We published an article last fall about the estate planning benefits of grantor retained annuity trusts. Based on recent economic developments, there are new opportunities with this planning technique and we have updated the article to highlight those opportunities.
Under current federal transfer tax law, you can transfer up to a combined total of $11,580,000 during life or at death without incurring federal estate or gift tax. If you transfer assets in excess of this exemption amount, there will be a transfer tax of 40% on the excess assets. If you are at risk of a transfer tax liability and have appreciating assets, a grantor retained annuity trust (“GRAT”) can be a useful tool to pass assets beyond your exemption amount free of tax. Based on the tax-savings that GRATs can provide and the fact that the usefulness of GRATs is at an all-time high, it is well worth your time to learn about this planning technique now.
A GRAT, at its most basic level, is an irrevocable trust. In most cases, creating and funding an irrevocable trust will reduce your federal estate and gift tax exemption amount by the value of the contributed assets. If you have already fully-utilized your estate and gift tax exemption amount, there will be a gift tax equal to 40% of the contributed assets. However, a GRAT can be structured so that a gift to it has a net present value of zero and will not reduce your exemption amount or otherwise trigger tax.
A net present value of zero is obtained by retaining a right to receive a stream of annual payments, an annuity of sorts, from the GRAT that offsets the value of the gift. For example, if you make a gift of $1,000,000 to a GRAT, you could retain the right to receive payments back totaling $1,000,000, plus interest, over a ten year term. Assuming the correct interest rate is used, the annuity payments have a net present value equal to $1,000,000. In other words, the annuity payments zero out the value of the gift.
Once the annuity payments have all been paid, the remaining GRAT assets can be distributed to your selected beneficiaries free of estate and gift tax. In most cases, the beneficiaries are children or trusts for their benefit. The beneficiary should not be a charity. There are much more tax-efficient strategies than GRATs for charitable gifts.
The key for a GRAT is the spread between the interest rate used to structure the annuity payments and the actual growth rate of the assets contributed to the GRAT. As the spread of the actual growth rate of the GRAT assets over the interest rate used to structure the annuity payments increases, the larger the remainder passing to your beneficiaries free of estate and gift tax. However, you cannot select the interest rate to be used. The IRS calculates and issues the rate on a monthly basis. The rate is commonly referred to as the IRC 7520 rate. The rate used for a given GRAT is the IRC 7520 rate in effect at the time the GRAT is created and funded. The IRC 7520 rate is 1.2% for April 2020, the lowest rate in almost seven years.
Continuing the example from above of a GRAT funded with $1,000,000, if we assume that the GRAT is funded in April of 2020, the annual annuity payments are paid to you over a ten year period, and that the GRAT assets grow at a rate of 7% during that ten year period, the result is that the GRAT remainder will be approximately $600,000 after the annuity payments. Assuming you have a taxable estate, $600,000 passing to your beneficiaries tax-free represents an estate tax savings of $240,000! The following table illustrates the year-to-year operation of the example GRAT:
* The annuity payments do not have to be level as long as no payment exceeds 120% of the value of the immediately preceding payment.
What are the income tax implications of a GRAT?
The funding of the GRAT in exchange for the right to receive annuity payments from the GRAT has no income tax consequences. Similarly, the transfer of the annuity payments to you from the GRAT, whether in cash or in-kind with non-cash assets, has no income tax consequences. This is because the GRAT is a grantor trust for income tax purposes. The IRS effectively views you and the GRAT as the same taxpayer and a taxpayer cannot engage in taxable transactions with himself or herself.
Since the GRAT is a grantor trust for income tax purposes, you are responsible for any income tax attributable to income generated by the GRAT assets. As the annuity payments are made over time, the GRAT ass