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George F. Bearup, J.D. Senior Legal Trust Advisor

30-Jul-20

Grantor Retained Annuity Trusts – There’s No Better Time

Take-Away: With current interest rates so low, there may be no better time than the present to create and fund a ‘zeroed-out’ grantor retained annuity trust (GRAT.)

Background: A grantor retained annuity trust, or GRAT, is expressly authorized by the Tax Code. [IRC 2702.] IRC 2702 provides that, for purposes of determining whether the transfer of an interest in trust to or for the benefit of a member of the transferor’s family is a gift (and the value of that gift) the value of any interest retained by the transferor is valued at zero ($0.00) unless the transferor’s retained interest is a qualified interest, which is either in the form of an annuity or a unitrust, or the transfer consists of a transfer in trust of a personal residence [the legal authorization for the well known qualified personal residence trust, or QPRT.]

  • Zero Valuation Rule: If the interest retained by the transferor, or Grantor, is not a qualified interest, for tax purposes it is valued at zero ($0.00) and nothing is deemed to have been kept by the Grantor for gift tax reporting purposes. This means a large taxable gift is the result if no value is assigned to the Grantor’s retained non-qualified
  • GRATs Shift Wealth Gift Tax-Free: The goal of a GRAT is to shift wealth to the remainder holder of the GRAT at the end of the GRAT’s term of years (when the annuity paid to the Grantor ends) gift tax- The present value of a remainder interest after a term of years is the value of the right to receive an amount in the future discounted by the interest rate that is used to reflect the time-value-of-money.
  • IRC 7520 Rate of Interest: The interest rate that is used to value the Grantor’s retained qualified annuity interest is the IRC 7520 rate of interest in the month the GRAT is funded. The IRC 7520 rate is 120% of the current applicable federal mid-term rate of interest.
  • IRC 7520 Hurdle Rate: The GRAT works to shift wealth when the assets transferred to the GRAT grow at a rate higher than the IRC 7520 rate that existed when the GRAT was created. If the assets grow at the same rate as the IRC 7520 rate, no wealth will transfer gift tax-free. If the GRAT assets grow at less than the IRC 7520 rate, all of the assets will be returned to the Grantor in the form of the retained annuity payments over the GRAT’s duration. A GRAT is successful if it beats the Section 7520 hurdle rate. In short, the GRAT works only if its investment returns are higher than the IRC 7520 rate that was used to determine the annuity amount when the GRAT was initially established.
  • Grantor Trust: A GRAT is a grantor trust for income tax reporting purposes. Thus, the Grantor can transfer assets to the GRAT without any gain recognition. Similarly, if there is not enough cash in the GRAT to fully pay the annuity to its Grantor, so transferred assets must be returned to the Grantor as part of the annuity payment, no gain is recognized if the assets appreciate inside of the GRAT. Also, as a grantor trust, the Grantor can substitutes assets of equivalent value with the GRAT’s assets at any time without any income tax consequences.
  • Zeroed-Out GRAT: When the GRAT is established, it can be zeroed-out. This means the annuity stream retained by the Grantor can be set high enough that there is no current or present value assigned to the remainder interest in the GRAT when the GRAT is established. Consequently, no taxable gift occurs when the assets are initially transferred to the GRAT. The transfer-tax-cost of a zeroed out GRAT is $0.00, i.e. no gift tax is paid for the transfer of the remainder interest in the GRAT.
  • Graduated GRAT: GRATs can also be structured under IRC 2702 with increasing annuity payments to the Grantor each year- 20% more each year during the GRAT’s annuity term.
  • Grantor’s Death: If the Grantor dies during the GRAT’s annuity term, i.e. the Grantor does not survive to the end of the annuity payment period, then the amount of assets held in the GRAT required to fulfill the remaining annuity payments is included in the Grantor’s estate for federal estate tax calculation purposes. Not all of the GRAT’s assets return to the Grantor’s taxable estate.
  • Risk-Free Strategy: Perhaps a bit of an overstatement, nothing is lost if the GRAT assets ultimately decline in value during the GRAT’s annuity term. The Grantor did not, with hindsight, ‘waste’ any gift tax exemption if the GRAT is zeroed-out. The transferred assets return to the Grantor in the form of annuity payments. Thus, only if the GRAT’s investment return exceeds the IRC 7520 hurdle rate will the GRAT work to shift wealth gift tax-free. Which is why a zeroed-out GRAT is almost a risk-free estate planning strategy to consider.

