As discussed in our various articles on estate planning and trusts, a trust can be a useful tool to avoid probate costs and maintain increased flexibility in one’s estate plan. Most people use revocable trusts in their estates which allows them to alter the trust at will until death.

Irrevocable trusts cannot be altered except in special circumstances and are considered a completed gift to the trust entity. Once completed, the assets are no longer part of your estate-but it is truly a completed gift and in most circumstances, one cannot again gain access to the asset. It may be useful to use them for estate tax and income tax planning purposes, but many people do not wish to alienate assets forever merely to save taxes.

There are particular irrevocable trusts, however, that grant economic benefits to the person creating the trust and are worthwhile to consider for larger estates. One discussed in this article is the GRANTOR RETAINED ANNUITY TRUST or “GRAT.”

The Basic Structure:

The Grantor Retained Annuity Trust, allows the person creating the trust (“trustor”) to avoid estate taxes if certain events occur and this can result in wealth transferring to the next generation for low or no estate or gift tax dollars. Recall that over five million dollars is the estate tax exemption as of 2017, so this would be useful for estates larger than that.

The GRAT works as follows:

1. The Trustor transfers specific assets into the GRAT Trust but retains the right to receive an annual annuity payment from those assets for a certain number of years. When the term of the GRAT ends, what is left in the GRAT is distributed to the trust beneficiaries (children or other beneficiaries as the Trustor directs when the trust is created).

2. The amount of the annuity payment that is required to be paid to the Trustor during the term of the GRAT is calculated by using an interest rate that is determined monthly by the IRS (the “section 7520 rate.”) As an example, the section 7520 rate for December 2013 was 2.0% and increased to 2.2% for January 2014.

3. Note that the Trustor can create the trust so that the annuity payment will be equal to the section 7520 interest rate, meaning that theoretically all of the assets that have been transferred into the GRAT will be returned to the Trustor in the form of the annuity payments and nothing will be left for distribution to the children or other beneficiaries when the GRAT ends. While ordinarily a transfer of assets owned by someone into an irrevocable trust for the benefit of someone else would be deemed a gift for federal gift tax purposes, with a GRAT since theoretically all of the assets transferred in could come back to the Trustor, the value of the gift to the beneficiaries of the GRAT will be at or close to zero. This is called a “zeroed-out GRAT.”

4. The purpose of the seemingly useless gift to the beneficiary is as follows: the trustor is hoping that the assets transferred into the GRAT will appreciate in value above and beyond the section 7520 interest rate, so while the trustor will receive the annuity payments, the beneficiaries of the GRAT will receive the underlying GRAT assets at their value that has appreciated over and above the section 7520 rate. If that is the case, that value goes to the beneficiaries without additional taxation while the trustor enjoys income from the assets.

5. There are downsides. With the section 7520 rate being as low as 1.0% in the past, assets that are expected to highly appreciate in value above and beyond a mere 1.0% to 2.0% can be transferred into a GRAT and in turn move a significant amount of property down to the beneficiaries of the GRAT when the term ends. There are, however, two downsides to using a GRAT:

a. The assets transferred into the GRAT could grow at a rate lower than the section 7520 rate. If this is the case, then the trustor will simply receive back the trust property at its depreciated value but will have a loss due to the legal fees that were paid to set up the GRAT.

b. The trustor could die during the term of the GRAT. If this is the case, then all of the property transferred into the GRAT would revert into the estate of the trustor and be taxable for estate tax purposes, and the trustor will still be out the legal fees that were paid to set up the GRAT.

Thus, there are two requirements to have this be beneficial for planning: one wants assets that appreciate above the annuity amount and one wants to outlive the term of the GRAT. If both those occur, this is a useful tool. If one or the other fails, one spent thousands of dollars in fees for naught. If sizable assets are transferred that do appreciate significantly, one can save well over thirty percent in estate taxes on that appreciation (under current law.) A third requirement that the trustor must keep in mind is that aside from the income from the annuity, these assets are out of reach of the trustor until the trust ends. If there is any real chance the trustor will need those assets, this is not a good plan.

GRATS were under attack by President Obama as an estate reduction tool in his later budget proposals. The budget proposals attacked GRATs on two fronts:

(1) GRATs would be required to have a minimum term of 10 years, thereby increasing the chance that the trustor will die during the term of the trust and cause the GRAT assets to be pulled back into the trustor’s taxable estate, and

(2) Zeroed-out GRATs would be eliminated and instead transfers into GRATs would be required to have a significant value for gift tax purposes. Both changes would severely limit the effectiveness of GRATs as an estate tax reduction technique. Neither was adopted by the Congress but those limits could be sought again under a new Congress.

And, of course, the administration after Obama’s wanted to eliminate estate taxes entirely, making the usefulness of GRATS even more problematical.

The lesson is that taxes are essentially politically based and changes in the rates and rules can be expected from time to time. Usually, already created structures are “grandfathered” in and remain effective if created before the new tax law.

So, as of now, GRATS still have usefulness in specific situations for trustors with significant assets.

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