by Steve Goodman
CPA, MBA – President & Chief Executive Officer
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[Readers unfamiliar with Intentionally Defective Grantor Trusts (IDGTs) are recommended to read the IDGT article in this Estate Planning section before reading this article.]
Grantor Retained Annuity Trusts (GRATs) and Intentionally Defective Grantor Trusts (IDGTs) are similar trusts used primarily to transfer privately held businesses and income producing property to future generations. Both are grantor trusts involving the transfer of an asset to a trust in exchange for a payment stream. There are significant differences that make each one a unique investment vehicle for a specific situation and risk profile.
GRATs require certain conditions to be effective investments.
- The grantor has a need or desire to pass assets on to children or grandchildren. As a grantor trust, the trust can readily accept shares in an S-Corp.
- The asset to be passed down throws off substantial cash annually.
- The grantor is in relatively good health.
- The grantor would like to remove assets from his/her estate for estate tax purposes.
- The grantor is comfortable shifting assets into an irrevocable trust.
- The grantor does not want to consume a substantial portion of his/her lifetime gift exclusion.
The reasons for these requirements will become clearer as we define how the trust works.
A GRAT works as follows:
- A grantor ‘gifts’ an asset to a trust called a GRAT.
- The trust provides an annuity to the grantor as payment for the asset. The IRS sets the minimum interest rate for the GRAT. (Interestingly, the GRAT rate is 20% higher than the comparable rate for an IDGT.)
The annuity is a period certain annuity. For instance, a 9-year annuity. Unlike other estate planning annuities, the private annuity, for example, the GRAT annuity terminates after the agreed upon time limit.
- During the annuity period, and while the grantor is alive, the trust is a grantor trust. That means the grantor assumes personal liability for any income taxes due from income generated by trust assets.
- GRATs can include an intentional gift component but it is not required. Assume an asset with value $2 million is to be transferred to the GRAT. The grantor can structure the deal by which the trust compensates the grantor with an annuity worth anywhere from zero to $2 million. Obviously, the zero-dollar annuity case is a simple gift. But let’s assume the annuity is designed to pay $1.5 million over its life (excluding interest). The grantor intends $500,000 to be a gift with the remaining $1.5 million repaid as an annuity. The GRAT is most interesting when the present value of the annuity payments equals the value of the asset. Known as a ‘Zeroed Out’ or Walton GRAT, future discussions in this article assume the GRAT under consideration is a Walton GRAT unless otherwise noted.
- If the grantor lives to the end of the agreed upon annuity length, and the trust makes the scheduled payments, the grantor collects the full value of the asset in annuity payments. The annuity payments offset the original asset ‘gift’ thereby ‘zeroing out’ the net gift position. Once the annuity payments are complete, the GRAT has no effect on the grantor’s lifetime gift exclusion. Following the end of the term, the assets are either distributed to the heirs, or the trust can continue for the benefit of the heirs. However, once the annuity term is over, the trust may no longer be considered a grantor trust by the IRS, depending on the language used in establishing the trust. If the trust is no longer a grantor trust, the trust becomes responsible for paying taxes on income the assets in the trust produce.
If, however, the grantor does not live to the end of the annuity length, the IRS resets the entire transaction. The assets return, in full, to the grantor’s estate. This nullifies the gift that placed the asset in the GRAT on day 1. The grantor’s gift exclusion status resets as if the transaction never happened.
If the grantor dies prematurely, the grantor’s tax position is essentially the same as it would have been had the GRAT never been established. The penalty is lost time and lawyers’ fees.
GRATs are effective when a trust asset is expected to grow substantially faster than the minimum annuity interest rate. If the asset yields an 8% annual cash flow, and interest costs are 3% annually, the different builds in the trust’s account.
GRATs are perfect examples of game theory.GRAT strategy is about setting the optimum time for the annuity. The grantor and the estate planner calculate benefits and probabilities based on the grantor’s health and expectations of longevity. If the term of the annuity is short, the asset may not appreciate enough to have made the strategy worthwhile. Too long, and the grantor may pass away just prior to the end date nullifying the previous years the GRAT existed. It is a complex computation involving tax rates, estimates of future estate valuations and other critical input. For larger assets, the benefits of a successful GRAT can be significant.
GRAT vs IDGT
GRATs and IDGTs both serve a similar purpose. They both transfer an asset, typically stock, a privately held company, or income-producing property, to a younger generation. Both usually involve the ‘sale’ of the asset to the trust in return for a payment stream. Both involve a set period of time for the payment stream.
Beyond the commonalities are several differences. Selecting the one most appropriate for a specific investor is a function of the following differences.
