The objective of the Grantor Retained Annuity Trust is to remove appreciation on the transferred assets from the grantor’s estate. The structure of the GRAT also allows this removal of appreciation to be done at minimal or no gift tax cost.
Operation of the GRAT
The grantor transfers an asset with high appreciation potential to the GRAT, which is an irrevocable trust. In return, the grantor retains a qualified annuity interest for a specific term of years. Common terms of years for annuity trusts range from 2 to 10 years. The initial term must be at least 2 years, but it may be 20 years or longer. In a particularly low interest rate environment, a shorter term GRAT may be preferred.
The longer the term of the GRAT, the more likely that positive performance and poor performance will offset each other, which reduces the chance that the GRAT will beat the assumed growth rate (discussed below).
After the initial annuity term ends, the grantor’s interest in the trust terminates and the remaining trust assets (the “remainder interest”) pass to the beneficiaries named in the trust instrument. The remainder interest may pass outright or in further trust, depending on how the GRAT is drafted.
Technically, a gift is made when a GRAT is created. The value of the gift is determined by calculating the remainder interest. To determine the remainder interest, you subtract the current value of the grantor’s annuity interest from the value of the entire asset transferred to the trust. The greater the value of the annuity interest, the lower the value of the gift.
The Treasury tables assume an expected growth rate equal to 120 percent of the federal mid- term rate (AFR). When that rate is lower than the annuity rate used in the GRAT, it is assumed that corpus of the GRAT is consumed each year to make up the difference. This reduces the gift tax value of the remainder interest. If the property’s actual rate of return exceeds the Treasury table rate, the remainder beneficiaries will receive substantially more property than the Treasury tables assume.
The Treasury table rates fluctuate monthly, so the timing for implementation of a GRAT is important. The rate is typically published on the 21st of each month for the next month, so it is possible to anticipate and react to rate changes before they occur.
A qualified annuity interest is an absolute right to receive a fixed dollar amount. In each case, the payment must be made at least annually. Since the retained interest gift you are contemplating is an annuity, the annual payments are fixed since they are based on the value of property when it is initially transferred to the trust. Transfers of additional property to a GRAT during the term of your retained interest are prohibited.
First, a GRAT freezes the value of the property at the time it is transferred. If you survive the trust term, the property passes to your beneficiaries without further gift or estate tax.
Second, under a GRAT, the value of the annuity can be made to approximate the value of the transferred property (zeroed- out), thereby virtually eliminating a taxable gift when the trust is funded. Because a gift to a GRAT is a remainder (or future) interest, and therefore not eligible for the annual exclusion from gift tax, the entire value of such interest is subject to gift tax, to the extent you have exceeded both of your unified credit equivalents using other planning vehicles. However, using a zeroed-out GRAT technique will result in no gift tax.
Generally, the requirement that a GRAT pay trust income and principal to the grantor causes you to be the owner of the trust property during the initial term for income tax purposes. All taxable income generated by GRAT property is taxed to you whether the income is actually distributed or accumulated for the benefit of your beneficiaries. The IRS may seek to treat the payment of tax by you on income accumulated in the GRAT for the benefit of your children as an additional gift to the GRAT. Since additional gifts to the GRAT are not permitted, the IRS may take the position that it is disqualified if the GRAT income taxable to you exceeds the annuity. It is also possible that you may not want to deplete your estate by paying income tax on income and capital gains in excess of the annual annuity. The IRS allows the trustee to make distributions in excess of the annuity, but these discretionary distributions are valued at zero when you are calculating the taxable gift of the remainder.
If the trust instrument does not permit the trustee to make discretionary additional payments to you, it will be difficult for the IRS to take the position that you made additional gifts, even if the GRAT income allocated to you exceeds the annual annuity. Alternatively, if the trust actually reimburses you for the excess tax cost, additional gifts to the GRAT will not have been made. As a practical matter, for shorter term GRATS, the annual annuity is quite high, which lessens the possibility that allocated taxable income will exceed the annuity. This could be an additional consideration in selecting the term of the GRAT.
If the grantor dies during the term of the trust, all or a substantial part of the trust will be included in his/her gross estate. Therefore, the initial term of the GRAT should be one that you can realistically survive. On the other hand, had the grantor not created the GRAT, the property would be includible in his or her estate anyway. Furthermore, strategies can be used in conjunction with a GRAT to hedge against a grantor’s premature death, such as using term life insurance to insure the grantor’s life for the GRAT term.
If you were to live beyond the specified term of each GRAT, there should be no further transfer tax since the gift was complete when the trust was funded. More importantly, 100% of post-gift appreciation in the property’s value escapes gift and estate tax. This makes a GRAT an excellent “estate freezing” device with respect to post-transfer appreciation.