Tansey Estate Planning

Protecting You and Your Loved Ones

Grantor Retained Annuity Trust

A Grantor Retained Annuity Trust (“GRAT”) is a Split-Interest Trust that is a product of gift and estate tax rules that requires the Settlor to receive annual payments during the Annuity Term (similar to the Initial Term for a QPRT). At the end of the Annuity Term, the property remaining in the GRAT, if any, is transferred without any further Gift Taxes to the Remainder Beneficiary.

The Settlor chooses the length of the Annuity Term. Currently, the minimum length of the Annuity Term is two years. Congress is looking at proposals to increase the minimum length of the Annuity to ten years. The required annual payment amount during the Annuity Term is dependent upon three factors: (1) the value of the property contributed to the GRAT; (2) the length of the Annuity Term; and (3) the AFR at the time of the creation of the GRAT.

The Gift Tax value of the GRAT is the actuarial value of the Remainder Interest after calculating the present value of the annuity payments during the Annuity Term using the three same factors listed above. Currently, under these calculations, the amount of the deemed gift for tax purposes can be “zeroed out” based on the AFR-based annuity paid back to the Settlor. However, Congress is looking at proposals to require that a GRAT create a minimum gift of 10% of the value of property contributed to the GRAT. The financial results of a GRAT are enhanced with low AFRs, because this strategy also makes use of the spread between the AFR and expected investment returns.

A special rule allows the annuity payment to increase by a maximum of 20% each year during the Annuity Term. This reduces the risk of poorer economic returns during the earlier portion of the Annuity Term hurting the possibility of the GRAT transferring assets at the end of the Annuity Terms.

If the IRS disagrees with the valuation of property transferred to a GRAT, no gift tax is due; rather, the annuity payments are modified so that the Trust settlor is paid back the excess value.

The primary advantage of the GRAT over other Advanced Planning Techniques is that if the GRAT fails economically, the Settlor is in no worse financial condition, except for the initial set-up costs. This means that the strategy of a GRAT is to harvest economic winners and ignore economic losers. In fact, the GRAT strategy is the opposite of normal investment strategies, where investors invest in different asset classes to mitigate financial risk of one asset class’ poor economic performance. Instead, a series of different GRATs should be created for different asset classes or even individual securities. This allows the Settlor to use the “economic winners” to transfer assets to the Remainder Beneficiaries without having to have those gains offset by the “economic losers.”

The best assets to contribute to a GRAT are those that generate income and will increase in value during the Annuity Term. If the assets in the GRAT do not generate enough income during the Annuity Term to make the annuity payment, the GRAT will have to distribute the property contributed to the GRAT “in-kind” to make up any shortage of cash payments. Assets that will rapidly increase in value during the Annuity Term, such as pre-IPO stock, are good assets to transfer to a GRAT. Also economically volatile assets are good assets to transfer to a GRAT.

In addition to the economic risk, the success of a GRAT carries an additional significant risk—the settlor must survive the chosen annuity term. Thus, longer Annuity Terms carry additional mortality risk than shorter Annuity Terms.

Rolling GRATS

One method to eliminate the GRAT mortality risk is to create a series of GRATs otherwise known as “Rolling GRATs.” The Settlor creates a two year zeroed-out GRAT (GRAT 1) in year 1. The first annuity payment from GRAT 1 would fund GRAT 2 in year 2. GRAT 1’s second annual annuity payment and GRAT 2’s first annuity payment would fund GRAT 3 in year 3. GRAT 2’s second annuity payment and GRAT 3’s first annuity payment would fund GRAT 4 in year 4, and so on. This process would go on until the Settlor wants to stop the process. Please note that once the Settlor funds the first GRAT in year 1, the Settlor would not need to transfer additional assets to the series of GRATs. The subsequent GRATs are funded with the annuity payments of previous GRATs. However, if the Settlor’s estate planning goals change, the Settlor could make additional contributions to the subsequent GRATs in addition to the funds received from earlier GRATs.

Another feature of the Rolling GRAT strategy is its flexibility. The Settlor can terminate the program at any time. For example, the Settlor decided to use a series of nine two-year GRATs instead of using a single ten-year GRAT. Instead of using a series nine GRATs, the Settlor will only need to set up a series of two or three GRATs if those GRATs’ economic performance met the economic goals at the end of two or three years. If the Settlor’s estate planning goals or circumstances change, her or she could run the Rolling GRAT strategy for as long as he or she wants. In other words, the Rolling GRAT approach adopts a “look back” approach to transferring assets the Settlor wants to transfer to his or her beneficiaries, whereas the amount transferred with a single long-term GRAT is dependent on the Settlor’s “guess” of the appreciation of the assets transferred over a longer period, for example the next ten years.

Another large advantage of the Rolling GRAT over the long-term GRAT is its lesser risk of having years of negative economic performance offset years of positive economic performance. Here is an extreme example. In the first scenario a person creates a ten-year GRAT using Lehman Brothers stock in 2000. That GRAT would fail to transfer any wealth, because the stock lost all of its value in 2008. In the second scenario, another person uses a series of two-year Rolling GRATs using Lehman Brothers stock for 10 years in 2000. Any wealth transferred Gift Tax free by the first six GRATs would not be offset by the collapse of Lehman Brothers in 2008. One should be aware there are proposals in Congress to eliminate the Rolling GRAT strategy by requiring that GRATs have a minimum ten-year Annuity Term.

Rolling GRATs

GST Concerns

GRATs are not useful for Generation Skipping Transfer Tax (“GST Tax”) planning, because under IRS rules, one cannot allocate GST Exemption until the end of the Annuity Term. However a GRAT is wonderful method to transfer assets to a Health Education Exclusion Trust, because that trust does not need any GST Exemption to make payments for the benefit of Skip Persons.

GRATs are Freeze transactions, which leverage Post-Transaction gains for the Remainder Beneficiaries.