By Christopher Canfield, Of Counsel, Goetz Fitzpatrick Trusts & Estates Group
Do you want to reduce estate and gift taxes for your beneficiaries? With interest rates close to zero and potentially depressed asset valuations, conditions are ideal for adding a Grantor Retained Annuity Trust (GRAT) to your estate planning portfolio. Simply put, a GRAT is a trust that holds business, investment, or real estate assets for a set term, with a two-year minimum. For each year of the trust term an annuity must be paid back to the Grantor and, upon termination of the trust, the remaining assets pass to the beneficiaries estate and gift tax free. GRATS are an excellent way to transfer assets at a reduced or even eliminated transfer tax cost.
How GRATS Generate Tax Savings
The year the GRAT is funded, the Grantor files a gift tax return to report the taxable gift portion of the transaction. This is calculated based on actuarial tables which vary depending on the terms of the trust. Goetz Fitzpatrick can help determine those calculations. Similar to a Qualified Personal Residence Trust (QPRT), the longer the term of the trust, the lower the taxable gift. However, if the Grantor dies during the trust term, the trust folds back into their estate, negating the tax benefits for beneficiaries. The annuity that must be paid to the Grantor can be set at any amount and the greater the annuity, the lower the taxable gift. It is common to do “rolling GRATS,” which are short-term GRATS that the Grantor renews over and over again to maximize the tax benefits while limiting the risk of reversion to the estate.
Pass On Appreciation Tax Free
A GRAT can also be “zeroed out,” meaning that the taxable gift is zero. A zeroed-out GRAT would require that 100% of the value of assets put in the trust plus the Applicable Federal Rate (AFR) of interest be paid out to the Grantor during the trust term. If the trust assets outperform the AFR (currently less than 1%) over the trust term, all of that excess appreciation and income pass to the beneficiary estate and gift tax free. The taxable income earned during the trust term is reported by, and the income tax is paid by, the Grantor, which actually provides further advantages to the beneficiary.
The Cost of a GRAT
Legal and tax prep fees as well as recurring appraisal fees are generally required. If rolling GRATS are used, new trusts are created every two years or so and qualified appraisals of assets are required each time. In addition, it is best to utilize LLCs or limited partnerships to simplify the continual transfers of ownership interests among the Grantor, the Trust, and the Beneficiaries, so that could be an extra cost. Further benefits can be achieved by utilizing valuation discounts for gifts of minority interests and these require specialized appraisals.
Because of the complexity and costs involved, it is best to consult with your estate planning attorney to find out if a GRAT is appropriate for you. However, if the current elevated federal estate tax exemption truly sunsets on December 31, 2025 as planned, a broader range of estates would benefit from using GRATS as well as other sophisticated estate tax planning tools.