Grantor Retained Annuity Trusts (GRAT)

Q1.      So, what is a GRAT?

A1. Actually, I think it will be easier if I describe the participants first:

Annuitant – As with any type of annuity, there is a person who receives the annuity payments.  In a GRAT, the client is typically the person who receives the payments from the GRAT.  It is important to keep in mind that the GRAT is a special from of trust designed to make stipulated payments to the Annuitant.

Trust – The trust is the essence of the GRAT, in that it holds the property, $1,000,000 in our example.  As illustrated below, the client/Annuitant is the person who transfers the property into the trust, in return for a specified payment from the trust to the client/Annuitant:

Now that you have seen the participants, the remaining explanations will be easier to put in perspective.

Q2.      How is the amount of the annuity arranged?

A2. This is the essence and most difficult aspect to explain.  The factors to be considered are:

Term Interest – The Term Interest refers to the length of time that the annuity payments are payable to the Annuitant.

Remainder Interest – At the end of the Term Interest, the annuity payment stops and the Property in the GRAT passes, generally, to a trust for the benefit of the client/Annuitant’s children.

Potential Gift – There are three aspects of the GRAT transaction that may result in a gift.

  1. a. Value of the Property – As we know, the value of the Property is $1,000,000.
  2. b. Term and Remainder Interests – When the use of property is divided into a Term Interest and a remainder interest, each has a separate value based upon the value of the property and the length of the Term Interest.  As an example, assume that the market rate of interest is 5%.  We now have to divide the use of the Property in the GRAT into a Term Interest and a Remainder Interest.
  3. c. Division of the Property – For an example, let’s assume that the Term Interest, the time the annuity is paid to the Annuitant, is 10 years, when the Property in the GRAT passes to the holders of the Remainder Interest.  We use the assumed 5% rate to determine the value of the Term Interest held by the Annuitant:

Actuarially, the value of a 10 year Term Interest, at 5%, equals $386,000.  Thus, the Remainder Interest has a value of $614,000, which means that such an annuity arrangement results in a gift by the Annuitant of $614,000.

  1. d. Avoiding the Gift – Rather than the assumed interest rate of 5%, the Internal Revenue Service provides an interest rate to be used.  The interest rate is provided in Internal Revenue Code Section 7520, based on a mix of marketable securities.  The current rate is 1.2%.  The value of the Remainder Interest for 10 years at 1.2% is:

Term Interest – $112,000

Remainder Interest – $882,000

It is important to remember that we have not taken the annuity payment into account.  That means the Term and Remainder Interests, taken on their own, only reflect the actuarial value without taking into consideration the fact that the Annuitant not only has use of the Property at the Internal Revenue Service’s proscribed rate.

Let’s go to the next step, the Annuity amount retained by the Annuitant.  This is a mathematical formulation designed to make the Remainder Interest equal to zero, so that no gift is made, this is referred to as a Zeroed-Out GRAT.

If the Annuity amount retained by the Annuitant is 10.6%, the value of the Remainder Interest is $6,700, deemed acceptable for purposes of this illustration.

Q3.      What does the math do?

A3. We are now at the crux of the matter.  As 10.6% reduces the value of the Remainder Interest to an acceptable amount, we now need to see if the $1,000,000 Property produces sufficient income.  Assume the property does, indeed, produce $106,000 in income per year, and, in addition, appreciates to $2,000,000 at the end of the 10 year Term Interest.

Here is how the math works out, from an estate and gift tax standpoint:

Annuitant’s Gift – $   6,700

Annuitant’s Accumulated Income               $1,060,000 (pre-tax)

Appreciation Shifted to Heirs $   940,000  ($2,000,000 – $1,060,000)

Q4.      Who pays the income taxes on the Property’s income?

A4. Because the GRAT is a “grantor trust,” the Annuitant pays the income taxes, so the $1,060,000 is reduced by income taxes, and other planning techniques.

Q5.  What happens if the Annuitant dies prior to the end of the Term Interest?

A.5 In that event, the property is included in the estate of the Annuitant, and the loss of benefits.

category: Trusts

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