GRATs are Great--If Designed Right
The Grantor Retained Annuity Trust is one of the hottest—and trickiest—wealth transfer strategies.
The resourceful business owner in today's economy is forced to be more receptive to the various vehicles, both simple and complex, that offer significant tax saving opportunities. Passing the business to the next generation is an increasingly difficult task requiring considerable foresight and planning. A top estate tax bracket of 60 percent (including the 5 percent surtax on estates between $10 million and $21.4 million) makes it imperative to consider gifts to heirs to reduce the overall taxable estate.
One option currently receiving a lot of attention is the Grantor Retained Annuity Trust (GRAT). A GRAT is a form of leveraged gift in which a donor makes an irrevocable transfer of an asset while retaining an income interest for a specified number of years. If the donor outlives the term of the trust, the balance of the trust assets will be excluded from the donor's estate and pass to the beneficiaries at a fraction of its original value; the present value of the income interest, valued using IRS tables, is deducted from the value of the gift. Thus, the retention of an income interest by the donor causes a reduction in the value of the gift to the ultimate beneficiary.
The GRAT can have an almost magical effect in the right circumstances and with proper tax planning. It accomplishes the seemingly contradictory aims of maximizing wealth transfer and maximizing retirement income.
Consider the example of a 60-year-old businessman who wishes to make a gift of stock in the family business to his two children. Let's assume the shares have a total value of $5 million. A qualified appraiser has determined that the gift should be valued using a 35 percent minority discount. Thus, the value at the time of the transfer is $3,250,000.
Let's say the term of the income interest to be retained by the donor is eight years (the GRAT term), and he is to receive a fixed annual income from the trust of $474,500 (annual payout). The fraction of the value that is taxable—the gift factor—is 0.15965; when multiplied by $3,250,000, this results in a gift value of $518,863.
If the business owner has not used his unified credit for prior gifts, he may apply it against this transfer and avoid paying any gift tax. Even if the stock does not appreciate, the estate at the end of the eight-year period will have transferred a $5 million asset at a $518,863 value. Given a 55 percent marginal estate tax rate, the tax savings at the end of the eight-year period will be $2,464,625. At the end of 15 years, if the stock appreciated at 4 percent, the value would increase to $9,004,718 for an estate tax savings of $4,667,220.
The estate tax savings from a GRAT with an eight–year term. The blue line shows the estate tax savings from a $5 million asset put in the GRAT. Savings begin at the end of the eighth year (no tax savings are realized until then) and rise rapidly thereafter. The bars show the accumulated income from the asset in the subsequent seven years. If the donor dies before the end of the eighth year there will be no estate tax savings.
After the GRAT term, all the asset income is payable to the beneficiaries. Assuming the company's pre-tax income, initially $525,000 (this gives a cushion over the $474,500 annual payout), grows at 4 percent and the money is invested at 4 percent, the 15-year estate tax savings projection grows to $7,337,073. (See graph above.)
For a variety of reasons, now is a good time to give the GRAT some serious thought. Shares of a closely held business that are put in the trust may benefit from the minority discount now permitted by the IRS for non-controlling stock interests. Minority discounts work well with a GRAT because of their effect on the GRAT gift factor. Using the same example, if the $5 million of stock was transferred into the GRAT without a minority discount, the gift would be valued at $2,268,873. This means that the 35 percent discount actually yields a 77 percent discount for the gift.
Another reason that GRATs are attractive at this time is low interest rates. The GRAT works by subtracting the present value of the annuity payments from the fair market value of the gift. The present value is determined by using the rate calculated monthly by the IRS known as the Section 7520 rate, which is 120 percent of the Applicable Federal Midterm Rate. The 7520 rate, which is 6.4 percent at the time of this writing, creates a highly favorable tax environment for a GRAT. The lower the 7520 rate, the higher the value assigned to the retained income interest. If the 7520 rate were 10 percent, as it was just few years ago, the $518,863 gift, without adjusting the payout or GRAT term, would become a $858,900 gift. Because donors are often reluctant to part with income, the GRAT may be drafted to allow the donor to receive all the income generated by the assets. The savings are still substantial ($4,667,220) and the donor is more comfortable making a considerable gift.
