Grantor Retained Annuity Trusts as a Tool for Wealth Transfer

We often discuss the benefits of including Living Trusts as part of an estate plan, but there are other types of trusts that may provide our clients with significant benefits as part of a larger estate plan, depending upon the client’s particular situation.

A Grantor Retained Annuity Trust (GRAT) is one method for wealthy clients to maintain an income stream for a period of time yet transfer property (often which is highly appreciating) to a child with minimal gift or estate tax. A GRAT consists of assets transferred into an irrevocable trust with the transferor retaining the right to annuity payments for a fixed term of years or their lifetime. If income earned by the trust assets is insufficient to cover the annual payment, the Trustee will make the required payments from principal. When the set time period ends, the remainder of the trust, including any appreciation, can go to a named beneficiary. Alternatively, it is possible to structure the GRAT to return the principal and a certain amount of income to the grantor, and distribute the excess income to the remainder beneficiary.

The gift tax value of the transferred assets is determined at the time of trust creation and funding by subtracting the value of the annuity interest from the fair market value of the assets transferred to the trust. The value of the annuity interest will depend on the interest rate used, the value received by the grantor, and the value of the remainder beneficiaries’ interest. The IRS Regulations set rules for determining what interest rates may be used in the calculation of valuations, especially when family members are involved.

As an example, if a 60-year-old client sets up a GRAT to last two years and uses the following provisions:

• Contributed Asset Value: $1,000,000,
• the §7520 interest rate required by IRS Regulations: 2%, 
• the asset earns 5% per year
• the asset appreciates at 5% per year 

Over the term of the Trust, the client will receive two annual payments of approximately $515,000, and the remainder beneficiary will receive approximately $130,000 remaining in the GRAT with no gift tax cost. If the asset is anticipated to appreciate faster than 5% per year, the benefit to remainder beneficiaries is even greater

Since the GRAT permits payment of both income and trust principal to satisfy the annuity payments, it is important to treat the GRAT as a grantor trust for income tax purposes. This means the client retains liability for taxes on income and realized gains on trust assets even if these amounts are greater than the trust's annuity payments. This further enhances this tool's effectiveness as a family wealth-shifting and estate tax saving device because the client pays the income tax, thus reducing the their estate.

         In the right circumstances, the GRAT can be a powerful tool to transfer assets with minimal gift or estate tax consequences, but clients should carefully review their financial situation with both an experienced attorney and financial advisor before entering into such a transaction.

Alan Ferrara