Estate planning comes in a variety of shapes and sizes. The Grantor Retained Annuity Trust (“GRAT”) has been around for decades. But how much do you know about the zeroed out GRAT?
In this article, we will discuss how this special form of a GRAT actually works and explain why you should consider it in your estate planning arsenal. Let’s dive in.
Table of contents
Some Background
A Grantor Retained Annuity Trust (“GRAT”) is an irrevocable trust whereby the grantor transfers assets to the trust and then will retain the right to receive fixed annuity payments, payable at least annually, for a specified term of years. Upon the expiration of the specified period, the remaining assets of the GRAT can be distributed outright to the remainder beneficiaries, such as the grantor’s children, or continued in further trust for the benefit of the remainder beneficiaries.
A GRAT is an estate planning technique based primarily on interest rate assumptions. The value of the initial taxable gift to the GRAT equals the property’s fair market value transferred reduced by the present value of the retained annuity interest. As such, the present value of the retained annuity interest is calculated using the assumed rate of return provided in Section 7520 of the Internal Revenue Code, as amended (the “Code”) (the “7520 rate”) applicable for the month of the transfer.
Zeroed Out GRAT
The GRAT can often be structured so that the present value of the retained annuity is essentially equal to the fair value of the property transferred. Therefore there is little gift tax consequence on the creation of the GRAT.
This type of situation (or arrangement) is typically referred to as a “zeroed-out GRAT.”
If the property transferred to a zeroed-out GRAT produces a return greater than the assumed 7520 rate there will be excess property remaining in the GRAT at the end of the specified term that will be passed on to the remainder beneficiaries free of gift tax.
Suppose the property transferred to a zeroed-out GRAT produces a return less than the assumed 7520 rate. In that case, the grantor will receive back all of the GRAT property through the annuity payments, and nothing will be left to benefit the remainder beneficiaries. In this circumstance, the grantor will not have used up much of their estate tax exemption and will be out only the administrative costs of creating and administering the GRAT.
What Happens Upon Death?
If the grantor dies before the end of the specified term, all of the GRAT assets will be includable in the grantor’s estate, and the estate tax advantages of the GRAT will be lost. Therefore, choosing a specified term for the GRAT this important at the grantor is likely to outlive.
For example, assume that a grantor contributes $1 million of property to a GRAT during a month where the 7520 rate is 6%. Under the terms of the GRAT, the grantor is to receive an annual annuity payment of $288,591 for four consecutive years. In this example, the value of the grantor’s retained interest is equal to the value of the assets transferred to the GRAT, and very little applicable exclusion amount is used.
Suppose the GRAT assets in our example produce sufficient earnings to satisfy the four annuity payments. In that case, any remaining earnings will be transferred to the remainder beneficiaries without incurring a taxable gift. For example, assume that the GRAT assets enjoy an annual rate of return equal to 15%. At the end of the four-year term, $307,963 will remain in the GRAT for the benefit of the remainder beneficiaries.
For federal income tax purposes, a GRAT will be treated as a grantor trust. The income generated during the annuity period will be taxed to the grantor and paid by the grantor with funds outside of the GRAT. Therefore, as long as the pre-tax return on the assets transferred to the GRAT exceeds the 7520 rate, the GRAT will produce a favorable transfer tax result. In addition, if the GRAT were funded with appreciated property which is then used to fulfill the required annuity distributions to the grantor, no taxable gain will be incurred on the distributions.
Conclusion
In summary, a properly structured zeroed-out GRAT funded with a property that produces a rate of return over the 7520 rate will allow property of greater value than reported as a taxable gift to pass to the remainder beneficiaries, and if the rate of return of the property transferred to the GRAT does not outperform the 7520 rate little has been lost. Therefore, there is little downside, and the upside could create significant estate tax savings.
