Donald M. Thompson - Wills, Trusts, and Estate Planning


Grantor Retained Annuity Trust (GRAT)

This is a trust created by someone (grantor) who transfers assets to the trust. It is irrevocable. The trust exists for a set term of years. At the end of the term of years someone else (such as a child) gets the trust assets. This person is called the remainderman and gets the remainder. During the term of the trust the grantor retains the right to an annuity payment. When the trust is created the remainder interest is treated as a gift.

The present value of the annuity payments is deducted from the total value of the trust assets to determine the value of the gift. In this way the trust assets can be transferred to the remainderman free of gift tax or at a discounted value. This is done by structuring the annuity payment and term of the trust so that the value of the remainder is very little. For instance, $1,000,000 could be transferred to a 2 year trust by a father with the remainder payable to his daughter. Valuation is made under IRS tables in which the rate of return is assumed. The trust could call for 2 yearly payments of about $533,000 each. This would give the remainder almost no value upon creation of the trust. The tables used for this example assume about a 4.4% rate of return. (The assumed interest rate changes each month). In other words at a 4.4% rate of return $1,000,000 will yield two yearly payments of $533,000. Nothing will be left after that. If the trust assets actually get a higher return there would still be funds left in the trust at the end of 2 years. In this case over $70,000 if the trust assets actually earned 9%. This would pass to the daughter free of gift tax. If the return on the trust assets was 4.4% or less there would be no transfer of funds to the daughter, but the grantor would get all of his funds back and the earnings on them (less transaction costs).

The annuity payment is a fixed percentage of the initial trust assets or a fixed amount. It must be paid each year. The value of the remainder (and thus the gift) is determined by the annuity payment amount, the length of the trust term and the interest rate used in the IRS tables.

GRATS exist under special rules meant to avoid under valuation of the remainder interest given to family members. Under these rules, in Section 2702, when an interest in a trust is given to certain family members and an interest is retained by the grantor (or other family members) special valuation principles apply. To begin with, the value of the retained interest is treated as 0 unless it is a qualified interest. This means the entire value of the trust assets is treated as a gift. If the interest retained by the grantor is a qualified interest then it is valued under actuarial principles and interest rates determined by Section 7520. One type of qualified interest is the fixed annual annuity type of payment.

While creation of the GRAT involves a gift, the entire value of the trust assets is in the grantor's taxable estate if the grantor dies during the trust term. For this reason GRATS often contain a reversion (the assets revert back to the grantor or the grantor's estate) if the grantor dies during the trust term. This is not a qualified interest and will not reduce the value of the gift under 2702.

A retained unitrust interest - the right to receive a set percentage of the value of the trust assets determined annually - is also a qualified interest. A trust providing for this type of payment is a grantor retained unitrust or GRUT.

The family members to which 2702 applies are spouse, ancestors, descendants and siblings and also spouses of any of the foregoing. Nieces and nephews, fiances or domestic partners are not included. When the transfer is not to a family member included in 2702 the trust is called a Grantor Retained Interest Trust (GRIT) and standard actuarial valuation principles apply (i.e., it is not assumed that the retained interest of the grantor is worthless unless it is a qualified interest).

The GRAT is usually arranged so that the remainder has no value. This is called a zeroed out GRAT. This is done to avoid paying gift tax. If the actual rate of return on the trust assets is less than the IRS rate then there will be no assets left for the remainder man at the end of the term. A donor does not know in advance if this will happen. Therefore creating a GRAT with a high remainder value can result in payment of gift tax when the remainder man gets less than the amount tax was paid on. If the GRAT is zeroed out this does not happen. If actual returns are less than the IRS rate the grantor gets his or her funds back with interest and pays no tax. If actual returns exceed the IRS rate, a tax free gift goes to the remainder men.

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Donald M. Thompson * 55 W. Monroe #3950; Chicago, IL 60603
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