Use of Grantor Retained Annuity Trusts in Estate Planning

 

I.              INTRODUCTION.

A.           A grantor retained annuity trust (“GRAT”) is a technique for transferring assets in a very favorable manner from a gift tax standpoint.

B.           A GRAT is an irrevocable trust designed to hold assets for a specified term.  During the term, the grantor of the trust receives a payment from the trust.  When the GRAT terminates at the end of the term, the assets are distributed to the beneficiaries designated in the trust.

II.            GIFT, ESTATE AND GENERATION SKIPPING TRANSFER TAXES

A.           Estate Taxes.

1.            Estate taxes are imposed on the transfer of assets from a decedent to his or her beneficiaries.

2.            Exemptions:

Year                                                                            Exemption

2008                                                                             2,000,000

2009                                                                             3,500,000

2010                                                                             Unlimited

2011                                                                                                                                                         1,000,000

3.         Property transferred at death receives a new basis equal to the fair market value as of date of death (or in some cases the alternate valuation date).

4.         Wisconsin currently has no estate tax effective 1/1/08.

B.           Generation Skipping Transfer Taxes (“GST Taxes”).

1.            Lifetime gifts and transfers at death to beneficiaries who are more than one generation below the transferor’s generation (for example grandchildren) may be subject to the generation skipping transfer tax.  The GST tax is designed to insure that, for the most part, all property is taxed at every generation’s level and is not avoided by skipping generations.

2.            Exemptions:

YEAR

GENERATION SKIPPING

TRANSFER TAX EXEMPTION

 

 

2008

2,000,000

2009

3,500,000

2010

Unlimited

2011

1,000,000 (indexed for inflation)

C.           Gift Taxes.

1.            A gift tax is imposed on the transfer of assets during a person’s life.  There are many exemptions from the gift tax, the most common of which are the following:

a)            Gifts to qualifying charities are exempt from gift tax.

b)            Annual exclusion gifts – the taxpayer may generally exclude the first $12,000 of gifts made to each donee during each calendar year from the gift tax.

c)            Tuition expenses and medical expenses paid directly to providers are exempt from gift tax.

d)            Each taxpayer has a $1,000,000 lifetime gift tax exemption but then the taxpayer’s estate tax exemption is reduced accordingly.

e)            Property transferred by gift takes a carryover basis meaning the donee takes the donor’s basis.

D.           GRAT Gift Tax Principles.

1.            Chapter 14 of the Internal Revenue Code generally provides that when a person transfers interests in closely held businesses, partnerships or trusts to a family member and retains an interest in the property, the retained interest is valued at zero unless the retained interest falls within certain approved formats for a retained interest.

Example:  Dad (age 52) transfers stock worth $100,000 to a trust for the benefit of his son.  Dad keeps the right to receive the dividends from the stock for 10 years at which time the stock passes to his son.  For gift tax purposes, Dad’s retained interest is disregarded and the value of the gift is $100,000 even though son won’t receive the stock for 10 years.

2.            §2702 provides that if a person creates a trust and retains a “qualified annuity interest” or a “qualified unitrust interest”, then the gift is valued by subtracting off the retained interest from the total value of the property transferred.

Example:  Same as above but Dad keeps the right to receive a payment of $4,000 per year for 10 years.  The value of his “qualified annuity interest” is $31,000 and the gift is only $69,000 (assuming 4.2% §7520 rate).

3.            The value of the qualified annuity interest is determined using the IRC §7520 rate which is 120% of the midterm applicable federal rate.  The lower the §7520 rate, the lower the gift.

4.            Important:  If the total return of the property transferred to the GRAT (income and appreciation) equals the §7520 rate, no leveraging of the gift will occur.  If the total return of the property transferred exceeds the §7520 rate, the technique will result in transferring wealth at no gift tax cost.

5.            A gift to a GRAT does not qualify for the annual gift tax exclusion.  The amount of the taxable gift will use part of the taxpayer’s lifetime exemption of $1,000,000.

6.            A gift tax return is required and disclosure sufficient to comply with Treasury Reg. §301.6501(c)-1 should be made in order to start the assessment period running.  The disclosure must include:

a)            Description of the transaction, the retained interest and the methods used to value.

b)            Identity of parties in transaction, relationships and all parties holding an interest in the entity transferred.

c)            Detail regarding valuation including actuarial factors, discount rates used and all relevant financial information about the value of the property or entity transferred.

E.           GRAT Estate Tax Principles.

1.            If the grantor survives the term, the property is out of the grantor’s estate (although some of the grantor’s exemption will most likely have been used to establish the GRAT).

2.            If the grantor dies during the term, and the GRAT provides that the property is returned to the grantor’s estate, all of the property will be included in the grantor’s estate and no tax savings will occur.

