What is a Grantor Retained Annuity Trust?

Grantor retained annuity trusts or GRATS can, given the right circumstances, be an excellent way to pass wealth to future generations.  The rules for GRATS are uncomplicated and are found at section 2702 of the Internal Revenue Code.  The person creating the GRAT (donor) transfers money to an irrevocable trust.  The donor then receives an annual payment of a specific dollar amount for a fixed number of years.  At the end of the term of years, anything left in the trust passes to a remainder beneficiary (donee) free of estate and gift tax.  The donee is typically a child of the donor.

Because the trust is irrevocable, a gift is completed for tax purposes on the date the trust is signed and funded even though the donee will not receive anything for years.  The value of the gift is calculated by assuming the funds in the trust will earn income at the percentage specified in Section 7520 of the Internal Revenue Code.  This rate is generally very low.  For example, as of July 2011 it is 2.4 percent.  The value of the gift is also reduced by the amounts distributed to the donee.  It is important to note that the value of the gift is calculated on day one, when the trust is created and funded.  The amount that actually passes to the donee at the end of the trust term may be much greater than the value of the gift that was calculated on the first day of the trust if the trust earns more than the 7520 rate.

This presents real opportunities for estate planning purposes.  Essentially, you only have to earn a rate of return that is greater than the 7520 rate.  Even in today’s difficult markets it is not hard to earn more than 2.4 percent.

It is possible to use these rules to transfer funds to family members without gift tax ramifications.  It is very easy to set up a GRAT that has a calculated gift value of zero or very a very small amount.  These are commonly called Zeroed Out GRATS or Walton GRATS.  They are known as Walton GRATS because a member of the Walton family used this strategy and was successful in court after being challenged by the IRS.  An example serves as the best explanation.

If, when the 7520 rate is three percent, a parent creates a GRAT with a child as remainder beneficiary, funds it with $1,000,000 and retains the right to take distributions of $220,000 at the end of each year for a five year period, the value of gift will be $20,736.  This is simply the present value of $1,000,000 reduced by $220,000 each year while earning three percent per year on the remaining balance.  However, if the actual earnings rate is five percent and the capital increases by five percent each year, then the amount that actually passes to the child will be $273,213.  The amount that actually passes is irrelevant for gift tax purposes, only the amount calculated on day one is considered.

Two Year Rolling GRATS

Another strategy that can be used by those who favor aggressive investments is a Two Year Rolling GRAT.  Under this scenario the donor sets up a GRAT for a two year period and withdraws enough at the end of each year to result is a calculated gift value of zero.  The donor then invests in assets that have the potential for a rapid increase in value.  At the end of the two year term of the GRAT the donor uses the funds withdrawn to create a new two year GRAT and starts the process over.  For example, again assume the 7520 rate is three percent and the donor funds the GRAT with $1,000,000.  If the donor withdraws $530,000 at the end of each of the two years, the value of the gift will be zero.  However, there is $1,000,000 invested for one year and approximately $500,000 invested for the second year.  If an investment in the GRAT does well, all of the gain will pass to the donee free of estate and gift tax.  If there is a 30 percent capital gain in year one, then $300,000 passes to the donee free of tax.  If you don’t have a big gain, you keep trying.

Flexibility and Security of GRATS

The donor need not change his or her investing strategy if a GRAT is established; the existing investments need only be transferred to the GRAT.  Another convenient feature of a GRAT is the ability to make contributions and take distributions in-kind.  The donor does not have to sell stock.  If the donor has $500,000 worth of Apple Computer, the shares can simply be transferred to a GRAT.  Each year the donor takes out Apple Computer shares equal in value to the established distribution and at the end of the term, any shares left are transferred to the donee.

Perhaps the most important feature of GRATS is their safety with respect to challenges from the IRS.  After the Walton case established the legal foundation for Zeroed Out GRATS, it appears that the IRS must respect any GRAT that meets the simple mathematical guidelines on section 2702.  Also, the ability of donors to establish a GRAT with no change in his or her normal investment strategy make GRATS a logical move for those with investable funds and a desire to pass wealth to the next generation.

Is A GRAT For Me?

In summary, a GRAT is simply an attempt to beat the 7520 rate.  If you have significant liquid investments and would like to transfer wealth to future generations, you should consider a GRAT.  At the present time, if you can earn more than 2.4 percent on your money, a GRAT would allow you to pass wealth to family members without estate or gift tax.  A GRAT allows an investor to make tax-free gifts of his or her profits from investing.  When all of this is possible without even selling stock, you may be leaving money on the table by not using a GRAT given the right circumstances.