The Investment Scientist

Grantor Retained Annuity Trusts – GRATs

Posted on: February 7, 2012

[Guest Post by Christopher Guest] There are ways a person could use the two year window provided in the Tax Compromise of 2010 to leverage a person’s gifting opportunities, reducing a person’s taxable estate. One strategy that can be used and would not consume any, or only minimally consume, your lifetime gift tax exemption is the Grantor Retained Annuity Trust, or “GRAT.” A GRAT is a form of irrevocable trust that allows the grantor to take a calculated risk to lower the grantor’s taxable estate.

The grantor transfers specific assets or property into the GRAT. The language in the GRAT stipulates that every year the grantor will receive a fixed payment, i.e. an annuity payment, back from the trust over a fixed number of years. A typically time period for a GRAT is 2 to 5 years. At the end of the term, the remainder beneficiaries get whatever is left. For gift tax purposes, the value of the gift is calculated on day one, when the trust is created and funded, but the gift value is discounted, as discussed below.

The amount of the annuity payment that is required to be disbursed by the GRAT to the grantor is calculated using an interest rate that is determined by the IRS called the Section 7520 rate or the “hurdle” rate. Given the current low interest rate environment, the January 2012 hurdle rate is 1.40%. That is extremely low and increases the amount a grantor can pass to beneficiaries free of gift tax. In fact, most GRAT are calculated to have a gift value of zero. These are called Zeroed-Out GRATS or Walton GRATSi . You must report the annuity payments on your individual income tax return, but any investment growth in excess of the Section 7520 interest rate passes to the trust’s beneficiary free of gift tax.

The best way to demonstrate how a GRAT works is by giving an example. In this case, a grantor places $1 million worth of stock in the GRAT with a five-year term and a Section 7520 rate of 3 percent. At the end of each year, based on financial calculations, the grantor would take annuity payments equal to $220,000 and based on discounting, the overall value of the gift would be $20,736. That gift value is determined by the present value of the $1 million reduced by $220,000 each year while earning 3 percent per year on the remaining balance.

The driving force is the hurdle rate. For instance, a three-year GRAT funded with $1 million and producing a 6% annual investment return would leave $78,476 tax free to a beneficiary if hurdle rate is 2.4%. If the hurdle rate was 5.8% like it was in March 2008, then only $4,405 would pass gift tax free. It is also key to place assets in a GRAT that have an expectation of great appreciation over the GRAT term like under-valued stocks, privately owned companies that are likely to go public or similar asset.

There are a couple of drawbacks to creating a GRAT. First, the grantor could die before the end of the term for the GRAT. If that happened then all of the property transferred to the GRAT would revert back into the estate of the grantor and would be in the grantor’s taxable estate for estate tax purposes. Second, if the grantor survives the term, the trust asset will be transferred to the beneficiary and the annuity will stop and the grantor must have other assets that are sufficient to absorb the loss of income. Another drawback is that if the GRAT does not beat the hurdle rate, you are out the professional fees associated with setting up and running the GRAT. Lastly, the attractiveness of GRATS have been targeted by the Obama administration. The White house has proposed a minimum term of 10 years for GRATs. Given the current financial environment, GRATs could be eliminated completely.

GRATS are not for everyone but are a useful estate planning tool for those that might have under-valued assets and wish to pass on assets to their beneficiaries without consuming their lifetime gift tax exemptions.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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