Patten and Company

Transfer Assets through Grantor Retained Annuity Trusts (GRATS)

 What is a GRAT?

There are several estate planning tools designed to assist in the transfer of assets to a trust for beneficiaries while also retaining the grantor’s right to income or use of the asset. Grantor Retained Annuity Trusts, or GRATs, have become a popular transfer technique with regards to appreciating assets or minority interest in a family business that is subject to valuation discounts. In 2000, GRATs became more useful for estate planning after tax courts held in favor Audrey Walton’s position in Walton v. US. This case both opened the door for the “zeroed out” or “near zero” GRAT and brought the concept of “rolling GRATs” to the public’s attention.

To create a GRAT, a grantor transfers assets to a trust, the gift value of which is determined using Code Section 7520.  Code Section 2702 values the retained interest at zero unless it meets exemptions as a “qualified interest”.  A qualified interest is:

  • any interest which consists of the right to receive fixed amounts payable not less frequently than annually,
  • 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), and,
  • any noncontingent remainder interest if all of the other interests in the trust consist of interests described in 1) and 2).

These “qualified interests” may be deducted from the gift value of the assets placed in the trust, reducing your gift tax and removing property from your estate.  The ultimate goal of a well planned and executed GRAT is to “zero out”.  To “zero-out” the annuity amount, expressed as a percentage of the initial fair market value of the property transferred to the GRAT, is 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 Section 7520 assumed rates of return.  While a complete “zeroing out” usually does not happen, most clients will want to create a “near zero GRAT”.  It should be noted, however, that for the GRAT to be “successful” the assets placed in the GRAT need to appreciate faster than the Section 7520 rate.  Otherwise a “zeroed out” GRAT’s assets would be depleted by the annuity payments.

Here is an example of a successful near zeroed out GRAT.  This example assumes a $1,000,000.00 initial contribution of assets, with a 10% rate of return, and an annuity payment based on the Code Section 7520 rate of 2.2% for January 2015.

 Beginning Balance10% growthAnnuityEnd Balance
Year 1$1,000,000$100,000$516,560$583,350
Year 2$583,350$58,335$516,560$125,035
Distributions to Grantor  $1,033,120 
Distributions to family   $125,035

As you can see in this example, the grantor’s annuity payment present value is almost equal to the value of the initial assets transferred to the trust.  In this case, the present value of the annuity payments would be $999,884.16.  If you subtract this amount from the value of the initial gift of $1,000,000 you will end up with $115.84 subject to gift tax on a transfer of $125,035.00 to your beneficiaries.

Strategizing your GRAT

One of the most important considerations in creating a GRAT is to be realistic about the life expectancy of the grantor.  If the grantor dies before the GRAT’s term expires, the amount of trust corpus required to complete the annuity payments as calculated by Section 7520 will be included in the decedent’s estate.   This can be mitigated by creating short term “Rolling GRATs,” in which nine 2-year GRATs that feed into one another are created in lieu of a single 10 year GRAT.  The annuity from the first GRAT would be used to establish the second GRAT.  This will continue until you get to the second year of GRAT 8. Thereafter, payments flow to the grantor instead of a subsequent GRAT.

Another consideration when establishing a GRAT is the Code Section 7520 rates that determine the appreciation of the assets.  If the assets fail to grow at 7520 rate, the assets in the GRAT will be depleted by the annuity payments and the GRAT will have failed in transferring assets at reduced gift value.  One of the benefits of a GRAT is that even in the event of a “failure”, the grantor’s only losses beyond opportunity cost are the legal and administrative fees required to establish and administer the trust.

In the current environment, longer term GRAT’s have become particularly attractive as low interest rates have resulted in a very low 7520 hurdle rate.  At the same time, market volatility has depressed certain assets and created a situation in which there is a large potential upside in combining this low IRS return assumption with depressed assets that could potentially appreciate at many times the IRS rate.  By setting up a longer term GRAT, the grantor can “lock in” at today’s historically low Section 7520 rates.  This could potentially result in substantial asset appreciation transferred to beneficiaries while minimizing gift tax liability.

If you are looking for guidance in transferring assets or handling your estate, call 214-696-1922 and ask for Mark Patten.

McKinnon Patten is a CPA Firm with over 40 years of experience dealing with trusts and estates. We specialize in asset transfers as well as family office and fiduciary accounting services.

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