Interactive Legal Systems

A grantor retained annuity trust (a "GRAT") is a trust from which the grantor has retained the right to receive a stream of annuity payments for a period of years. When the grantor's entitlement to receive the payments ends, the property passes to, or is held in further trust for, others (the "successor beneficiaries"). If the successor beneficiaries are members of the grantor's family within the meaning of Code Sec. 2702 (such as Grantor's descendants), the entire amount transferred to the GRAT may be subject to gift tax unless the annuity interest in the GRAT constitutes a "qualified interest" within the meaning of Code Sec. 2702(b). The regulations issued under that section set forth detailed rules about GRATs that need to be followed for the annuity interest in the GRAT to be such a qualified interest.

While the desire to transfer value to other family members is the primary purpose, a GRAT is often implemented to transfer wealth to other family members (such as children) at very low relative gift tax cost and without any estate tax. As explained below, the GRAT will be successful only if the combination of growth and income (the "total return") exceeds the Section 7520 rate, and only if the grantor survives the retained annuity term-it is the position of the IRS that the entire GRAT is included in full in the grantor's estate for federal estate tax purposes if the grantor dies during the GRAT annuity term.

How GRATs Achieve Savings

If the annuity stream in the GRAT is a qualified interest, the gift the grantor makes to the successor beneficiaries (such as his or her children or a trust for their benefit) is determined by subtracting the value of the annuity stream retained by the Grantor from the value of the property transferred to the GRAT. In order to obtain a private ruling that the GRAT is a qualified interest, the IRS requires that the value of that interest for the successor beneficiaries (which we will refer to as the "remainder") must be at least 10 % of the value of the property transferred to the trust; Yet many practitioners believe the value of the remainder may be made very small, if not zero. For example, in Walton v. Commissioner, 115 TC 589 (2000), acq. IRS Notice 2003-72, 2003-44 IRB 964, the value of the remainder was substantially less than one percent and the IRS did not challenge the GRAT on that ground. The value of the taxable remainder is kept small by having the value of the retained annuity stream almost the same (only slightly less) as the value of the property transferred to the GRAT. That is done by retaining annuity payments of sufficient size and for a sufficient time. That, in turn, is accomplished by having the grantor retain the right to receive back the entire value (or nearly the entire value) of what he or she has transferred to the GRAT together with interest at the so-called "Section 7520 rate". The Section 7520 rate is determined monthly by the IRS and it is the Section 7520 rate for the month in which the GRAT is created that is used to determine the value of the retained annuity stream.

If the value of the remainder and, therefore, the taxable gift, is very small (such as one percent or less), the GRAT provides an opportunity to "leverage" growth occurring above the Section 7520 rate for the month it is created. Indeed, the GRAT "works" to the extent the total return during the annuity term exceeds the Section 7520 rate used to value the retained annuity stream. And the GRAT works well because the successor beneficiaries receive the total return above the Section 7520 rate on all property in the GRAT and not just on the value of the remainder.

Let's use an example of a one year GRAT (which is much easier to explain) even though it is not certain that the annuity term of a qualified GRAT may be that short in duration and still be a qualified interest under Code Sec. 2702. A taxpayer transfers $1 million to a GRAT when the Section 7520 rate is 5%. That means that the IRS will assume that the GRAT will be worth $1,050,000 at the end of the year. If the grantor retains the right to receive $1,049,000 at the end of the year (which is, under our example, when the trust will end), the grantor will be deemed to have made a gift of $9,524, which is the present value of the right to receive $10,000 in one year using the Section 7520 rate of 5% as the discount rate. If the total return for the year is 5%, the trust will grow to $1,050,000, the grantor will receive $1,049,000, the successor beneficiaries will receive $1,000, which is what the $9,524 gift would grow to in a year if it earned 8% for that year. If the total return during the year is 8%, the trust will be worth $1,080,000 at year end. The grantor would, in that event, receive $1,049,000 and the successor beneficiaries would receive approximately $31,000-over 30 times more than if a "straight" gift had been made.

The key, as explained above, is that the successor beneficiaries get the growth above the Section 7520 rate on the entire amount in the GRAT and not just the total growth on the gift. Of course, if the growth in the GRAT does at least equal the Section 7520 rate, the GRAT will be inferior to a direct gift. It will also be inferior if the grantor dies during the annuity term.

Effects of Longer GRATs

GRATs must make annual payments to the grantor rather than just a single payment at the end. This is unfortunate because the leverage is reduced. In the foregoing example of a one year GRAT, a gift of $9,524 leverages growth above the Section 7520 rate on $1,000,000-nearly 100 to one. However, with each year's mandatory annual payment in a multiple year GRAT, the leverage is reduced, less remains in the GRAT by reason of annuity payments to the grantor.

