Leveraged Gifting with GRATs
Planning for large, taxable family wealth is typically complicated by the fact that most often these clients have already made family gifts and have little or no exclusions and applicable exemption amounts left. The annual $12,000 annual exclusion amount per donee is often not much help, so thought must be given to the various leveraged gifting techniques and estate freezing techniques. In this regard, there are various special trusts and entities under the tax code that help accomplish the transition of substantial wealth. Used in conjunction with life insurance, these techniques not only prevent substantial erosion of wealth due to estate taxation, but can also provide substantial asset protection for one’s family and for generations to come. One of these very effective techniques is the Grantor retained annuity trust, which is commonly referred to as a “GRAT”.
Essentially, a GRAT is an irrevocable trust in which the grantor of the trust (typically the “parent”) retains the right to a fixed payment for a specified term (an annuity). At the end of the annuity term, any remaining assets in the GRAT (the remainder interest) are paid either outright to children and heirs or paid to one or more irrevocable trusts for the benefit of the grantor’s children and heirs. In the event the grantor dies during the term that the GRAT is in existence, the fair market value of the remaining trust assets will be included in the grantor’s estate. However, this result is no worse than if the grantor did not engage in any GRAT planning at all, and can be hedged effectively by the use of life insurance to cover the GRAT annuity period.
With proper planning and structuring, the GRAT can transfer substantial value to children and future generations with low (or no) immediate gift tax consequences. This is accomplished because under the Internal Revenue Code (the “IRC”), the grantor is treated as having made a completed gift at the time the GRAT is established equal to the value of the property transferred less the value of the retained annuity interest. The value of the grantor’s retained annuity interest is a function of the number of annual annuity payments retained by the grantor, the desired amount of the retained annuity, and the interest rate that is published monthly by the IRS for the month the GRAT is established. As long as the actual rate of return achieved on the GRAT assets outperforms the IRS mandated interest rate, then assets will transfer to children and future generations free of any current or future transfer taxes. Thus, the lower the IRS mandated rate, the more attractive GRATs are as an estate planning technique.
When the grantor has used most or all of his or her lifetime gift tax exclusion, it is critical that the calculated gift comes as close to zero as possible such that there is no current gift tax liability. This is referred to as the “Zeroed Out GRAT” or the “Walton GRAT”.
The zeroed-out GRAT will allow the grantor to transfer significant amounts of property out of his/her estate with minimal or no taxable gift. If the grantor survives the term of the trust, but dies while the estate tax is in effect, the GRAT can significantly reduce any tax that might be owed. If the estate tax is repealed, there are no lost dollars, because the transfer did not result in the payment of any tax.
The nature of the asset transferred into the GRAT is an important component of this type of planning. For example, cash transferred into a GRAT will not yield as good a result as an asset with a low initial value but which is anticipated to appreciate at a rate substantially above the initial IRS rate. Assets to plan with would include closely held stock which the grantor anticipates may be sold at a substantial premium (like “IPO stock”). Another very good asset is an interest in a family limited partnership (“FLP”) or limited liability company (“LLC”), since they can be used to obtain valuation discounts thereby increasing the effective rate of return on the GRAT assets. Accordingly, the GRAT a great tool for transferring closely held stock, rental real estate, and even some marketable securities. It works particularly well with S corporation stock where there are distributions to shareholders of appreciation and for taxes. This is an area where an estate planning attorney well versed in the “mathematics of estate planning” should be consulted.
If limited partnership interests or other discounted assets are used, there is always the possibility that the IRS will try to revalue the assets. A GRAT can minimize this risk of revaluation when the annuity is expressed as a percentage of the initial trust assets. Should the assets be revalued, the annuity payment will either increase or decrease as the case may be, but no additional gift tax (or a minimal amount of gift tax) will be owed.
At the termination of the GRAT interest, the recipient of the net GRAT assets is an important consideration. For example, if the recipient of the GRAT were an irrevocable trust which owned life insurance on the grantor’s life (the “ILIT”), then the assets passing into the ILIT could be used to fund future insurance premiums without having to look to the grantor for future contributions to the trust. In very large taxable estates, once the grantor’s cumulative insurance premiums have exceeded $1 million, substantial complexity is injected into the scenario, since all future premiums are now subject to the gift tax. This issue is avoided, since the assets being received from the GRAT are now being received cleansed of all exposure to estate or gift taxes.
This could be accomplished as follows.
The grantor first establishes an ILIT which then obtains insurance on the grantor’s life. Premium payments would then be funded by the grantor as usual. However, the donations to the trust would not be treated as gifts, but as “loans”, with adequate interest, in accordance with recently released IRS regulations addressing “split dollar” plans. The grantor would also establish a zero-GRAT with increasing, income producing assets. When the term of the GRAT ends, the GRAT assets are then paid into the ILIT. The ILIT then uses the funds received from the GRAT to pay part or all of the split dollar loan from the grantor.
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