Low Interest Rates: A GRAT is highly attractive strategy to use when interest rates are low. When prevailing interest rates are low, the applicable IRC 7520 rate of interest used to value the Grantor’s retained annuity stream will also be low. When interest rates are low, the Grantor’s ‘income interest’ is worth less, as it is assumed to be earning less. An annuity interest is worth more because the stream of payments is discounted less by virtue of the low interest rate presumed to take place during the entire annuity payment period. The IRC 7520 rate of interest for August 2020 is 0.4%, the lowest ever. [For comparison purposes, the IRC 7520 rate in August 2019 was 2.2%, in August 2018 it was 3.4% and in August 2010 it was 2.6%.]

Duration of the GRAT- Death of the Grantor: There is the risk that the Grantor will die during the GRAT term, which results in the inclusion of some of the GRAT’s assets in the Grantor’s taxable estate. This is called the mortality risk tied to a GRAT. In the past this mortality risk has resulted in relatively short-term GRATs, to assure that the Grantor survives the GRAT’s annuity period. That practice of short-term GRATs could very well change now with such a low IRC 7520 rate locked-in for the duration of the GRAT’s annuity payment period, even if the Grantor dies during the annuity payment period.

Examples: How a GRAT functions, and why it may prove to be an excellent estate planning device to shift wealth at little or no cost when the IRC 7520 interest rate is so low, is indicated in the following examples.

  • Basic GRAT: Glen funds a GRAT with a $1.0 million in assets. Glen’s GRAT is a ‘zeroed-out.’ The GRAT will pay to Glen an annual annuity over the next 10 years. Using the IRC 7520 rate of 0.40% Glen’s annual annuity payment from the GRAT will be $102,213 for each of the 10 years. Over the 10-year annuity period Glen will receive $1,022,130 in annuity payments, or $22,130 more than his initial investment in the GRAT.
  • Estate Planning GRAT: Greg funds a GRAT with $10,000,000. Greg’s GRAT is a ‘zeroed-out.’ The GRAT will pay to Greg an annual annuity over the next 10 years. Using the IRC 7520 rate of 0.40% Greg’s annual annuity payment from the GRAT will be $1,022,129. Over the 10-year annuity period Greg will receive $10,221,290 in annuity payments, or $221,290 more than his initial investment in the GRAT.

Planning Perspective: Suppose that Greg’s GRAT’s assets produce a total return of 3% per year [cue the eye-roll from the wealth management advisors] for each of the 10 years of the GRAT. When the annuity payments cease, there will be $1,721,600 left in the GRAT that can pass either to Greg’s children, or a dynasty trust for his children, gift tax-free. If the total return of Greg’s GRAT’s assets was 5% each year [cue the nay-saying shake of heads by the wealth management advisors] at the end of the GRAT’s 10 years, the amount that would pass gift tax-free to Greg’s children or a trust for their benefit would be $3,432,718. If the total return of the GRAT’s assets was 7% each year [now the wealth management advisors are laughing out loud at that bold assumption] $5,549,321 will left in the GRAT after 10 years that will pass gift tax-free to Greg’s children or a trust for their benefit. Beating the IRC 7520 hurdle rate can potentially transfer enormous wealth gift tax-free depending upon the investment performance of the GRAT’s assets.

