How Can I Reduce or Even Eliminate Gift and Estate Tax?

A GRAT can be an effective estate planning tool for lowering taxes.

What Is a GRAT (Grantor Retained Annuity Trust) and What Are the Benefits?

A Grantor Retained Annuity Trust, or GRAT, is an estate planning tool that provides an individual the opportunity to transfer the growth on appreciating assets to their children or other named beneficiaries with very little or no gift tax consequences.

GRATs are often referred to as “split-interest trusts,” indicating the two types of interests that comprise a GRAT: a retained interest and a remainder interest. The creator of the GRAT (the grantor) makes an irrevocable gift of assets to the trust and retains the right to receive an income stream from the trust for a predetermined number of years. The grantor receives this retained interest in the form of an annuity, which is a fixed amount determined at the creation of the trust. The beneficiary of the GRAT receives the remainder interest at the termination of the trust.

GRATs Have a Positive Impact on Gift Tax

The creation of a GRAT will generally produce a more desirable gift tax outcome than an outright gift. Usually no taxes are owed on the gift as the value of the gift may be zero or entirely offset by the grantor’s applicable lifetime gift tax exclusion. In order to determine the taxable gift to a GRAT, the fair market value of the property contributed to the trust is reduced by the amount of the grantor’s retained interest to determine the amount of the gift. Valuation of any taxable gift is always determined at the inception of the trust. The larger the amount of the retained interest, the smaller the taxable gift. Consider the following examples:

Example 1: 10-year GRAT

A 55-year-old engineer has a stock portfolio he would like to transfer to his two children in the future. The entire portfolio, which is valued at $2.5 million, is gifted to a 10-year GRAT and the engineer will retain an annuity of 5% (or $125,000 per year).

Using the IRS assumed rate of return (Section 7520 rate) of 2.2% for January 2014, the engineer’s retained interest would be valued at $1,111,164 based on an actuarial calculation. The taxable gift is equal to $1,388,836.

Assuming that the engineer has not made any taxable gifts in the past, his entire gift tax payable can be offset by using his applicable lifetime gift tax exclusion. As long as the assets contributed to the GRAT appreciate at a higher rate than the Section 7520 rate (2.2% for January 2014), then the appreciation will be transferred to the beneficiaries gift tax free.

If the assets achieved an annual rate of return of 8% at the end of the 10-year GRAT term, the beneficiaries would receive $3,586,492 and the engineer would only have used $1,388,836 of his lifetime exclusion resulting in an estate tax savings at 40% of $880,000.

Example 2: Zero-ed Out GRAT

Assume the engineer creates a two-year GRAT and funds it with $1 million. Let’s assume that the GRAT will realize a 20% annual rate of return. At the completion of Year 1, the engineer will receive an annuity payment of $516,556. The annuity payment consists of one-half of the initial contribution or $500,000, plus the IRS assumed rate of return (Section 7520 rate) of 2.2% for January 2014). At the end of Year 2, the engineer will receive another annuity payment for $516,556. At the expiration of the trust term, the remaining assets, amounting to $303,578, will pass to the trust’s beneficiaries and completely avoid gift taxation.

You Can Most Likely Lower Your Estate Tax with a GRAT

From an estate tax perspective, the annuity payments that the grantor receives over the term of the trust are includable in their gross estate. Since GRATs allow the grantor to retain an interest in the gifted assets to the trust, all or a portion of the assets will be includable in the grantor’s estate at fair market value at the time of death. In order to completely avoid estate taxation, the grantor must survive the term of the GRAT, at which time the remainder interest is distributed to the trust beneficiaries.

Significant tax savings can be achieved when the grantor outlives the term of the GRAT. The appreciation of the contributed assets in excess of the Section 7520 rate used to initially value the retained interest is transferred to the beneficiaries tax free.

The popularity of GRATs has skyrocketed in recent years due in large part to extremely low Section 7520 interest rates. In order to benefit from the use of a GRAT, the contributed assets must appreciate more rapidly than the Section 7520 rate in effect at the inception of the trust.

Proposed Legislation

Recently, there has been proposed legislation that would place restrictions on the use of GRATs. One of the provisions in the new legislation would prohibit a GRAT from being zero-ed out, meaning the value of the retained interest would be equal to the value of the assets contributed, resulting in a taxable gift of $0.

Another proposed provision would require GRATs to be subject to a minimum term of ten years. This could produce an undesirable outcome since there is a greater chance that the GRAT could experience a period of poor investment performance with a longer term, and thus lead to an unsuccessful attempt at transferring wealth and avoiding gift tax.

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