A grantor retained annuity trust (GRAT) transfers to the grantor’s children the difference between the actual earnings of the trust and the earnings the IRS assumes the trust will earn based on the section 7520 rate in effect the month the GRAT was created. In general, short-term GRATs have been thought to be the most advantageous because in any given period assets will either out-earn the rate, in which case value will be trapped in the trust, or will underperform in which case the assets will be returned to the grantor to be contributed to a new GRAT. In principle, a series of one-day GRATs would be most efficient but section 2702 (b)(1) defines a qualified annuity interest in the plural - - the right to receive fixed amounts payable not less frequently than annually - - which suggests that the minimum term of a GRAT may be two years.
Interest rates that are extremely low facilitate an alternative strategy: the very long-term GRAT. The longer the term the lower will be the annuity required to zero-out the GRAT, that is to produce no gift. Treas. Reg. §20.2036-1(c)(2) provides that where a grantor retained an interest in an annuity the value of the property included in the grantor’s estate will be the amount required to produce the annuity using the section 7520 rate in effect at the grantor’s death. See Examples 1 and 2 of the referenced Regulation.
A 99 year GRAT funded with $1,000,000 in a month when the section 7520 rate is 1.0% will require annual payments of $15,959.35. per year to produce a zero gift. Suppose that when the grantor dies the section 7520 rate has increased. Merely by the increase, assets will be excluded from the grantor’s estate. To illustrate:
The initial section 7520 rate is important. For instance, a 99 year trust funded with $1,000,000 in a month when the rate is 4.0% would require annual payments of $40,841 and an increase in the rate to 6% would produce inclusion of $680,683.33.
The term length is important too. A 50 year term would in a month when the section 7520 rate is 2.0% would require payments of $31,823.22 for trust funded with $1,000,000. That annuity would require the rate to rise to 3.2% before “breaking even” ($994,475.63 included) and an increase in the rate to 6% would include $530,387 in the grantor’s estate. Similarly, a term that is longer than 99 years would, mathematically, produce more efficient results.
Few clients may be expected to survive a 99 year term. Thus, consideration must be given both to the payment of estate tax on the assets included in the grantor’s estate and to the operation of the trust after the grantor’s death. In order for the value of the annuity to be valued for the full term, and for the trust to produce no gift, the GRAT ought to be designed such that the grantor’s death does not affect the payment of the annuity. Estate taxes ought to be paid from another source rather than apportioned to the GRAT. Further, if the remainder interest is vested in separate trusts, one for each child, and the annuity interest is assigned by the grantor’s estate to each of the grantor’s children, then there would seem to be little argument that the grantor’s death does not affect the payment of the annuity.
Might a child, and the trustee of a child’s trust, decide to combine the two property interests after the grantor’s death so as to give the child fee ownership of the child’s portion of the GRAT? In many instances the answer will be yes but the actions of beneficiaries after the death of the grantor ought not to affect the treatment of the GRAT when created by the donor. The question of what should happen to the interest of a deceased child – should it be paid to the deceased child’s estate (in which case the child who dies before the grantor will have a remainder interest on which to pay estate tax), or to the descendants of a deceased child (which will produce a generation skipping tax absent exemption being available to be allocated which will rarely be available), or to the surviving children (which generally will require the descendants of the deceased child to be equalized in the grantor/parent’s estate plan) – is the same as with any GRAT.
Suppose during the grantor’s lifetime the section 7520 rate increases substantially. The amount included in the grantor’s estate under section 2036 were the grantor to die at such time would be reduced. May the grantor purchase the remainder interest from the remainder beneficiaries, or may the remainder beneficiaries purchase the annuity interest, and lock in savings? Even under the conservative approach of the Gradow decision, ensuring that the grantor receives an amount equal to what would be included in the estate under section 2036 would seem sufficient. Care must be taken that the trustee has no role in such a transaction in order to minimize the risk that it is treated as a commutation which is specifically prohibited. The income tax consequences of the purchase or sale are uncertain. Suppose the annuitant and the remainder beneficiaries funded a general partnership with their respective interests with the result that the grantor/annuitant received a partnership interest having a pro rata value equal to the value of the GRAT that would be included in the grantor’s estate. Would such a transaction produce a better income tax result?
The 2012 Obama Administration estate tax reform proposals would limit the term of GRATs to no shorter than 10 years and no longer than life expectancy plus 10 years. A 60 year old has a 21.54 year life expectancy. A 31 year GRAT when the section 7520 rate is 1.2% requires annual payments of $38,820. An increase in the rate from 1.2% to 5% causes inclusion of $776,400.
Easy Funding Examples
Notes. Consider a client who has sold assets to a grantor trust and continues to hold notes. If those notes have an interest rate in excess of the amount required to make the annuity payments, then holding the notes in a long-term GRAT would seem to have no risk and to be likely to produce a reduction, perhaps a significant reduction, in the grantor’s estate.
Marketable securities. A client with a large single holding, or multiple holdings, that produce sufficient income to make the annuity payments may achieve a reduction in the grantor’s estate, and the exclusion of appreciation, through a long-term GRAT.
Non-Zeroed Out GRAT. Suppose a client funds a discount entity with $15,000,000 producing 2% annual cash return. If the client transfers 99% of that entity to a 20 year GRAT paying an annuity of 297,000 annually (99% x $300,000), then client will have made a taxable gift of just under $4,750,000. If the client survives the 20 year term the assets are out of the client’s estate - - capital appreciation of 3% produces a total of $19,000,000 at the end of 20 years. If the client dies during the 20 year term, when the section 7520 rate is at least 2%, less than the underlying value of the entity is included in the client’s estate. If the section 7520 rate exceeds 6.4% then no amount beyond the original gift should be included in the client’s estate. Where a client desires to retain the income from a low income producing asset with high appreciation potential, this approach bears consideration.
This illustration was not written (or intended) to be relied on, and it may not be used by any taxpayer to avoid Federal tax penalties. This Disclaimer complies with Circular 230 that governs practice before the Internal Revenue Service.
Copyright 2012 Turney P. Berry, All Rights Reserved