Low interest rates and stock market volatility are contributing to the popularity of an IRS blessed estate planning technique known as a grantor retained annuity trust (“GRAT”).

 

Once used primarily by entrepreneurs to transfer businesses and real estate to children at reduced gift and estate tax cost, GRATs are now being used more and more by owners of large holdings of marketable securities to do the same.

 

A GRAT is a trust established by a taxpayer to which the taxpayer transfers property while retaining the right to receive a set annuity for a certain number of years. At the end of the term, any property remaining in the GRAT is then held for the benefit of the taxpayer’s family members free of gift and estate tax.

 

When a GRAT is established, for federal gift tax reporting purposes, the taxpayer is viewed as making a gift to the trust equal to the fair market value of the property reduced by the value of the annuity to be paid to the taxpayer from the GRAT during the term of the GRAT. The value of the annuity is determined at the time of the gift using an interest rate set by the IRS for the month the trust is created. The current IRS rate is 3.8%.

 

In the event a taxpayer transfers marketable securities to a GRAT, a benefit is realized when, during the term of the GRAT, the securities appreciate at a rate greater than the IRS rate. The greater the amount the actual rate of return exceeds the IRS rate, the greater the amount of property that will be transferred from the taxpayer’s taxable estate free of gift and estate tax. 

 

For GRATs funded with marketable securities, annuity payments from the GRAT to the taxpayer are not subject to income tax and can be made with securities with a fair market value equal to the annuity payable, thus avoiding the sale of securities.

 

A popular twist to the GRAT technique is to create multiple “rolling GRATs”. In general, this involves creating an initial short-term GRAT (typically 2 years) and then funding additional short-term GRATs with the 2 annuity payments received from the initial GRAT. Although more complicated than a typical GRAT, rolling GRATs maximize the shift of assets free of gift and estate tax.

 

Following is an example of the gift and estate tax savings to be realized by establishing a GRAT. For purposes of this example, we assume a taxpayer has $5 million in marketable securities and that he or she establishes a GRAT with a term of 5 years. We also assume the IRS interest rate is 3.8% and the securities appreciate by 8% per year over the term of the GRAT. The chart below summarizes the results:

 

 

Under this example, at the end of the term of the GRAT, the taxpayer would be transferring $888,270 from his or her taxable estate. For gift tax reporting purposes, the amount of the gift is $0; thus no gift tax is payable.

 

If for any reason the marketable securities were to fail to appreciate by the IRS rate (3.8% in our example), then all property initially transferred to the GRAT would be returned to the taxpayer and no amounts would be transferred from the taxpayer’s taxable estate. At that point, the taxpayer would only be out of pocket the relatively modest professional fees incurred in establishing the GRAT.

 

The attorneys in the firm’s Wealth and Succession Planning practice are experienced in established GRATs and are happy to answer any questions you may have. For more information, please contact your attorney or a member of the firm’s Wealth and Succession Planning group at (312) 840-7000. Members of the group include Karen K. MacKay, Stephanie H. Denby, Jonathan W. Michael, Martin P. Ryan, Melissa Cover Selinger, Melanie Witt, Julia A. Turk and Gregory M. Winters. Martin P. Ryan contributed this article to the BWM&S Bulletin.