A Grantor Retained Annuity Trust (GRAT) is a planning technique that can remove the growth of an asset from a grantor’s estate and transfer that growth to the next generation without a gift tax on the asset growth. Under this type of plan, a grantor creates an irrevocable trust for a predetermined number of years and places into the trust an asset that the grantor feels has the potential for substantial growth. The GRAT really resembles an estate freeze on the transferred asset since the growth post transfer is outside of the grantor’s estate assuming that the grantor survives the GRAT time frame. The GRAT generally works best in a low interest rate environment such as what we have today since a low interest rate decreases the amount of the annuity payments due back to the grantor.
Let’s dig a little deeper. GRAT’s are generally set up for a few years up to 10 years. The grantor will receive an annuity from the GRAT for the term life of the GRAT with interest based upon the Internal Revenue Code §7520. This interest rate is known as the “7520 Rate” and it is based upon the Applicable Federal Rate (AFR) which is published monthly. Once the GRAT is established, that monthly rate is locked in for the entire term of the GRAT. Since 2009, the long term rate has ranged from a high of 3.4% to a low of 1.0%. The short term rate (three years or less) for November 2017 is 1.38%; long term, 2.4%.
As noted, the grantor retains 100% of the initial fair market value of the assets transferred to the GRAT in the form of the annuity. And, since the GRAT is deemed to be a grantor trust, any income generated or capital gains realized within the GRAT during the GRAT term is taxable to the grantor, just as if the asset remained in the grantor’s name. This would be the case even in situations where the income tax liability exceeds the annual annuity payable to the grantor.
So, why are we going through all of these gyrations? The simple reason is that the grantor is betting on the fact that the assets transferred into the GRAT will appreciate in value above the §7520 interest rate. So, even though the grantor will be receiving annuity payments, the beneficiaries of the GRAT will receive the underlying GRAT assets at their appreciated value tax free when the GRAT term ends. We refer to this type of GRAT as a “Zeroed-Out GRAT” because it does not result in the grantor making a taxable gift due to the retention of an annuity equal to 100% of the assets contributed to the GRAT. Otherwise, there is a taxable gift at inception that is equal to the value transferred less the retained interest.
Please keep in mind the following factors in order to ascertain whether a GRAT is right for you:
We welcome the opportunity to explain the benefits of this estate-planning tool further with you. Please feel free to give us a call at The Unger Company Ltd., 212-755-4777.