A Grantor Retained Annuity Trust (commonly called a “GRAT”) is a special trust used to pass ownership of assets to children or other family members after a specified number of years.  Potentially, a GRAT can achieve significant gift tax savings for the grantor, as well as remove the assets from the grantor’s gross estate for estate tax purposes.  GRATs can perform particularly well when the valuation rate, known as the 7520 rate, is lower—and those rates have been at historic lows in recent months.

A GRAT is created when a person (the Grantor) transfers one or more assets, which are expected to appreciate in value, into an irrevocable trust and retains the right to an annuity payment for a fixed number of years.  At the end of that period, any assets remaining in the GRAT are distributed to the beneficiaries (the “remainder beneficiaries”) who were designated by the Grantor in the trust document.  The annuity payment is usually expressed as a fixed percentage of the original value of the assets transferred into the GRAT. 

All income and appreciation, in excess of that required to make the annuity payments to the Grantor, accumulates for the benefit of the remainder beneficiaries.  Consequently, it may be possible to transfer assets to the beneficiaries that, when the trust terminates, have values far greater than their original values when transferred into the trust and, more importantly, that far exceed the gift tax value of the transferred assets.

The gift tax value of the transferred assets is determined using the “subtraction method” when the trust is created and funded.  That is, the gift tax value equals the value of the assets transferred into the trust at the time of the transfer minus the value of the interest retained by the Grantor, i.e., the value of the annuity payments.  The value of the retained stream of annuity payments is determined using actuarial tables which take into account the number of years the GRAT will exist.  For purposes of the actuarial valuation, it is assumed that the trust assets will earn income at a rate set under Section 7520 (“7520 rate”) of the Internal Revenue Code.  The rate changes monthly.

The general effect of the 7520 rate on a GRAT’s performance is that the average annual appreciation and income in excess of the 7520 rate is transferred to the remaindermen free of estate and gift taxes.  Thus, it is more likely for a GRAT to be successful in transferring appreciation when the 7520 rate is low.  The 7520 rate for January 2012 is 1.4%—as low as that rate has ever been.

As noted above, the annuity payout rate may be a fixed percentage of the original value of the assets transferred into the GRAT.  Another option, permitted under the tax laws, is to provide for the annuity percentage to increase or decrease in a systematic manner each year; however, it may not increase or decrease by more than 20% from year to year.  Under either method, the payout percentages for the annual payments can be calculated and scheduled at the time of the creation of the GRAT in such a way as to produce a “remainder” value (i.e., the actuarial value of the assets eventually to pass to the remainder beneficiaries) of zero.  Thus the value of the gift to the remainder beneficiaries, for gift tax purposes, is zero. 

There is a catch.  If the Grantor dies before the end of the selected GRAT term, the value of the GRAT assets, generally, as valued on the date of the Grantor’s death, is included in the Grantor’s gross estate for estate tax purposes.

Let’s look at an example.  Assume Grantor transfers $2,000,000 of a single stock into a five-year GRAT with level annual payments to be made.  The GRAT is established in December, 2011, when the 7520 rate is 1.6%, and therefore, to produce a taxable gift of zero, the GRAT will require that each of the five annual payments be $419,401.  Those payments are made using any cash (from dividends, for example) and stock in the GRAT.  If the stock appreciates at a steady rate of 10% per year, the assets passing to the remaindermen at the end of the five-year GRAT term will be worth over $660,000.  The Grantor will have neither paid any gift tax to transfer that $660,000 nor used any gift tax exemption.

A GRAT is structured so that the Grantor is taxed on all income and realized gains on trust assets even if those amounts are greater than the trust’s annuity payments.  This also means that the use of an appreciated asset to satisfy an annuity payment is not a taxable event and does not generate any taxable gain.

GRATs, as we currently know them, are “endangered” trusts.  Recently, there have been efforts to enact legislation tightening the rules on GRATs.  In his 2012 Budget Proposal, President Obama has suggested that the tax law be changed to require a minimum GRAT term of ten years, making GRATs less likely to be successful for older taxpayers due to the requirement of surviving the trust term.  Several recent legislative proposals have called for GRATs to be structured to produce a minimum gift, perhaps as high as 10% of the value of the assets transferred to the GRAT.  With these threats of legislative change and with the historically low 7520 rates, now is the time to consider using a GRAT as an estate planning and wealth transfer strategy.

Written by Christine Buchanan and Diane Thompson.