The interest rates issued by the IRS, commonly referred to as Section 7520 rates, coupled with a depressed economy, real estate values, and stock market, continue to afford clients rare estate planning opportunities. One of these opportunities is referred to as a short term Grantor Retained Annuity Trust (“GRAT”). In November 2012, the IRS 7520 rate was an almost unprecedented 1.0%, making GRAT’s an extremely attractive vehicle for removing future appreciation of assets out of a person’s estate. Although the rates have increased slightly since then, the rate for March, 2014 is 2.21%. Find the current rate here.
A GRAT is a trust established by a client for the benefit of himself for a period of years, and then for his children at the end of the term. The idea behind the trust is that over the term of the trust (frequently as short as two or three years, and sometimes as long as 99 years) the assets transferred to the trust, plus the interest at IRS 7520 rate, is paid back to the Grantor. At the end of the trust, any appreciation exceeding the IRS 7520 rate (currently 2.21%) passes to the children or other beneficiaries with no gift tax.
As an example, assume an asset worth $1,000,000 is placed in a GRAT with a three year term. Assume further that this asset is likely to appreciate at 15% because it is land, a closely held business, or a speculative stock. Over the three year term, the principal and interest (at the IRS 7520 rate) must paid back to the Grantor in annual installments. However, if the asset does in fact appreciate at 15%, there is $312,000 left in the trust for the children (or other remainder beneficiaries) at the end of the trust.
The $1 million contributed to the trust is not a taxable gift of the full $1 million because the IRS assumes that, because of the mandatory annual payments to the trust creator, there is little or nothing left in the trust at the end of the trust. In fact, the taxable gift in the above scenario is only 20 cents! The creator of the trust therefore uses only 20 cents of his lifetime exemption for federal gift tax purposes and pays no federal or Tennessee gift tax.
Because the trust is a “Grantor Trust” for income tax purposes, no income tax consequences are produced by creating the trust, transferring the assets to the trust, or distributing the assets back to the Grantor. Income earned by the trust is taxed to the creator of the trust and reported on his personal income tax return.
What if the Asset Value Declines?
But what if the asset does not beat the IRS 7520 interest rate? What if the asset was a stock worth $20 when the trust was created and it stayed the same or went down in value? In that case the creator of the trust is in the same position as he was without doing the GRAT. In other words, you can only “win” (if the assets goes up more than the IRS 7520 rate) or “draw” (if the assets stays the same or goes down). The only downside is the legal fees incurred in creating the trust.
What is the Optimum Length of a GRAT?
The utilization of a short term GRAT can be structured so that it runs for as little as two years or for several years. Studies have shown that the shorter the term, the more likely the tax benefit in most situations. With that said, there is a limited circumstance when you want to go the opposite direction and create a 99 year GRAT.
After the first year, what if the asset still has not increased in value, but the trust creator still believes that the stock will increase in value. In the example above, he received back approximately one-third of the assets that he put in the trust, at the end of the first year. What does he do? The answer is simple. He creates a second identical GRAT. It has the same terms as the first GRAT although the assumed interest rate may have changed. He takes the assets which were distributed back to him from the first GRAT, adds some additional stock and starts a second GRAT containing substantial identical terms.
The goal is to continue to roll the investments out of one GRAT and into another GRAT and wait patiently until the stock does what you assume it will do, which is to jump substantially when the market or economy or land values improve. This technique is commonly referred to as a “Rolling GRAT” since stock rolled out of one GRAT is rolled into the next GRAT.
The down side of this technique is if the stock does nothing, the assets placed into the GRAT come back to the Grantor. The Grantor incurs a transaction cost in the preparation of the trust, fees in the management of the trust, and fees for the preparation of tax returns. On the other hand, if the stock substantially outperforms the assumed IRS return, establishing a GRAT or a series of Rolling GRATs is an excellent technique to move appreciation to the children or other beneficiaries without substantial gift tax costs.
C. Michael Adams, Jr. and Robert D. Malin (2014)