WHAT YOU SHOULD KNOW ABOUT A GRANTOR RETAINED ANNUITY TRUST (GRAT)?

Introduction

Grantor Retained Annuity Trust, or GRAT for short, is a special type of irrevocable trust that allows the Trustmaker/Grantor to gamble against the odds and, if the Trustmaker/Grantor plays their cards right, then a significant amount of wealth can be moved down to the next generation for virtually no estate or gift tax dollars.

How Does a GRAT Work?

Here is a general overview of how a GRAT works:

1. The Grantor/Trustmaker transfers specific assets into the name of the GRAT and, as the name suggests, retains the right to receive an annual annuity payment for a certain number of years. When the term of the GRAT ends, what is left in the GRAT is distributed to the trust beneficiaries (children or other beneficiaries of the Grantor's/Trustmaker's choice).

2. The amount of the annuity payment that is required to be paid to the Grantor/Trustmaker during the term of the GRAT is calculated by using an interest rate that is determined monthly by the IRS called the section 7520 rate. The section 7520 rate for December 2013 is 2.0% and will increase to 2.2% for January 2014, which is still very low indeed.

3. The Grantor/Trustmaker can set the annuity payment so that it will be exactly equal to the section 7520 interest rate, meaning that theoretically all of the assets that have been transferred into the GRAT will be returned to the Grantor/Trustmaker in the form of the annuity payments and nothing will be left for distribution to the children or other beneficiaries when the GRAT ends. While ordinarily the transfer of assets owned by someone into an irrevocable trust for the benefit of someone else would be deemed a gift for federal gift tax purposes, with a GRAT since theoretically all of the assets transferred in could come back to the Grantor/Trustmaker, the value of the gift to the beneficiaries of the GRAT will be at or close to $0. This is called a “zeroed-out GRAT.”

4. So why would someone do this, set up a trust for the benefit of someone else but get all of the assets back in the form of annuity payments? This is where gambling against the odds comes into the picture, because the Grantor/Trustmaker is really betting on the fact that the assets transferred into the GRAT will appreciate in value above and beyond the section 7520 interest rate, so while the Grantor/Trustmaker will receive the annuity payments, the beneficiaries of the GRAT will receive the underlying GRAT assets at their value that has appreciated over and above the section 7520 rate.

What Are the Drawbacks of Using a GRAT?

With the section 7520 rate being as low as 1.0% in the past year, assets that are expected to highly appreciate in value above and beyond a mere 1.0% to 2.0% can be transferred into a GRAT and in turn move a significant amount of property down to the beneficiaries of the GRAT when the term ends. There are, however, two downsides to using a GRAT:

1. The assets transferred into the GRAT could grow at a rate lower than the section 7520 rate. If this is the case, then the Grantor/Trustmaker will simply receive back the trust property at its depreciated value and will only be out the legal fees that were paid to set up the GRAT.

2. The Grantor/Trustmaker could die during the term of the GRAT. If this is the case, then all of the property transferred into the GRAT would revert back into the estate of the Grantor/Trustmaker and be taxable for estate tax purposes, and the Grantor/Trustmaker will also be out the legal fees that were paid to set up the GRAT.

What Is the Bottom Line?

GRATs are not for everyone or just any type of asset. The Grantor/Trustmaker must be willing to take a gamble and bet that the property transferred into the GRAT will outperform the section 7520 interest rate, that the Grantor/Trustmaker will live to see the end of the term of the GRAT, and that the Grantor/Trustmaker will not need the gifted property later in life to pay for living expenses or long term care.

Aside from the drawbacks discussed above, one other important thing to note is that President Obama has attacked GRATs as an estate reduction tool in his most recent budget proposals. The budget proposals attack GRATs on two fronts: (1) GRATs would be required to have a minimum term of 10 years, thereby increasing the chance that the Grantor/Trustmaker will die during the term of the trust and causing the GRAT assets to be pulled back into the Grantor's/Trustmaker's taxable estate, and (2) Zeroed-out GRATs would be eliminated and instead transfers into GRATs would be required to have a significant value for gift tax purposes. Both of these changes would severely limit the effectiveness of GRATs as an estate tax reduction technique.
If you are considering a GRAT, the only way to determine if it is the right estate tax reduction tool for you and your family is to consult with Marini & Associates, P.A.