Grantor Retained Income Trust – Infrequently Used

Take-Away: A grantor Retained Income Trust, or GRIT, is an infrequently used trust to remove an asset from the grantor’s taxable estate with a discounted value for the gift, which may still be useful albeit in limited situations.

Background: A grantor retained income trust (GRIT) is an irrevocable trust where the settlor transfers assets to the trust while retaining the right to receive all of the net income from the trust for a fixed term of years. The net income is distributed by the GRIT trustee to the settlor annually or on a more frequent basis as determined by the trust’s terms. At the end of the initial or fixed term, the remaining trust principal is either distributed to beneficiaries, or held in a continuing trust for beneficiaries. If the settlor surives the initial fixed term of years, the principal of the GRIT is excluded from the settlor’s taxable estate.

Advantages: The primary advantage of establishing a GRSIT is that the assets transferred by the settlor to the GRIT are valued for federal gift tax purposes at a discount, depending upon the length of the fixed terms and the AFR in effect in the month when the GRIT is established. It thus functions much like a GRAT to shift future appreciation away from the settlor’s taxable estate.

Disadvantages: The Tax Code section that authorizes the GRIT, IRC 2702, [the same provision that governs GRATS and QPRTs] limits the identity of the GRITs beneficiaries. The settlor’s spouse, the settlor’s ancestors, the ancestors of the settlor’s spouse, any lineal descendant of the settlor or the settlor’s spouse, any sibling of the settlor or his or her spouse, or the spouses of any of this class of individuals, cannot be remainder beneficiaries of the GRIT.

Therefore, a GRIT could be established for the lineal descendants of siblings, i.e. the settlor’s nieces and nephews, and relatives even more remote than nieces or nephews, or friends of the settlor and his or her spouse.

Fixed Terms: During the fixed term of the GRIT, it will be a grantor trust for income tax reporting purposes. Usually, like a GRAT or QPRT, the settlor will retain a reversionary Interest in the GRIT, since the reversionary interest will further reduce the value of the gift at the time the settlor funds the GRIT.

Taxes: If the settlor retains a reversionary interest which exceeds 5% of the initial value of the GRIT, the GRIT will be a grantor trust with regard to both ordinary  income and capital gains. This will result in the settlor paying capital gains tax on capital gains realized by the GRIT, even though none of the capital gains are distributed to the settlor, This increases the amount of wealth that is shifted to the ultimate beneficiaries of the GRIT as a reduced gift tax value.

Conclusion: Like its cousins the GRAT and the QPRT, the GRIT only works to save federal estate taxes if the settlor survives the fixed initial term. Thus there is the risk that the GRIT will not ‘work’ as intended and the settlor will be out the transactional costs incurred to set up the GRIT without saving any federal estate tax. However, in a narrow set of circumstances a GRIT can be an effective tool that allows a substantial reduction in the underlying assets for valuation purposes under the gift tax laws, while allowing the settlor to leverage his or her applicable exemption amount.