3.            If only the annuity payment is to continue to be made to the grantor’s estate, then a portion of the trust assets will be included in the estate.

F.            GRAT Generation Skipping Tax Principles.

1.            GRATs are not effective for generation skipping transfer tax planning.

2.            GST exemption cannot be applied at the time the GRAT is set up – rather it is allocated at the end of the GRAT term to whatever the then current value of the assets are that pass to the beneficiaries.

G.           GRAT Income Tax Issues.

1.            A GRAT should be structured to be a “grantor trust”.  In order to be a grantor trust, the grantor should:

a)            Retain a reversion worth at least 5% of the GRAT assets, §673(a); or

b)            Give the grantor the right to substitute assets of equivalent value in a non-fiduciary capacity, §675; or

c)            Grant a non-adverse trustee the power to distribute income to the transferor’s spouse.

2.            Implications of grantor trust status.

a)            Transactions between the grantor trust and the grantor are ignored and for most purposes the grantor trust is not a taxable entity.

b)            Avoids realization of capital gain upon exchanges of appreciated property between the grantor and the GRAT.  This could occur if the income generated by the entity transferred to the GRAT was not sufficient to pay the required annuity payment and shares of stock had to be distributed out to the grantor in payment of the required annuity.

c)            Grantor trusts qualify as S Corporation shareholders.

d)            Payment by the grantor of the GRAT’s income taxes is not a gift because the grantor is liable for the taxes; GRAT assets can accumulate income tax free.

e)            Important Note:  An important factor to keep in mind in implementing a GRAT is that if the underlying assets of the GRAT are sold, all of the capital gain will flow through to the grantor even though the sales proceeds do not.

f)             At the end of the GRAT term, the assets pass to the beneficiaries with a carryover basis.  This would be the grantor’s basis adjusted during the term of the GRAT (not the basis at the beginning of the GRAT).

III.           REQUIRED TERMS OF A GRAT.

A.           Annuity Payment.  The annuity amount to be paid to the grantor must be a fixed amount:

1.            A fixed dollar amount, or

2.            A fixed percentage of the initial fair market value of the property transferred to the trust.  This is more common because it results in an automatic adjustment to the annuity payment in the event the IRS audits and adjusts the value of the gifted property.  It doesn’t keep the gift at the same amount if the value increases upon audit but it results in a significantly smaller gift increase than if a fixed dollar amount payment were used.

3.            Annuity payments may increase each year to a maximum of 120% of the prior year’s payment.

B.           Frequency of Annuity Payments.

1.            Must be paid at least annually.

2.            Proration is required for a short year such as the initial year.

C.           Prohibition Against Use of Notes to Fund Annuity Payments – the GRAT must prohibit the trustee from issuing a note to satisfy the annuity payment.

D.           Formula Adjustment Requirement.  If the annuity payment is defined as a set percentage of the initial contribution to the trust, the GRAT must require adjustment of annuity amounts previously paid if an error was made by the trustee in determining the value of the property transferred (i.e. if the IRS adjusts the value).

E.           Additions are Prohibited.

F.            Commutation is Prohibited – the trustee cannot prepay the annuity thereby accelerating the transfer to the ultimate beneficiaries.

G.           Prohibition Against Payments to Other Persons During GRAT Term.

H.           Term of GRAT.

1.            Life of annuitant.

2.            Specified term of years.

3.            Shorter of life or term of years.

IV.          EXAMPLE OF GRAT.

A.           Facts of Case:

Mom (49) and Dad (53) have two children, Son and Daughter.

Mom’s and Dad’s assets:   

Home          $   500,000
Investments            2,500,000
100 shares of S corporation stock                5,000,000
Total          $8,000,000
 

 

 

 

 

 

 

Mom and Dad work full-time at S Corporation and receive combined compensation of $300,000.  In addition, S Corporation distributes approximately $240,000 in S distributions or $60,000 quarterly.  The value of S Corporation is appreciating at least 5% per year.

Mom and Dad are concerned about estate taxes.  Their estate continues to grow as they are saving a significant portion of their income and their assets continue to appreciate.

B.           Existing Estate Plan: Diagram not available

C.           Considerations in Setting the Parameters of the GRAT.

1.            Percentage of corporation to transfer.

a)            Grantor should keep sufficient portion of corporation to provide necessary income after GRAT ends.

b)            Grantor will be responsible for all income taxes on a sale of S Corp during the term of the GRAT so it is critical to keep a sufficient portion of the corporation to pay income taxes and have enough remaining proceeds to be financially comfortable.

