By Steven J. Oshins, Esq., AEP (Distinguished)
The federal estate and gift tax exemption is at an all-time high, thereby leaving only a tiny percentage of people who have taxable estates. This shift in demand for advanced estate tax planning has similarly reduced the number of estate planners who handle advanced estate tax planning, an expected result of supply and demand. Even if an estate planner doesn’t personally practice in the high-net-worth area, the planner absolutely must be aware of certain estate tax-saving techniques such as the Grantor Retained Annuity Trust (“GRAT”).
A GRAT is an irrevocable trust into which the settlor makes a gift and retains a stream of annuity payments for a term of years, for life or for the shorter of a term of years or life. Most GRATs are for a term of years. The value of the gift for gift tax purposes is determined using the subtraction method. The subtraction method computes the gift by subtracting the present value of the retained annuity stream from the value of the assets transferred to the GRAT. Thus, if the present value of the retained annuity stream is valued at $1 less than the fair market value of the assets transferred to the GRAT, then the reportable gift is $1.
At the end of the term of years of the trust, if there are any assets remaining, those assets pass to the remainder beneficiaries free of any gift tax. Thus for a taxable gift of nearly zero, there is the potential of a huge upside. Therefore, the GRAT is one of the leading wealth-shifting vehicles. And because it can be designed without a gift tax, there is no limit as to the value of the assets gifted to the GRAT.
A Successful GRAT
In order to be successful, the GRAT assets will generally need to outperform the Applicable Federal Rate that exists as of the month the assets are transferred to the GRAT. However, since most GRATs are funded with assets subject to a valuation discount, there is a built-in advantage from the beginning since the annuity payment is determined based on a percentage that is applied to the fair market value of the assets transferred to the GRAT. If those assets are discounted to reflect a lack of voting control and that the business is entity is closely-held and has little marketability, the annuity percentage is applied to a lower-valued asset.
The GRAT is successful if the settlor outlives the term-of-years of the trust. If the settlor fails to outlive the term-of-years, then some or all (in most cases, all) of the trust assets are includible in the settlor’s estate. Thus, a GRAT is considered a bet-to-live technique. An advisor contemplating the use of a GRAT when preparing for a wealth-shift should consider the probability that the settlor will outlive the term of the trust. Thus, a GRAT is more suited for a younger settlor than an older settlor. A settlor in his/her 80s or 90s should generally use a different technique. Life insurance can be used to hedge against the possibility of the settlor predeceasing the term of the GRAT.
One limitation of a GRAT is that the trust cannot generation-skip. Thus, there is a transfer tax at the beneficiary’s death. However, if the transferee doesn’t have a taxable estate, then this “disadvantage” is often an advantage, assuming the assets have appreciated in value, because they get a new income tax basis at the transferee’s death.
One advantage of a GRAT that generally doesn’t apply to other wealth-shifting techniques is that there is nearly zero gift tax risk. The reason this is the case is that the trust can use a numerical percentage of the fair market value of the gifted asset in determining the annuity payments. Thus, if the valuation of the gifted asset is doubled on an audit, rather than increasing the value of the gift on a dollar-for-dollar basis, the gift tax value simply doubles. Therefore, if the GRAT is set up as having a gift tax value of $1, then if the IRS audits the valuation of the asset transferred to the GRAT, then the gift tax value is increased from $1 to $2. Many clients feel comfortable knowing that no gift tax will be owed. This makes it ideal for a risk-averse client.
Short-Term vs. Long-Term GRATs
One strategy is to gift a high concentration in a single publicly-traded stock to a short-term two-year GRAT in order to take advantage of the higher volatility of a short-term GRAT as opposed to that of a long-term GRAT. As the annuity payments are made to the settler using stock to make those payments in-kind, the settler will often re-GRAT that stock into new two-year GRATs, a technique called “rolling GRATs”. By continuing to do this, the settlor will often have some successful GRATs in strong two-year periods and some unsuccessful GRATs during weak two-year periods. If just some of the GRATs are successful, the strategy works well.
Another strategy is to structure a high-cash-flow asset, such as a business interest, so that the gift to the GRAT is made using a minority interest, non-voting interest or limited partnership interest. Because of lack of control and lack of marketability discounts, the gift is valued at an amount that is substantially less than pro rata value. The annuity payments are made using the cash flow from the gifted assets. Depending upon the valuation discount and the cash flow, these longer-term GRATs are often approximately six to 12 years in duration.
Conclusion
The GRAT is one of the leading wealth-shifting techniques. It is ideal for clients who want to move substantial wealth out of their estate, especially when they have minimal gift tax exemption remaining and when the client doesn’t want to take on excessive gift tax risk.
RELATED EDUCATION & PRODUCTS
Below are some related educational programs and products available on the subject of GRATs.
- ON-DEMAND PROGRAM: The Grantor Retained Annuity Trust: Significant Estate Tax Savings with Nearly Zero Gift Tax Risk
ABOUT THE AUTHOR
Steven J. Oshins, Esq., AEP (Distinguished) is an attorney at the Law Offices of Oshins & Associates, LLC in Las Vegas, Nevada, with clients throughout the United States. He is listed in The Best Lawyers in America®. He was inducted into the NAEPC Estate Planning Hall of Fame® in 2011 and was named one of the 24 Elite Estate Planning Attorneys in America by the Trust Advisor. He has authored many of the most valuable estate planning and asset protection laws that have been enacted in Nevada. He can be reached at 702-341-6000, ext. 2, at soshins@oshins.com or at his firm’s website, www.oshins.com.