AGrantor Retained Annuity Trust is a
popular estate-planning tool used by
business owners for wealth preservation. When utilized properly, a GRAT can
assist in transferring wealth on a nearly tax-free basis.
New IRS proposed regulations, however,
could significantly alter this form of trust.
“The proposed regulations impose tough
valuation standards that work indirectly to
undermine the transfer tax benefits that certain grantor trusts have traditionally been
able to provide,” says Mouris Behboud,
principal-attorney at law for Gumbiner
Smart Business spoke with Behboud
about GRATs, the benefits they provide and
what effects the IRS regulations are likely
What is a Grantor Retained Annuity Trust?
A Grantor Retained Annuity Trust is an
irrevocable trust that pays an annuity to its
grantor for a specified period of time. At the
end of the term of the GRAT, the remainder
passes to the grantor’s descendants or other
beneficiaries. If the rate of return on the
GRAT assets exceeds the applicable
Internal Revenue Code Section 7520, wealth
passes to the remainder beneficiaries upon
termination of the grantor’s annuity interest
with the grantor having made a small or no
taxable gift. The use of GRAT has become
one of the most powerful estate-planning
techniques since the enactment of IRC
Section 2702 in 1990.
What type of benefits does this technique provide as an estate-planning tool?
A properly formed GRAT achieves the
possible transfer of wealth on a tax-free or
nearly tax-free basis. It is an excellent technique when the trust assets are likely to
appreciate substantially and rapidly. For
example, the owner of a closely held business who plans to sell his business may consider using a GRAT. The value of the business interest contributed to the trust is
reduced using valuation discounts for lack
of control and marketability. When the business is sold within the term of the GRAT, the
trust receives the proceeds of the sale, which may be substantially higher. In
effect, the GRAT has provided for a significant transfer of wealth to the business
owner’s descendants or the remainder beneficiaries.
Another popular form of GRAT is a
zeroed-out GRAT, also known as a Walton
GRAT, which is created without generating
a taxable gift. Simply put, this involves dividing the original principle amount by the rate
of the appropriate factor for the corresponding term of years and Section 7520 in order
to compute an annual payment that results
in an annuity having a present value equal to
the original trust principle.
When forming a GRAT, what considerations
should be taken into account?
One of the critical considerations in forming a GRAT that practitioners usually face is
the length of the term of the GRAT. The benefits of using a short-term GRAT are
twofold. First, a short-term GRAT minimizes
the possibility that a year or two of poor performance of the GRAT assets will adversely
impact the overall effectiveness of the
GRAT. A series of short-term GRATs funded
with volatile securities perform better than
a single long-term GRAT. In turn, the remainder beneficiaries receive significantly higher
value using a series of short-term GRATs.
The second advantage of using a short-term
GRAT is the reduced exposure to the risk
that the grantor will die during the term.
On the other hand, when funding annuity
payments is likely to be a problem because
of insufficient cash flow, a long-term GRAT
may provide a good solution. An additional
advantage of using a longer-term GRAT is in
a low interest rate environment when one
can lock in the low interest rate applicable
at the beginning of the term.
How do the new IRS-proposed regulations
affect this form of the trust?
On June 7, 2007, the IRS published proposed regulations to IRC Section 2036 and
2039 regarding the inclusion of GRAT assets
in the estate of the grantor when the grantor
does not survive the term of the trust. These
new proposed regulations appear to be part
of the IRS’s larger strategy to curtail the use
of grantor trusts and other similar techniques used as vehicles for minimizing
transfer tax liability.
Under the proposed regulations, the
amount includible for estate tax purposes is
not based on the present value of the future
stream of annuity payments. Rather, it is the
amount of trust corpus that is necessary to
yield the annuity payment based on the IRC
Section 7520 rate in effect at the date of
death or alternate valuation date.
In light of these proposed regulations, how
important are timing issues?
These proposed regulations are especially
not favorable for short-term GRATs. Since a
short-term GRAT has a high annual annuity
payment intended to zero-out the taxable
gift, the result of the formula under the proposed regulations can significantly exceed
the total value of the assets in the GRAT.
This problem is magnified if the GRAT
assets significantly outperform the IRC
Section 7520 rate. IRC Section 7520 provides valuation tables for annuity, any interest for life or a term of years and remainder
or reversionary interests.
MOURIS BEHBOUD is principal-attorney at law for Gumbiner
Savett Inc. Reach him at [email protected] or (310) 828-9798.