May
06
Grantor Retained Annuity Trust (GRAT)
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Estate planning techniques have funny sounding acronyms:  GRAT, GRUT, CRAT, CRUT.  Sounds like something you might get on your shoe!  Here's some information about one of these techniques called a Grantor Retained Annuity Trust (GRAT). A GRAT is frequently used to transfer assets to family members while minimizing taxes.  It is a frequently used device when someone owns an asset that they expect to rapidly appreciate (like, say, options or stock in a company about to have an IPO).   With a GRAT, an individual (usually called the "Grantor" or "Settlor"), transfers such an asset to a trust.  In return, the Grantor gets an "annuity" for a specified term (i.e., 5 years, 10 years, 20 years).  At the end of the stated term, whatever is left in the Trust (called a "remainder interest"), passes to the beneficiaries as stated in the Trust, usually the Grantor's children or grandchildren.   The transfer to the remainder beneficiaries is a taxable gift. The taxable event occurs when the asset is transferred into the Trust.  The actual value of the transfer is determined by actuarial tables using discount rates issued by the IRS on a monthly basis.  These rates are known as the "7520" rates.   In other words, the value of the gift is not its actual market value, because it is "discounted" by virtue of the fact that you are giving up control.  The longer the term, the bigger the discount.  However, the Grantor must outlive the term.   If the Grantor dies within the stated term, the value of the asset returns to the Grantor's taxable estate. Why do a GRAT?  For one, it removes the appreciation from the Grantor's estate, where it would be subject to capital gains tax on the Grantor's return if and when sold.  Two, it removes it from the Grantor's taxable estate for estate tax purposes.  The asset and the growth of the asset have been transferred out of the estate at a reduced gift tax cost. The GRAT is a 'Grantor trust'.  This means that any income generated during the term is taxable to the Grantor.  This is good news (no, really) because the payment of the income taxes further reduces the size of the estate and leaves the trust assets free to continue growing without diminishing them through taxes. The GRAT technique can be built on with another estate-planning device, the ILIT (Irrevocable Life Insurance Trust).   An individual might consider doing this if they are already using their annual exclusion gift (currently $14,000 per year) to make gifts to a trust other than an ILIT. Here's a hypothetical of how it works: John is in sales development of a start-up that is expected to launch an IPO in 4 years.  He has $1 million in vested stock and several hundreds of options with a strike price of a few dollars.  John does not need to access the principal of the stock but would like access to the income that it generates.  John creates a GRAT trust by having his estate planning attorney draft a trust document that John signs as the Grantor and his selected Trustee signs as the trustee.  The terms of the GRAT have a period or term of years that John identified when the GRAT was drafted.  (the longer the term, the greater the tax savings; the shorter the term, the lower the tax savings).  John "gifts" the stock to the GRAT by retitling the shares or the account holding the shares from his individual name into the name of the Trust. The transfer of the stock into the Trust is not eligible for the annual gift tax exclusion (currently $14,000 in 2014).  John will need to either pay a gift tax or use his lifetime estate and gift tax credit toward the transfer to the GRAT (currently the credit is $5.34 million in 2014, annually adjusted for inflation).  However, the value of the asset transferred into the GRAT is not it's actual market value; instead it receives a "valuation discount" because John has retained an income interest in the assets for the specified term. John receives a fixed income as an annuity during the term specified in the GRAT.   If John outlives the specified term, the corpus (the stock transferred to the GRAT) and all of its appreciation has been removed from his estate and is therefore not subject to estate tax.  If John dies before the end of the term, the asset is included in his estate. An additional technique to protect against the possible exposure if John dies before the specified term, John could establish an Irrevocable Life Insurance Trust (ILIT) to purchase life insurance on John's life.  The insurance proceeds could help pay the additional estate tax if the GRAT were to be "unwound" by a death before the term ends. At the end of the GRAT term, the assets in the GRAT transfer to the remainder beneficiaries, usually the Grantor's children.  The assets can also continue to be held in trust if the Trust provides for that continuation. In short, a GRAT is a sophisticated technique that, if used properly, preserves appreciation and income-producing assets, allows the grantor to have access to income for a period of time, and reduces estate size and taxes. Summary of GRAT highlights: - The basis of a GRAT is the "qualified annuity interest" which is an irrevocable right to receive either a stated dollar amount or a fraction or percentage of the initial fair market value of the property transferred to the trust. The annuity does not have to be identical in each year as long as it does not exceed 120% of the annuity amount in the preceding year. - In a typical GRAT, a Grantor retains the right to be paid an annuity equal to a percentage of the initial fair market value of the property transferred to the trust. - The annuity must be payable to the Grantor annually. The trust must also prohibit distributions to anyone other than the Grantor (the annuity holder) during the stated term. - There cannot be a prepayment of the annuity and the trustee must be prohibited from issuing a note to satisfy the annuity. - If the trust is a "grantor trust," the distribution of appreciated property in satisfaction of the annuity should not cause the trust to recognize gain for income tax purposes.      

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