by Peter Klenk, Esq.

Recent developments have clarified the advantages of using the estate planning technique known as a “GRAT” (Grantor Retained Annuity Trust). Once attacked by the IRS, the GRAT (Grantor Retained Annuity Trust) has evolved into a key estate planning tool allowing you to pass assets outside of probate to children free of estate tax, gift tax and inheritance tax.

A successful GRAT would work like this. You have an asset, such as shares in your company, which you believe will soon increase in value. As you will see, this estate planning tool works best if the asset appreciates in value at a rate higher than marketplace projections. You transfer your asset into a trust, the GRAT. The GRAT’s terms state that at some point in the future whatever remains in the trust passes to the beneficiaries (typically your children). Normally a transfer to an irrevocable trust would be subject to gift tax, but unlike most trusts a GRAT states that the trust must pay back to you… the Grantor… an annual Annuity payment (hence the name, Grantor Retained Annuity Trust). Because you have “Retained” the annuity right, the value of the gift into the trust is the fair market value of the asset transferred into the GRAT less the value of the Retained Annuity. Because of the results in the Walton case it is now clear that the value of the Retained Annuity can equal the value of the asset transferred to the trust… a “Zeroed Out GRAT”. If a GRAT is Zeroed Out, then no Gift Tax is due, as there is no resulting gift to the beneficiaries. The transfer is not a gift because the Grantor has given away no value, $X is transferred in and the Grantor receives back an annuity valued at $X. In theory the beneficiaries will get nothing, everything comes back to the Grantor.

Now comes the clever part, how to get your children something from nothing.

When valuing the annuity payment certain assumptions are made, including an assumption of how much the asset in the trust will grow in value over time. In order to prevent unscrupulous taxpayers from inventing their own formula, the IRS requires use of “the 7520 rate”, named after Section 7520 of the IRS Code. This rate is calculated each month as a prediction of value growth. When an asset is placed in the GRAT the rate is locked in. By using a formula based on the gifts fair market value, the 7520 rate and the length of the annuity, we can calculate the value of the transfer to the trust. Then, using another formula we can calculate the value of the retained annuity. If the gift is of greater value than the annuity, you are deemed to have made a gift to the eventual beneficiaries (Gift Tax Payable). If the gift’s value is equal to the annuity’s value then no gift has been made (a “Zeroed Out GRAT).

Given that the 7520 Rate is a prediction, one thing is very likely… the real growth in value of your stock will not be equal to the 7520 rate calculation. The growth will either be less or more. If the stocks in our hypothetical trust grow at a rate higher than the 7520 Rate, then after making all annuity payments the trust will have assets that pass to the children… free of probate, estate tax, inheritance tax and gift tax. If the stocks decrease in value then the entire amount passes back to the Grantor… nothing passes to the children. The trick is to choose an asset that will at a rate higher than the 7520 rate. GRATs can be crafted to your specific set of facts and circumstances.

For more information or to determine if a GRAT can be part of your overall estate plan, please feel free to contact our office for a free consultation.