Tuesday, February 24, 2015

The Grantor Retained Annuity Trust as a Tool for Wealth Transfer

     We often discuss the benefits of 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 yet transfer property (often which is highly appreciating) to a child with minimal Gift or Estate Tax. A GRAT allows the client to transfer assets into an irrevocable trust and retain the right to annuity payments for a fixed term of years or their lifetime. When the set duration 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. While it is possible that the trust will earn insufficient income to cover the required annual payment and thus the Trustee must make that payment from the principal, with proper planning the GRAT is a powerful tool for wealth transfer.
     When using a GRAT to transfer assets, the gift tax value of the 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 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 at the termination of the GRAT. Since the value of the annuity interest exceeds the fair market value of the assets transferred into the GRAT there is no Gift Tax liability to the client, nor do they use any of their Lifetime Gift Tax Exemption. If the client funds their GRAT with assets 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.

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