- Payments – IDGTs offer the option of paying interest only on the loan balance for the term of the loan followed by a lump sum payment. From a cash flow perspective, this is highly favorable for a business that may need reinvested capital to grow. The GRAT requires an annual annuity payment. Assuming comparable time periods, the IDGT offers substantially more opportunity to build cash in the trust until the final lump sum payment is due.
- Interest – Though the two trusts are similar, they use different minimum interest rates. The IDGT uses the ‘applicable federal rate’ (AFR), a number published monthly by the IRS.IRS GRAT guidelines specify that the annuity should be based on 120% of the “mid-term” AFR. Two effectively equivalent transactions, one a GRAT and one an IDGT, with the same time horizon and principal amount use different interest rates in their calculations.
- Regulatory Guidance – There are significant differences between the IDGT and the GRAT in settled law and IRS regulations. The IRS recognizes GRATs as permissible trusts. The rules and procedures are clearly defined in the tax code. While the IDGT has some authority behind it, it is not spelled out in the tax code. It exists because people have gone to tax court over the years to carve out this trust, one provision at a time. Every new situation represents an opportunity for the IRS to challenge the trust in court.
- If the Grantor Dies During the Life of the Payments – If the grantor dies before the annuity is completed, the GRAT rules specify that the asset returns to the grantor’s estate. The GRAT is unraveled. The gift status is reset to zero as if the GRAT never existed. In the case of the IDGT, there is no official guidance from the IRS as to how they will treat the trust and its assets. Nearly all tax professionals recognize that upon death, the IDGT loses its grantor status. What is not clear is when that occurs. Does the grantor’s estate owe income taxes on the unpaid balance of the sale? Does the grantor now become liable for income taxes on the note payments as the trust and the grantor are no longer considered two versions of the same tax paying entity? The IRS can provide guidance after the death but offer no guarantees when planning the IDGT. Grantors, their beneficiaries, and their estate planners do not have a clear picture of the cost of premature death of the grantor.
- Gift Taxes – The GRAT treatment of gift taxes became settled law due to a 2000 tax court case between the Walton family and the IRS. The IRS challenged the ability of Walton to ‘zero-out’ the gift tax exclusion by completing the annuity payments. The IRS lost the case and issued guidelines that formally accept this decision. Therefore, it is possible to design a GRAT that incurs no gift provisions, thereby preserving the grantor’s gift exclusion. In the case of an IDGT, the grantor must seed the trust with a gift of at least 10% of the asset’s value. This gift is permanent and counts towards the grantor’s lifetime gift exclusion.
- Valuation Issues – Both the GRAT and the IDGT allow the trust to enjoy the full benefit of the asset’s growth without affecting the grantor’s estate provided the grantor survives the payment period. The estate planning term for this is ‘estate freeze’.
But what of the valuation of the asset placed in the trust to start the process? There is a temptation to place the asset into the trust at a less than fair market value. The lower the asset valuation, the more effective the trust is at passing wealth to younger generations. A properly crafted GRAT will express the value of the annuity payments as a percentage of the initial asset valuation. Therefore, a GRAT requires an annual appraisal of the asset.
In general, if the IRS successfully challenges the valuation of an asset in an IDGT, the difference becomes charged to the grantor as a gift. However, many attorneys use special drafting language to automatically change the value of the sale in the event of an IRS audit. This can negate the gift tax risk.
- Life Insurance – Life Insurance is not required for either trust but is often advised. In the GRAT case, a life insurance policy can help defray estate taxes due to the asset being returned to the grantor’s estate at market value should the grantor die early. IDGTs often build cash quickly. The cash balance can fund insurance premiums that can help to fund the lump sum payment as necessary. The IDGT policy can also be used to defray estate taxes and costs upon the grantor’s death.
- Generation-Skipping Transfer Tax (GSTT) Avoidance – The IDGT is the preferred vehicle when GSTT is a primary goal of the trust. Using an IDGT, an asset’s value is set for GSTT purposes the minute it is sold to the IDGT. If the trust is structured to repay the asset over 10 years, the ten years of asset appreciation do not count against the grantor for GSTT purposes.
The GRAT situation is less favorable for purposes of GSTT. Unlike the IDGT, the GSTT for a GRAT is measured at the end of the annuity term. Therefore, all of the asset’s appreciation that occurs during the annuity term is counted against the grantor’s GSTT exemption.
CPA, MBA – President & Chief Executive Officer
About Steve Goodman
For more than 30 years, Steven has provided insightful solutions to the challenges of business succession, wealth preservation and charitable planning, focusing on the needs of owners of closely held businesses and high net worth individuals.
He's been featured in the New York Times and is an accomplished speaker and has presented over the years to many organizations and professional groups on efficient business succession, estate planning issues and tax strategies. Steven is a CPA who was vice president of the Trust and Investment Division of JP Morgan Chase and a supervisor for KPMG Peat Marwick, and holds an MBA from Fordham University.