  • Graduated GRAT: Gloria funds a GRAT with $10,000,000. Gloria’s GRAT is ‘zeroed-out.’ The GRAT will pay Gloria an annual annuity over the next 10 years. However, Gloria opts for a permissible form of annuity permitted by IRC 2702, which starts with a lower amount, but the annual annuity amount increases by 20% each year. Using the IRC 7520 interest rate of 0.40%, Gloria’s first annuity payment will be $396,003. Gloria’s annual annuity will increase by 20% each and every year thereafter for the full 10 years. If the GRAT’s assets produced a total return of 3% each year, at the end of 10 years the amount that would pass to Gloria’s children or a trust for their benefit would be $2,146,509. If the total annual return from the GRAT’s assets was 5% each year, the assets that would pass gift tax-free to Gloria’s children after 10 years would be $4,2424,953. If the total return of the GRAT’s assets was 7% each year, the amount remaining in the GRAT after 10 years that would pass to Gloria’s children gift tax-free would be $6,802,680.
  • Grantor’s Death: Ginger creates a 20-year non-graduated GRAT. Ginger transfers $10,000,000 to that GRAT. The IRC 7520 rate of interest is 0.40%. Ginger’s GRAT is zeroed-out. The annual annuity payment to Ginger is $521,265. Ginger dies 15 years into the annuity period. At that time the IRC 7520 rate is 7%. Using the estate inclusion formula [found in the IRC 2031 Regulations] the amount that will be included in Ginger’s taxable estate will be $7,446,643, no matter how large the GRAT’s assets may have grown over that 15-year annuity payment period.

Avoiding the ETIP: In the above examples you will note that I did not include grandchildren as the GRAT remainder beneficiaries. That is due to the estate tax inclusion period, or ETIP. So long as some of the GRAT assets could be included in the Grantor’s estate caused by not surviving the GRAT annuity period, some of the GRAT assets are included in the Grantor’s estate. The Grantor’s generation skipping transfer tax exemption (currently $11.58 million) cannot be allocated to the assets held in the GRAT. It is only after the annuity payment period has ceased will the Grantor then be able to allocate his/her GST tax exemption to the GRAT’s remainder interest when it is distributed to the remainder beneficiaries. In short, while the transfer of the remaining assets to the remainder beneficiaries is gift tax-free, the transfer may be subject to the generation skipping transfer tax if those beneficiaries are skip persons with regard to the Grantor. Restated, all of the appreciation of the GRAT’s assets during the annuity payment period will soak-up some of the Grantor’s generation skipping transfer tax exemption, if it can be applied only at the end of the annuity payment period, which is not an effective use of the Grantor’s GST exemption.

The End of Rolling GRATs?: Since the success of a GRAT is tied to beating the IRC 7520 interest rate hurdle, it was often thought that the best way to use a GRAT was to cycle annuity payments received into another GRAT, using the then-current IRC 7520 rate. This would result in several rolling or cascading GRATs all functioning at one time with different annuity amounts paid to their Grantor. With the short duration of a GRAT, like two years,  it was more likely that the IRC 7520 interest rate hurdle could be beat. With a long-term GRAT there was the dangers that (i) the Grantor would not outlive the GRAT term, the mortality risk; and (ii) interest rates would change during the GRAT term, making it less likely that the IRC 7520 interest rate hurdle could be overcome. As such, most GRATs were of short duration trying to hedge against these risks. However, now that the IRC 7520 rate is so low, it may make more sense to simply  lock that low IRC 7520 rate in for a much long duration GRAT, like 10 or 20 years.

Conclusion: For individuals who are reluctant to make large lifetime gifts out of a fear of running out of their wealth, or for those individuals who have already fully used their lifetime federal gift tax exemption amount, a GRAT is an effective way to possibly transfer wealth without incurring any gift tax. In effect, a GRAT only shifts appreciation above the IRC 7520 rate of the GRAT’s assets. With the current IRC 7520 interest rate of 0.40% being so low, it would seem that almost all GRATs created in the next few months will be able to beat the IRC 7520 interest rate hurdle, regardless of how long that GRAT’s annuity payment period exists and despite any mortality risk the Grantor faces. There may be no better time than the present in which to establish and fund a GRAT.