The Grantor Retained Annuity Trust - Is It Right For You?
THE COUNSELOR
Volume 10 • Issue 7 • September 2020
The Counselor is a monthly newsletter of Hallock & Hallock dedicated to providing useful information on estate planning and business planning issues. This month's issue will discuss another type of irrevocable trust - the Grantor Retained Annuity Trust. If you are interested in learning more about the ideas and processes discussed in this newsletter, please contact us for an initial consultation.
When planning with trusts, there is an alphabet soup of different types of trusts that can be used to achieve different objectives. While most individuals and couples utilizing a trust in their estate planning have the traditional revocable living trust, many of the special purpose trusts are irrevocable trusts. In a recent YouTube video, we discussed the differences between revocable and irrevocable trusts.
While the ongoing COVID-19 pandemic has wreaked havoc on all of our lives, as Benjamin Franklin once said, “Out of adversity comes opportunity.” Though many have seen the value of assets rebound, a perfect storm still exists as a result of low interest rates coupled with high estate tax and gift tax exemption amounts. Because of this perfect storm, now may be a perfect opportunity to move assets to the next generation or to an irrevocable trust. This is especially true in light of the fact that the higher exemption amounts are scheduled for reduction in the near future. If you can still sell or gift the assets at a lower value, even better, as future appreciation will happen outside of your estate for estate tax purposes.
One of the tools that can be used for this purpose is the grantor retained annuity trust, or GRAT. A GRAT is an irrevocable trust used to eliminate the tax consequences on large financial gifts. One benefit of a GRAT is to freeze the value of a property transferred to the trust, so that the future appreciation on such property will pass estate tax-free to the beneficiaries.
How A GRAT Works
With a GRAT, the person making the gift, the grantor, gives certain property to the trust. The grantor retains the right to be paid a specified amount (the annuity payment) for a specified term of years. The annuity payment must be a fixed amount expressed either in the terms of a fixed dollar amount or a fixed percentage of initial fair market value of the property contributed to the GRAT. It is important to understand that the grantor receives the annuity payment and not the income of the trust. If a GRAT does not generate sufficient income, the trustee will be required to use principal to make the annuity payment. The annuity payment is based on the original value of the assets contributed to the GRAT with a rate of return required by the IRS. This required rate of return is known as the 7520 rate.
The 7520 rate is based on Section 7520 of the Internal Revenue Code and is the lowest rate of return the IRS will allow for the month the assets were transferred to the trust. The current 7520 rate as of the writing of this article is 0.4%. You can find the 7520 rate here. Any actual appreciation of the assets in excess of the 7520 rate will pass to the beneficiaries free of gift tax. For a GRAT to be successful, the assets must appreciate at a rate that is greater than the 7520 rate. This is made much easier when the 7520 rate is at historic lows as it is currently. Assuming the grantor survives the full term of the GRAT, if the assets appreciate at a rate higher than the 7520 rate, all of the appreciation will pass to the beneficiaries free of gift and estate tax. If the assets do not appreciate at a rate greater than the 7520 rate, there is really no downside as the assets are merely back in the grantor’s estate. Other than time, effort, and the cost of creating and administering the GRAT, the grantor has not incurred any negative consequences.
A GRAT is established for a term of years. While congress has looked at an increase in the minimum length, it is currently just two (2) years. Deciding on the term can be one of the most important decisions you and your advisory team make. There is no single right answer. What is right will depend on the goal you are trying to achieve and the assets that are being used. One hard rule is that the GRAT term should be well within your life expectancy. If you do not survive the term, any benefit would be defeated as it would be deemed to have never been established and the value of any assets would remain in your estate.
What Should I Contribute to My GRAT?
As indicated above, assets that work best in a GRAT are going to be those that would likely outperform the 7520 rate. Examples could include appreciating stock, pre-IPO stock, real estate, and closely held business interests. If S corporation stock is to be contributed, the GRAT can be a shareholder so long as it is structured as a grantor trust.
An Example
While there are many ways to structure a GRAT here is one example: Assume you contribute stock presently valued at $1,000,000. Based on the current Section 7520 rate of 0.4% the trust will pay an annuity of $102,212.91 to the Grantor for 10 years. If the trust earns 0.4% or less each year, the Grantor will receive the entire trust property back and there will be nothing left after ten years for the remainder beneficiaries. However, if the assets appreciate at a rate of 6%, the remainder interest distributed free of estate tax or gift tax consequence to the beneficiaries will be $443,600.30. If the term is extended to 15 years, the annuity payment will be $68,819.81 and the remainder going to the beneficiaries would be $794,710.39.
If instead, the trust term is reduced to two years, the annuity payment will be $502,992.81 and the “tax-free” remainder would be $87,434.82. Not necessarily as good. But, if you expect a really large short term return - say 20% - the annuity payment remains the same, but the tax free remainder would now be $333,415.82. So, as you can see, long or short, the term will be governed by the facts applicable to your situation and your assets.
As with any estate planning strategy, the tools to be used and how they are used is highly client specific. So talk to your estate planner and find out whether a GRAT might work in your unique situation.
This Newsletter is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. Nothing herein creates an attorney-client relationship between Hallock & Hallock and the reader.