2.            Annuity Payment.

a)            The income flow from S Corp must be sufficient to pay the annuity amount.  Otherwise, retained cash will need to be distributed from the S Corp or else shares of the S Corp will need to be returned to the Grantor in payment of the annuity payment.

b)            The higher the annuity payment, the lower the gift.

3.            Term.

a)            Pick a term that grantor is certain to outlive absent something unexpected happening.

b)            Consider buying additional term insurance for the term of the GRAT to hedge against a premature death.  The insurance should not be owned by the grantor (use a life insurance trust or have the children own the policy).

c)            Have each spouse create their own GRAT to hedge against a premature death.

4.            Comparison of Parameters.

DISCOUNTED VALUE

PERCENT PAYMENT

ANNUITY PAYMENT

TERM OF
YEARS

GIFT

 

 

 

 

 

650,000

7%

45,000

10

297,000

650,000

8%

52,000

10

247,000

650,000

7%

45,500

15

180,000

650,000

8%

52,000

15

113,000

650,000

7%

45,500

20

95,000

650,000

8%

52,000

20

15,000

D.           GRAT Plan

·        A professional valuation is done of S Corporation.  The total value of S Corporation is $5,000,000 or $5,000 per share.  The appraiser determines that a gift of a 20% interest in S Corporation is entitled to a discount of 35% for lack of marketability, minority interest and lack of voting rights.  Accordingly each share of non-voting stock is valued at $3,250.

·        Mom and Dad recapitalize S Corporation and create voting and non-voting stock.

·        Mom and Dad each create a GRAT naming themselves as the Trustee.

·        Mom transfers 20% of non-voting stock of S Corporation to Mom’s GRAT – Gross value $1,000,000; discounted value $650,000.

·        Dad transfers 20% of non-voting stock of S Corporation to Dad’s GRAT – Gross value $1,000,000; discounted value $650,000.

·        Mom’s GRAT retains an annuity payment of 7% for a term of 17 years (to age 66) – 7% x $650,000 = $45,500.

·        Dad’s GRAT retains an annuity payment of 7% for a term of 15 years (to age 68) – 7% x $650,000 = $45,500.

E.           Administration of GRATS.

·        S Corporation will now make its quarterly distributions of $60,000 as follows:

Mom (30% $18,000
Dad (30%)  18,000
Mom's Grat  (20%)  12,000
Dad's Grat               (20%)                          12,000

 

 

 

 

 

·        Mom’s GRAT will make a quarterly annuity payment of $11,375 ($45,500 ÷ 4) to Mom.

·        Dad’s GRAT will make a quarterly annuity payment of $11,375 ($45,500 ÷ 4) to Dad.

·        If S distributions are not sufficient to make the annuity payment, shares of S Corporation stock can be used to make up the difference.

·        Mom and Dad can use the annuity payment to make their estimated tax payments.

F.            Summary of GRATS

Mom’s GRAT 

Gross value of assets transferred           $1,000,000
Discounted value of stock                650,000
Less: Retained 7% annuity interest using   
                   17 year term and 4.2% AFR              (518,000)
Value of Gift           $   132,000

 

 

 

 

 

 

 Dad's GRAT  

Gross value of assets transferred           $1,000,000
Discounted value of stock                650,000
Less: Retained 7% annuity interest using   
                   15 year term and 4.2% AFR              (470,000)
Value of Gift           $   180,000

       

                       

 

 

 

 

 

 

G.           Estate Tax Consequences (Assuming Mom and Dad live out terms)           

 

Without GRATS

With GRATS

Assets

8,000,000

8,000,000

Less: Gross gifts

              0

2,000,000

Net

8,000,000

6,000,000

Plus taxable gifts:

            Mom

            Dad

 

              0

              0

 

   132,000

   180,000

Taxable estate

8,000,000

6,312,000

Estate tax

(1,800,000)

(1,040,000)

Net to children

$6,200,000

$6,960,000

Difference - $760,000

 

 

H.           Results

·        Estate tax savings of $760,000 – assuming Mom and Dad outlive term and no appreciation.

·        Assume the stock actually appreciates 5% per year the value of the stock at the end of each GRAT would be: 

Dad’s GRAT (15 years)       $2,710,000

Mom’s GRAT (17 years)      $3,180,000 

                                                                        Without GRATS         With GRATS

                                    Estate Tax                  $3,550,000                $1,040,000 

                                    Difference -  $2,510,000

·        Mom and Dad keep control of S Corporation.

·        Mom and Dad keep an income stream from the gifted property through ages 66 and 68 respectively.

 

 

 

This document provides information of a general nature.  None of the information is intended as legal advice.  Additional facts and information or future developments may affect the subjects addressed in this document.  You should consult with a lawyer about your personal circumstances before acting on any of this information because it may not be applicable to you or your situation. 

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