
principal or the assets that were originally transferred into the GRAT.
Example #2
To illustrate both a short
term GRAT and using principal to satisfy the annuity obligation, consider the
following. Dad transfers $1,000,000 of
non-dividend paying stock into a two year GRAT.
Dad retains a 53.17167% annuity interest. If the stock grows 10% each year, the GRAT
must pay $531,716.70 of value to Dad each year for two years. This payment can be made by distributing the
appreciated stock to Dad. If the trust
does this for two years, the trust will have $93,395 of stock remaining after
the last payment to Dad. According to
the Walton Tax Court Decision, Dad made a taxable gift of under $1.
