GRATs are GRReat

By: Elizabeth A. Hartnett

A Grantor Retained Annuity Trust (“GRAT”) should be considered by wealthy individuals as part of a tax efficient gifting pro¬gram designed to minimize gift and estate taxes.

With a GRAT, a Grantor transfers property to an irrevocable trust. That trust makes annual payments of a specified amount back to the Grantor (hence the “Grantor Retained Annuity” name) for a specific term. When the term expires, whatever assets are left (the remainder) passes outright or to trusts for the Grantors beneficiaries.

At the end of the GRAT term, the remainder interest that passes to the beneficiaries is com¬pletely out of the Grantor’s estate. This reminder interest is treated as a taxable gift by the IRS. The amount of associated gift tax depends on the value of the property transferred at the GRAT’s expiration. But because no one can say what the value of the assets will be at the end of the trust term, the IRS makes an educated guess. It uses the current values of the property transferred to the GRAT and a prescribed interest rate (the “Section 7520” rate) set at the time of the transfer to the trust, reduced by the scheduled annuity payments the Grantor is to receive back from the trust in order to calculate the growth of the trust property so as to assign a hypothetical value to the remainder that will pass to the beneficiaries.

Interest rates are now at historic lows (2.2% for August and September 2014). These low rates create a window of opportunity between the higher rates of seven years ago (dropping from the 6.2% peak of August, 2007 to a low of 1.0% in January 2013). Since the low of January 2013 the Section 7520 interest rate, adjusted monthly, has risen slightly. The current relatively low rate is a window that can be exploited now. The significance is that the lower the Section 7520 rate, the smaller the projected GRAT remainder, and the less potential gift taxes imposed on the gift.

To come out ahead, trust’s assets must grow at a faster rate than the Section 7520 rate that was used to value the reminder (currently 2.2%). This requires generally adequate management ability and is probably more likely in a rising market or with property that may appreciate rapidly. For example, assume a transfer $2 million in publicly traded securities to a GRAT. The annuity payments are structured so that the value of the remainder interest is close to zero on the transfer to the GRAT. But if the securities gain value during the term of the trust at a rate greater than 2.2% (the so-called “hurdle rate”), the beneficiaries will receive the extra value without any additional gift tax.

For example, assume a 5-year GRAT funded with $2 mil¬lion where it is anticipated that the trust investments will grow at 6% and earn 2% income annually while the IRS Section 7520 assumed rate is 2.2%. Under those assumptions a taxable gift valued at $80,960 (sheltered by the Grantor’s lifetime gift tax exemption) results in a gift transfer of $544,748 at the termination of the GRAT and a return to the Grantor of the entire $2 million initially placed in the trusts. The term of years of the GRAT, the initial asset transfer and the annuity payments are variables that can change depending on the Grantor’s specific objectives.

There are potential drawbacks. The first occurs if the rate at which the trust assets appreci¬ate ends up being less than the IRS Section 7520 rate. In such event the Grantor has wasted a portion of the Grantor’s lifetime gift tax exemption. However, this risk applies to any gift. Second, if the Grantor dies before the end of the GRAT term, the trust assets revert to the Grantor’s estate and could be subject to estate taxes. But the potential benefit of establishing a GRAT generally outweighs these risks and provides a vehicle to transfer significantly more of the future appreciation on the Grantor’s assets to beneficiaries.