About four years ago, I became a Certified Estate Planner. My goal was to work with an attorney to help clients avoid the estate tax. I probably completed about 60 plans for clients, but then the attorney whom I was collaborating with could no longer work with me because of his move to Iowa.
I thoroughly enjoyed estate planning, and from time to time, I still dabble in it. When I was devising my plans, I would sometimes use a grantor retained annuity trust (GRAT), which could usually remove the family business from the taxable estate. Even without a taxable estate, a GRAT could make sense.
A GRAT is a trust that typically is established by a grantor. The trust’s grantor transfers assets – such as stock or closely-held business interests – to the GRAT for a specific term of years. In my experience, the time frame was usually between five and 10 years; however, a GRAT can also be set up for a two-year term.
The language of the GRAT document is often written to provide that the parent retains the right to receive back, in the form of annual fixed payments (the “annuity”), 100 percent of the initial fair market value of the assets transferred to the GRAT.
In addition, the grantor receives a rate of return on those assets based upon the IRS-prescribed interest rate known as the “7520 rate,” named after Code Section 7520. This code section details how this rate is to be calculated, and the IRS’s 7520 rate for November 2016 is 1.6 percent.
The beauty of the GRAT is that any asset remaining in the GRAT at the end of the trust’s term of years passes to the named beneficiaries without additional gift tax. In my experience, the beneficiaries are the grantor’s children. This type of GRAT is often referred to as a “zeroed-out GRAT” because it does not result in the grantor making a taxable gift due to the retention of annuity equal to 100 percent of the assets contributed to the GRAT.
So, let’s say we put the stock of a family business into a GRAT for a term of 10 years. The value of that stock is $500,000. (One word of caution here: If you put the stock of an S corporation into a GRAT, you have to refile the S-election under the QSub rules.) The term is 10 years and the 7520 rate is 1.6 percent, so you would pay the grantor $50,000 a year, plus 1.6 percent interest.
What the GRAT does is freeze the asset, so in 10 years after the GRAT has zeroed out, the appreciated value would remain in the GRAT and pass to the beneficiaries gift-tax free.
There’s just one tiny, little problem with the GRAT: If the grantor dies during the term of the GRAT, the assets remain in the grantor’s taxable estate and the amount does not evade gift tax.
Is the GRAT perfect? Far from it. However, it can be used as an effective way to remove assets from an estate.
Craig W. Smalley, EA is the CEO and Founder of CWSEAPA®, PLLC, located in Orlando, Florida, with clients all over the country in every industry. He has been admitted to practice before the IRS as an Enrolled Agent, and has a Master's Certificate in Taxation from UCLA. He has been in practice since 1994, specializing in individual, partnership...