GRATs in 2010: Still a Viable Estate and Gift Tax Planning Option

Editor: Michael D. Koppel, CPA, MSA, MBA, PFS, CITP

Estates, Trusts & Gifts

The grantor-retained annuity trust (GRAT) is the Dirty Harry of estate and gift planning. It is complicated, unconventional, and politicians in charge hate having it around. Yet the GRAT has so far successfully resisted efforts to rein it in. And, like the fictional San Francisco homicide inspector, it continues to be very effective in the right situations.

A GRAT is designed to transfer wealth to the next generation without paying estate tax to do it. It is a bet that the client will live to the end of the term of the GRAT, which may be two years or longer. The major disadvantage is that the grantor must survive the trust term for all of the trust’s remaining property to be excluded from the grantor’s estate. Therefore, planners often create multiple GRATs and vary the terms of the trusts to balance the risk of the grantor’s untimely demise with the potential benefits that GRAT planning provides.

A GRAT is also a bet that the assets the client places into the trust will appreciate in value at a rate that is greater than an IRS-prescribed interest rate. Therefore, GRATs typically are funded with property expected to appreciate in value. The trust is required to pay an annuity back to the grantor during the trust’s term, which is what makes the trust a GRAT. The annuity that is paid back to the grantor is determined by reference to the so-called Sec. 7520 rate, which ranged from 2.4% to 3.4% in 2010.

At the end of the GRAT’s term, whatever assets are left in the trust are distributed to the trust’s beneficiaries and the GRAT is terminated. The end result is that the grantor has transferred to the GRAT’s beneficiaries any growth in the value of the trust’s property that exceeds the Sec. 7520 rate. Clearly, a GRAT is worth considering today because lower interest rates reduce the amount of the annuity that the GRAT must pay.

A client could be a candidate for GRAT consideration if he or she has:

• Real estate that is currently at a much lower value than the client believes it will be when the real estate market recovers;
• A securities portfolio that is currently at a much lower value than the client believes it will be when the market rebounds;
• A business that is currently at a much lower value than the client believes it will be when the economy improves; or
• Assets, of any kind, that the client expects to greatly appreciate in value over the next several years, whether because of increased demand for a product or through expertise that the client will bring to bear in the marketplace.

The GRAT’s effectiveness can also be increased by carefully choosing the nature of the property used to pay the annuity back to the grantor. More often than not, the annuity is paid using some of the property contributed by the grantor, because GRATs typically do not accumulate much cash. However, cash may constitute part or all of a GRAT’s annuity payment if the GRAT owns an interest in a passthrough entity that provides funds to help cover the grantor’s tax obligations.

Practitioners should consider the following rules of thumb when helping clients plan for the annuity payments:

• If the GRAT holds interests in closely held passthrough entities that make tax distributions to the entities’ owners, the distribution should be treated as having been made to the GRAT and then transferred by the GRAT to the grantor. This is because the GRAT is the legal owner of the interest, but the grantor bears the responsibility for taxes assessed on the income allocated to the GRAT by the passthrough entity.
• If the GRAT has interests in more than one passthrough entity, it is preferable to use ownership interests in the entity with the lowest growth potential to pay the annuity back to the grantor. This leaves the property with the highest potential appreciation in the GRAT to eventually be distributed to beneficiaries.
• When paying the annuity, always use cash first, followed by property with the lowest growth potential, working up to the property with the highest potential for growth.

Although the GRAT is still under fire from politicians, total repeal seems unlikely. The most recent proposal to rein it in would establish a minimum term of 10 years for a GRAT. Even if this proposal eventually becomes law, it is likely that the GRAT will continue to be a viable weapon in a planner’s arsenal.

EditorNotes

Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.

For additional information about these items, contact Mr. Koppel at (781) 407-0300 or mkoppel@gggcpas.com.

Unless otherwise noted, contributors are members of or associated with CPAmerica International.