The GRAT strategy can backfire, however, if the business owner dies during the GRAT term. In such cases, all or part of the assets in the trust will be included in the estate of the deceased; if the assets are valued at $5 million, a total of $2,198,000 in estate taxes will be due. This is a significant risk which can be alleviated by the purchase of life insurance. If the beneficiaries purchase low-cost term insurance for an eight-year period, the average cost would be $13,142 per year. This ensures the transfer of $5 million of stock at a cost of $105,135 instead of $2,198,000. If the donor survives the eight-year GRAT term, the premium payments would have been a small price to pay to ensure tax savings of more than $2 million.
A GRAT works best in specific circumstances. Stock in S corporations with high income levels is one of the best assets to put in the trust; the strong earnings from such shares tend to increase the payout and lower the value of the gift. Unleveraged, income-producing real estate can also be a good choice for a GRAT.
The key to a successful GRAT is the proportion established between the income interest and the remainder interest. The size of the income interest is a result of the amount of the payout and the duration of the payout, or the GRAT term. The more income the donor receives and the longer he receives it, the larger the retained income interest and the smaller the taxable value of the gift to the remainder beneficiaries (see table above).
It is important to remember, however, that if the business does not earn enough to meet the annual payout, some of the stock in the trust may have to be sold or distributed back to the donor. Returning principal to the donor is a highly undesirable result that defeats the purpose of the GRAT, which is to remove assets from the donor's estate. Using a high income asset that can surpass the income requirement will provide the margin of safety needed to allow the GRAT to perform best.
The potential gain from a GRAT must be weighed against the risks. As indicated, a donor must outlive the term of the trust to avoid having all or part of the value of the asset included in his or her estate. At present, there are no IRS guidelines or tax court rulings on how the exact amount to be included in the donor's estate will be calculated. To avoid an immediate estate tax upon the donor's death, the trust can be set up to pass the remainder interest to the surviving spouse. The assets may then qualify for the marital deduction, deferring estate taxes until the second death. Any gift tax paid when the GRAT was established will be credited against the donor's estate tax liability.
Another risk is that the IRS may challenge the value assigned to the asset. A successful challenge would add to the taxable amount of the gift and require a higher annual payout. The value chosen for the asset should thus be reasonable and well documented by an independent, knowledgeable appraisal company.
Then there is the risk, mentioned above, that the trust may not earn sufficient income to make the mandatory GRAT income payment. If the payment is not made, the trust would have to liquidate or transfer assets back to the grantor; otherwise, gift taxes on the unpaid income would certainly be assessed.
Finally, many potential donors fear the irrevocability of the gift, particularly when stock in the business is involved. Stock put in a GRAT is no longer owned by the donor, and so may threaten his or her majority control of the business. One way around that risk of loss of control would be to issue nonvoting stock to put in the GRAT, but of course that would affect the value of the transferred shares.
GRATs are a sophisticated tool for wealth transfer, offering significant opportunities for tax savings. But they are not for everyone. To fully understand the risks and maximize your benefits, consult with your advisors to find out which experts in your area have a thorough grasp of the legal issues and tax calculation methods.
Harris L. Sherman, of the Sherman Company for Family Business in Costa Mesa, California, designs estate and succession strategies for family firms.
Figuring the GRAT gift factor
The gift factor for GRATs of different terms set up by a 60–year–old man. The larger the payout and the longer the GRAT term, the smaller the value of the gift. Using the IRS’s September 7520 rate, and actuarial assumptions about longevity, a discount of 6.4 percent would be applied to figure the value of the annuity. The market value of the asset multiplied by the GRAT gift factor gives the value of the gift for tax purposes.