GRANTOR RETAINED ANNUITY TRUSTS. GRATs Generally

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1 GRANTOR RETAINED ANNUITY TRUSTS A grantor retained annuity trust ( GRAT ) is an irrevocable trust technique that is used to transfer significant wealth at little or no gift or estate tax cost. GRATs work especially well for pre-ipo stock and other appreciating assets. This article explains GRATs, generally, and provides examples of the significant tax savings that can be achieved through their implementation. GRATs Generally A GRAT is an irrevocable trust in which the grantor retains an annuity interest during the GRAT term, with any excess remainder existing at the end of the GRAT passing tax-free to beneficiaries. In order for the GRAT assets to produce any excess remainder, however, the GRAT assets must outperform the benchmark rate (or 7520 rate ) that is published by the IRS in the month of creation of the GRAT. The reason is that in order for the GRAT to produce a zero gift tax, the GRAT must pay back to the grantor an annuity amount totaling the initial value of the contributed assets to the GRAT, increased by phantom interest at the 7520 rate. For January 2011, the IRS 7520 rate is only 2.40% per year. For this reason, now is a great time to establish a GRAT using assets that are expected to outperform the low 2.40% rate. Such assets can include business interests, securities, and any other investment with significant earnings and/or anticipated appreciation. It is important to note that although the 7520 rate is currently only 2.40% per year, this rate changes monthly. Increases can be dramatic just last month, the 7520 rate increased from an all-time low of 1.80% in December 2010 to the current 2.40% rate. Thus, if you are interested in establishing a GRAT, you should act quickly. How GRATs Work Below is a diagram of the typical GRAT structure: Grantor Assets payments (total value = assets value + IRS 7520 interest) GRAT Excess appreciation/income passes tax-free at term Beneficiaries - 1 -

2 As shown above, after contributing property interests to the GRAT, the grantor retains the right to receive annual annuity payments for the length of the GRAT term. The amount of the annuity payments are determined so that they zero out the gift tax value of the remainder. To do this, the present value of all annuity payments (discounted by the IRS 7520 rate) must equal the initial value of the property interests contributed at the outset. This way, there is no gift tax at creation since the remainder value is zero; in other words, the IRS treats the beneficiaries as receiving nothing at creation of the GRAT. If the GRAT assets outperform the IRS benchmark rate, any excess appreciation existing at the GRAT term passes to remainder beneficiaries, free from gift tax. Nevertheless, if the GRAT property fails to outperform the IRS benchmark rate, there is no downside since the grantor receives back everything in the form of annuity payments as if the GRAT had never been created. Thus, GRATs pose little or no risk since there is unlimited upside, without any downside risk. There is a catch in addition to the assets outperforming the IRS benchmark rate, the grantor must also survive the GRAT term in order to pass on the remainder. Nevertheless, the tax consequences from death are roughly the same as if the GRAT had never been created: all of the GRAT assets and the appreciation on those assets are included in the grantor s taxable estate, which is the same result as if the grantor had continued to hold onto the GRAT assets until death. Examples Below is a model of a 6-year GRAT with an initial contribution of $1 million of property. The model assumes the current 2.40% IRS 7520 rate which produces six (6) annuity payments of $180,943 each in order to produce a zero remainder value 1. Based on an average return of 4.83% per year, this particular GRAT results in $105,553 passing to beneficiaries: 6-YEAR GRAT Return End of Term 6 3-3% $769,459 ($180,943) $588, % $600,286 ($180,943) $419, % $448,697 ($180,943) $267, % $286,496 ($180,943) $105, % Total to Beneficiaries $105,553 GRATs are especially well-suited vehicles for pre-ipo stock. Consider if the stock placed in the above GRAT had instead realized a successful IPO in 3 that resulted in a 100% gain. All else equal, this results in $1,059,708 passing to the younger generation, tax free: 1 In practice, each annuity payment is increased by 20% each year (the maximum permitted under the Treasury Regulations) in order to backload the annuity payments. This allows the GRAT to retain the maximum amount of investment assets for the longest time possible. For sake of simplicity, all annuity payments in this article are calculated on a straight line basis

3 6-YEAR GRAT IPO SPIKE Return End of Term % $1,586,514 ($180,943) $1,405, % $1,433,682 ($180,943) $1,252, % $1,340,430 ($180,943) $1,159, % $1,240,651 ($180,943) $1,059,708 22% Total to Beneficiaries $1,059,708 Rolling GRATs Depending on the assets used, it may be advisable to establish a series of 2-year rolling GRATs, rather than one long-term GRAT. With rolling GRATs, the grantor creates short-term GRATs and uses the annuity payments from each preceding two-year GRAT to establish a new two-year GRAT. This process continues as long as desired. Rolling GRATs offer the unique advantage of diversifying downside risk. The reason is that any unsuccessful 2-year GRATs that fail to outperform the IRS benchmark rate do not decrease the total amount passing to beneficiaries from each successful 2-year GRATs. In other words, unsuccessful GRATs do not taint the pot. Consider the following comparison had the grantor of the following 6-year GRAT used a series of three 2-year rolling GRATs: 6-YEAR GRAT Return End of Term 6 3-3% $769,459 ($180,943) $588, % $600,286 ($180,943) $419, % $448,697 ($180,943) $267, % $286,496 ($180,943) $105,553 Total to Beneficiaries $105,553 ROLLING 2-YEAR GRATs CONSTANT IRS RATE Return End of IRS Rate 2.40% 1 10% $1,100,000 ($518,071) $581,929 GRAT Contribution $1,000, % $616,845 ($518,071) $98, % $1,005,058 ($536,795) $468, % $477,628 ($477,628) $0 5 7% $1,085,433 ($525,543) $559, % $599,082 ($525,543) $73,538 Total to Beneficiaries $172,

