“What’s a GRAT?”, you may ask. A grantor retained annuity trust, or GRAT for short, is a popular estate planning tool that assists in sheltering appreciating assets from the burdens of estate taxation. Coupled with two other advanced estate planning techniques (i.e., valuation discounts and dynasty trusts), you can shift wealth to your heirs using this technique at little or no tax cost without losing control over the asset being transferred.
Particularly useful in times of depressed values and low interest rates, GRATs have grown increasingly popular, so much so that President Obama has tried to limit the use of short-term GRATs (along with the other techniques mentioned above) in his last four budgets. Here is how the technique works in very basic terms.
Let’s say you have an asset – such as stock in a closely-held corporation – that is undervalued today but has great potential for growth in the future. You could transfer 10% of the stock into a GRAT, which is a trust initially for your benefit. The GRAT pays you an annuity based upon the value of the asset being transferred. If you transfer a minority stock interest in a closely-held corporation, the stock’s value most likely will be discounted heavily, because the stock represents a minority interest (which also may be non-voting stock) and lacks marketability (i.e., cannot be sold or transferred easily).
Although the 10% interest in the corporation may be worth $1,000,000 before discounts (assuming the corporation is worth $10 million), the interest may be discounted by as much as 40% or more, depending upon the facts of your case (N.B. – the Obama administration previously attempted to eliminate the ability to use such discounts for transfers within family groups of entities). This means that you are transferring an asset currently valued at $600,000 for gift tax purposes into the GRAT. You can set the payment period for the GRAT to as short as two years (N.B. – the Obama administration wants GRATs to be no less than 10 years, but current law allows a shorter period). See http://www.treasury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2014.pdf at page 142. Based upon today’s extremely low IRS interest rate, you could set the percentage payout for the annuity to 50.9% and effectively “zero out” the GRAT. This means that nothing is left at the end of the GRAT term for your heirs for gift tax purposes, and no gift tax or use of your lifetime gift tax exemption results from the transfer. In reality, the amount of the discount plus any appreciation in value is shifted out of your estate and preserved for your heirs.
At the end of the GRAT term, you could distribute the remaining assets to a dynasty trust for your children, grandchildren or other heirs (N.B. – President Obama wants to limit the duration of dynasty trusts to 90 years). See http://www.treasury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2014.pdf at page 143. This third leg of the estate planning stool not only allows you to avoid estate and gift tax on the transfer, but it also avoids generation skipping transfer tax on distributions to grandchildren and lower generations.
This technique – and a variation using intentionally defective grantor trusts – has been popular among entrepreneurs who are anticipating a liquidity event (i.e., merger, acquisition or initial public offering) in the not too distant future. Invariably, the valuation of the corporation before the liquidity even is contemplated is much lower than the corporation may be worth at the exit event. So, even if your net worth is well below the current estate and gift tax lifetime exemption level of $5.25 million, imagine how much estate tax your heirs would save if you utilize this technique and the corporation grows significantly in value.
Using the example from above, let’s say you grow the corporation to $50 million in five years. The 10% interest transferred to the GRAT is now worth $5 million, which would save approximately $2 million in estate tax at the current rates. The downsides of GRATs include the fact that you may have to pay the income tax on the capital gains generated when the 10% interest is sold, the need for the GRAT asset to increase in value over time, and the requirement for the GRAT to pay you the annuity over the term of the trust (hopefully using cash flow distributions from the corporation or toehr cash you may give to the trust).