Grantor
Retained Annuity Trust (GRAT)
This is a trust
created by someone (grantor) who transfers assets to the
trust. It is irrevocable. The trust exists for a set term of
years. At the end of the term of years someone else (such as
a child) gets the trust assets. This person is called the
remainderman and gets the remainder. During the term of the
trust the grantor retains the right to an annuity payment.
When the trust is created the remainder interest is treated
as a gift.
The present value
of the annuity payments is deducted from the total value of
the trust assets to determine the value of the gift. In this
way the trust assets can be transferred to the remainderman
free of gift tax or at a discounted value. This is done by
structuring the annuity payment and term of the trust so
that the value of the remainder is very little. For
instance, $1,000,000 could be transferred to a 2 year trust
by a father with the remainder payable to his daughter.
Valuation is made under IRS tables in which the rate of
return is assumed. The trust could call for 2 yearly
payments of about $533,000 each. This would give the
remainder almost no value upon creation of the trust. The
tables used for this example assume about a 4.4% rate of
return. (The assumed interest rate changes each month). In
other words at a 4.4% rate of return $1,000,000 will yield
two yearly payments of $533,000. Nothing will be left after
that. If the trust assets actually get a higher return there
would still be funds left in the trust at the end of 2
years. In this case over $70,000 if the trust assets
actually earned 9%. This would pass to the daughter free of
gift tax. If the return on the trust assets was 4.4% or less
there would be no transfer of funds to the daughter, but the
grantor would get all of his funds back and the earnings on
them (less transaction costs).
The annuity
payment is a fixed percentage of the initial trust assets or
a fixed amount. It must be paid each year. The value of the
remainder (and thus the gift) is determined by the annuity
payment amount, the length of the trust term and the
interest rate used in the IRS tables.
GRATS exist under
special rules meant to avoid under valuation of the
remainder interest given to family members. Under these
rules, in Section 2702, when an interest in a trust is given
to certain family members and an interest is retained by the
grantor (or other family members) special valuation
principles apply. To begin with, the value of the retained
interest is treated as 0 unless it is a qualified interest.
This means the entire value of the trust assets is treated
as a gift. If the interest retained by the grantor is a
qualified interest then it is valued under actuarial
principles and interest rates determined by Section 7520.
One type of qualified interest is the fixed annual annuity
type of payment.
While creation of
the GRAT involves a gift, the entire value of the trust
assets is in the grantor's taxable estate if the grantor
dies during the trust term. For this reason GRATS often
contain a reversion (the assets revert back to the grantor
or the grantor's estate) if the grantor dies during the
trust term. This is not a qualified interest and will not
reduce the value of the gift under 2702.
A retained
unitrust interest - the right to receive a set percentage of
the value of the trust assets determined annually - is also
a qualified interest. A trust providing for this type of
payment is a grantor retained unitrust or GRUT.
The family
members to which 2702 applies are spouse, ancestors,
descendants and siblings and also spouses of any of the
foregoing. Nieces and nephews, fiances or domestic partners
are not included. When the transfer is not to a family
member included in 2702 the trust is called a Grantor
Retained Interest Trust (GRIT) and standard actuarial
valuation principles apply (i.e., it is not assumed that the
retained interest of the grantor is worthless unless it is a
qualified interest).
The GRAT is
usually arranged so that the remainder has no value. This is
called a zeroed out GRAT. This is done to avoid paying gift
tax. If the actual rate of return on the trust assets is
less than the IRS rate then there will be no assets left for
the remainder man at the end of the term. A donor does not
know in advance if this will happen. Therefore creating a
GRAT with a high remainder value can result in payment of
gift tax when the remainder man gets less than the amount
tax was paid on. If the GRAT is zeroed out this does not
happen. If actual returns are less than the IRS rate the
grantor gets his or her funds back with interest and pays no
tax. If actual returns exceed the IRS rate, a tax free gift
goes to the remainder men.
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