When the use of a GRIT for financial assets was restricted in 1990, the same tax legislation created the concept of a GRAT, which is similar but requires that a designated fixed annuity be paid each year to the grantor whether or not the trust has any income. There is thus less opportunity for abuse because the trust investments cannot be manipulated to divest the grantor of his annuity payments in favor of the remaindermen.
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Rules and Requirements
If the grantor passes away during the term of a GRAT, there will be at least partial inclusion of the trust assets in his gross estate for estate tax purposes. In general, if there has been net appreciation in the trust principal, a portion of that appreciation will be excluded from estate tax.
Regardless of the GRAT term and the annuity payout, if the actual performance yield of the trust is greater than the IRS discount rate — recently around 4.0% – – the remaindermen will receive a benefit greater than the taxable gift component of the GRAT. However, suppose the taxable gift component of the GRAT is substantial. In that case, the GRAT may not be a particularly effective way of utilizing one’s lifetime exemption, primarily because of the possibility that the assets may decline in value.
Pros and Cons
On the other hand, if the GRAT is structured so that the taxable gift component is small or negligible — for example, a 9% annuity for 15 years, a 12% annuity for ten years, a 19% annuity for six years, a 36% annuity for three years, or a 53% annuity for two years — the transaction will not use up any significant portion of the lifetime exemption. This is commonly known as a “zeroed-out GRAT.”
With a “zeroed-out GRAT,” it is unnecessary to earn the annuity amount to achieve a tax benefit. So long as the investment performance exceeds the IRS discount rate, there will be some residual value in the trust at the end of the term, passed virtually gift tax-free to the remainder beneficiaries.
And suppose the investment performance does not meet the IRS discount rate. In that case, all of the assets will be returned to the grantor in satisfaction (or partial satisfaction) of his retained annuity, but with no adverse gift tax results because there was no substantial taxable gift at the outset. In other words, placing assets in a zeroed-out GRAT has upside potential but no downside risk from an estate planning standpoint.
This characteristic of a zeroed-out GRAT can be further exploited by creating multiple GRATs and placing different assets in each GRAT, mainly where the assets are speculative. For example, if one GRAT achieves an annual return of 14% and another GRAT goes bust, the family unit in the aggregate will have a 7% investment return.
Approximately half will pass to the remainder beneficiaries free of any estate or gift tax. On the other hand, if both investments were in one GRAT, the combined 7% return would be used in its entirety to help make up the annuity payment to the grantor, with no residual value at the end of the term and thus no estate planning benefit.
In summary, a GRAT with a substantial taxable gift component is usually not the most desirable form of estate planning. Still, a zeroed-out GRAT, or multiple zeroed-out GRATs where appropriate, can provide a no-lose estate planning opportunity.