Several steps should to be considered in response to this issue of diminishing leverage, especially since most practitioners believe the annuity term in the GRAT must be at least two years. One of these steps is to have each annual annuity payment increase by 20%. Reg. § 25.2702-3(b)(1)(ii) provides that an annuity payment is considered "qualified" only to the extent the annual increase does not exceed 20% of the prior year's payment. The effect of increasing each annuity payment is to slow down the "deleveraging" of the GRAT.

Other Steps to Enhance the Chances of Success of a GRAT

One "problem" with a GRAT is that one year's poor investment performance can offset good performance in other years. For example, assume that the GRAT has a total return above the Section 7520 in the first two years but a total return below that rate in the third year. In that event, nothing may pass to the remainder beneficiaries. Hence, it seems appropriate to consider making the GRAT as short as the practitioner believes legally allowable-taking each annuity payment and "rolling" it into a new GRAT. That way, poor performance is less likely to adversely affect good performance already experienced in the GRAT.

There may, however, be some downside to using short-term GRATs. First, GRATs could be "outlawed" in the future, made less efficient on account of changes in the law (e.g., requiring that the value of the remainder be at least 10% of the amount contributed to the trust as is required under Code Sec. 664(d) for a charitable remainder trust) or the Section 7520 may have increased significantly.

Just as poor investment performance in one year may offset good performance in an earlier year, poor investment performance of one asset class may offset good investment performance in another asset class. For example, a grantor funds a two year GRAT with hedge funds worth $500,000 and publicly traded U.S. stocks of $500,000. The stocks increase by 10% in the first year and 20% in the second year. But the hedge funds drop 5% in the first year and 25% in the second. The GRAT will now fail to provide any benefit for the successor beneficiaries. But if the grantor had instead created two GRATs, funding one with the hedge funds and one with the stocks, the second GRAT would have been successful. Although there seems to be no reason why a taxpayer cannot create such multiple GRATs, it may be safest to have each one last for a different term (e.g., the GRAT funded with hedge funds to last for two years and the GRAT funded with the stocks to last for three years) and with different successor beneficiaries (e.g., the GRAT funded with hedge funds to pass to the older child and the GRAT funded with the stocks to pass to the younger one).

Effectively Using the 105 Day Delayed Payment Option

The annual GRAT annuity payments can be based on a calendar year (under which the first annuity payment must be payable at the end of the first calendar year) or the anniversary of the commencement of the GRAT (under which the first annuity payment would be not be payable until a full year after creation of the GRAT). However, in either event, the payment can be delayed. In the case of the calendar year payment plan, the payment can be delayed until the time when the trust's income tax return is due to be filed without regard to extension (generally, April 15) or, in the case of a GRAT with its payments on the anniversary of the start date, within 105 days after such anniversary. Although this may not seem very significant, it may in fact be very important in making the GRAT successful.

For example, again using a one year GRAT only for purposes of illustration, assume a taxpayer transfers $1 million to a GRAT when the Section 7520 rate is 5%. The grantor retains the right to receive $1,049,000 at the end of the year, when the trust will end. If the total return during the year is 6.5%, the trust will be worth $1,065,000 at year end. The grantor will receive $1,049,000 and the successor beneficiaries will receive $16,000. But if the payment due the grantor is delayed for 105 days, and the trust continues to grow at an annualized rate of 6.5% during the 105 day period, the trust will be then worth $1,084,937. The grantor will receive the $1,049,000 annuity payment and the successor beneficiaries will receive $35,937, more than twice that which would have been transferred if the payment had not been delayed. One way of looking at this phenomenon is that, in essence, the successor beneficiaries are receiving an interest free loan for 105 days of the annuity otherwise due the grantor.

Although not certain, it does not seem that the 105 day delayed payment constitutes an interest-free loan under Code Sec. 7872. Even if it is, it is expressly authorized in the regulations issued under Code Sec. 2702. In fact, specific authorization for the delay, pursuant to those regulations, is included in the SmartContent of Wealth Transfer Planning's GRAT. If that 105 day deferral were to be considered a loan for purposes of Code Sec. 7872, it is possible that the grantor could be treated as making a gift equal to Applicable Federal Rate interest. But, again, it should be emphasized that it does not seem that the delay in the payment for 105 days is such an interest free loan.

Summary and Conclusions

GRATs can be a very powerful estate planning tool for individuals who have assets likely to produce a total return in excess of the Section 7520 rate. "Rolling" short-term GRATs are more likely than longer term GRATs to be successful—although future changes in the law or in the Section 7520 rates could mean a longer GRAT would be better suited. On the other hand, separate GRATs for separate asset classes are almost certainly more likely to be a success than a single GRAT holding all of the classes. Although it may seem like a minor matter, using the 105 day delayed payment provision may substantially increase a GRAT's performance.

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