Article:
Grantor Retained Annuity Trusts (GRATs)
by Paul H. Roskoph
July 1, 2006
Grantor Retained Annuity Trusts ("GRAT's") are irrevocable trusts expressly authorized under the existing tax law of the Internal Revenue Code. These irrevocable trusts provide payments to the creator (grantor) for a specified term measured by a number of years or the life of the grantor. These can be in the form of income trusts ("GRITs"), annuity trusts ("GRATs") or unitrusts ("GRUTs"). The income trust pays all of the income to the grantor for the term; the annuity trust pays a specific amount each year during the term; and the unitrust pays a fixed percentage of the value of the trust calculated annually.
The typical use of the GRAT for estate planning purposes is to create a gift which will use an asset anticipated to substantially appreciate over a short term (typically an IPO in the heydays) whereby the grantor was retaining the right to recover the principal transferred to the trust plus a reasonable rate of return over a short-term, usually two or three years. There has been speculation that Congress would prohibit these, but to date no such action has taken place.
The purpose of the accelerated GRAT (three years) is to establish a payout period that will result in the value transferred to the remainder interest (the children) equal to or near zero so that substantially all of the appreciation in the asset is transferred to the children without gift tax consequences.
The typical example would be to take an asset that is anticipated to double in value in a short term, and require the trust to pay to the grantor the original value transferred plus a reasonable rate of interest. The reasonable rate of interest is established by the tax code on its monthly rate determinations. For example, if an asset worth $100 is expected to increase to $200 over the next three years, the trust would be written so that it is obligated to pay $100 plus the reasonable rate of interest over three years. In valuing this remainder interest for gift tax purposes, the value would be relatively insignificant. As a result, substantially all of the appreciation (diminished by the interest factor payable to the grantor) is passed gift tax-free to the children.
GRAT's are an excellent concept under appropriate circumstances. Unfortunately, the crystal ball is not always clear and many GRAT's do not work because the assets fail to appreciate as projected. The most recent stock market debacle has shown the uncertainty of this approach to planning. If the GRAT doesn't work, there is no penalty. The result is that the asset is returned to the grantor through the terms of the trust with no effective transfer of the remainder interest to the children.
If you would like further information or are interested in establishing a GRAT, please contact our office by email or at (650) 470-5300.
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