4 As shown above, the three rolling GRATs pass $172,312 to beneficiaries, while the 6-year GRAT with the same asset performance passes only $105,553. The reason is that, with the 6-year GRAT, the amount passing to beneficiaries in 6 is a function of the asset performance for all years, including the drag from s 3 & 4 (in these years, the assets returned -3% and 2%, respectively, and therefore under performed the 2.40% benchmark rate). With the rolling GRATs, however, the successful 1/2 and 5/6 GRATs pass their appreciation of $98,773 and $73,538 to the beneficiaries, respectively, without being affected by the unsuccessful 3/4 GRAT. Instead, the under performing 3/4 GRAT merely returns its capital to the grantor (even though it does not have enough to cover the 4 payment of $536,795) and the grantor uses the capital received to establish the 5/6 GRAT. This is the diversifying benefit of rolling GRATs. Rolling GRATs should not be used where it is believed that the IRS benchmark rate will substantially increase. Consider the effects of using rolling GRATs in an environment of rising IRS benchmark rates: 6-YEAR GRAT Return End of IRS Rate - 1st GRAT 2.40% 1 10% $1,100,000 ($518,071) $518,929 IRS Rate - 2nd GRAT 4.00% 2 6% $616,845 ($518,071) $98,773 IRS Rate - 3rd GRAT 7.00% GRAT Contribution $1,000, % $1,005,058 ($549,359) $455, % $464,813 ($464,813) $0 5 7% $1,085,164 ($560,930) $524, % $560,930 ($560,930) $0 Total to Beneficiaries $98,773 In this example, the grantor would have been much better off locking in the low 2.40% rate (shifting $105,553), rather than using rolling GRATs to diversify the performance fluctuations (shifting only $98,773). Thus, in selecting the GRAT term and deciding whether to use rolling GRATs, it is important to analyze the interaction between the expected rate of return on the GRAT property, as well as any anticipated increases in the IRS benchmark rate. Summary of Tax Consequences The following is a summary of the tax consequences of a GRAT: Gift Tax: There are no gift taxes on the creation or termination of a GRAT. By providing for the grantor s retained annuity interest amount to be equal to the value of the contributed assets (as adjusted by the IRS 7520 rate), the taxable gift can effectively be zeroed out. Future appreciation on the contributed assets is not included in determining the value of the taxable gift. Estate Tax: If the grantor dies during the GRAT term, then all of the remaining GRAT assets (including appreciation) get pulled back into the grantor s taxable estate. If the grantor survives the GRAT term, - 4 -

5 then only the value of the annuity payments remain part of the grantor s taxable estate. Income Tax: For income tax purposes, the grantor is treated as the owner of all of the assets in the GRAT during the GRAT term. Accordingly, income earned on any GRAT asset during the GRAT term is taxable to the grantor. Any transfers between the grantor and the GRAT (such as when assets are contributed to the GRAT or annuity payments are made to the grantor) during the GRAT term are not treated as taxable events for income tax purposes. If you have any questions or would like to discuss any of the above in more detail, please feel free to contact one of our estate planning attorneys listed below: SAN JOSE OFFICE THE LETITIA BUILDING PALO ALTO OFFICE (408) (650) Jim Quillinan jquillinan@hopkinscarley.com Peter LaBoskey plaboskey@hopkinscarley.com Jennifer Cunneen jcunneen@hopkinscarley.com Charles Packer cpacker@hopkinscarley.com John Hopkins jhopkins@hopkinscarley.com Darin Donovan ddonovan@hopkinscarley.com Bruce Roberts broberts@hopkinscarley.com Laurie Look llook@hopkinscarley.com Don Sherer dsherer@hopkinscarley.com Diane Fong dfong@hopkinscarley.com Jonathon Morrison jmorrison@hopkinscarley.com Richard Schachtili rschachtili@hopkinscarley.com Jenny Alberts jalberts@hopkinscarley.com Circular 230 Notice Recently adopted Internal Revenue Service regulations generally provide that, for the purpose of avoiding federal tax penalties, a taxpayer may rely only on formal written advice meeting specific requirements. Any tax advice in this message does not meet those requirements. Accordingly, any such tax advice is not intended or written to be used, and it cannot be used, for the purpose of avoiding federal tax penalties that may be imposed or for the purpose of promoting, marketing or recommending to another party any tax-related matters