When Life Gives You Lemons, Create a GRAT

March, 2008

When Life Gives You Lemons, Create a GRAT

In the wake of the credit market problems and marketplace volatility that have our economy stumbling, a key estate planning opportunity is now available.

In today’s low interest rate environment, where depressed value equities are not hard to find in an investor’s portfolio, the use of a particular type of trust, a Grantor Retained Annuity Trust (or “GRAT”), is an effective way to transfer significant wealth to junior family members with minimal transfer tax consequences. Current Federal tax law limits an individual’s ability to make cumulative lifetime gifts to $1 million without imposing a gift tax, so finding ways to make gifts without paying gift tax is an important consideration [1].  For that reason, estate planners should be conscious of the GRAT and the historically low applicable interest rates.

A GRAT is an irrevocable transfer of assets by a “Grantor” to a trust for a specified term of years.  The Grantor reserves the right to receive fixed annual annuity payments from the trust based on a percentage of the value of the assets transferred. At the end of the term, when all of the fixed annuity payments have been made to the Grantor, any remaining assets can pass free of transfer tax to the Grantor’s junior family members. 

For Federal gift tax purposes, the transfer of assets to a GRAT is a taxable gift equal to the present value of the assets that will eventually pass to the remainder beneficiaries.  The amount of the Grantor’s taxable gift (which counts against the $1 million exemption noted above) is calculated using an IRS interest rate that is adjusted monthly.  The IRS interest rate represents an assumed rate of total return (both income and growth) that the assets of the GRAT will produce.  In other words, based on current economic conditions, the IRS makes a prediction as to the total return on investment the GRAT assets will generate.  If the transferred assets appreciate in excess of the IRS rate, that appreciation benefits the next generation.

The GRAT is likely to be successful when the assets funding the GRAT have potential for rapid growth.  In the event the Grantor has used up his or her entire $1 million gift tax exemption (or just does not wish to expend a portion of the exemption), a transfer to a GRAT can be structured to reduce the gift tax element to nearly zero. For example, assume the Grantor (age 63) transfers an asset worth $1,000,000 to a GRAT in March 2008 (when the applicable IRS rate is 3.6%) and retains the right to receive an annuity equal to 27.153% of the value of the transferred property, or $271,530, for four years.  Given the substantial amount of the annual annuity, the IRS valuation tables indicate the Grantor is making a gift with a present value of approximately $5,000.  Now, assuming the transferred assets appreciate by 9% annually, the remainder beneficiaries will receive $170,000 at no transfer tax cost when the trust ends in four years. If the assets appreciate by 13% annually, the beneficiaries will receive $313,600 at no transfer tax cost.

Except for mid-2003 when the IRS applicable interest rate hovered briefly in the 3.0 to 3.8 range, the rate is at an historic low.  This single-subject Advisory notes one estate planning tool that is effective when the IRS interest rate is low. Any of the attorneys in the Private Clients practice group are prepared to discuss the suitability of integrating a GRAT into an overall estate plan.

[1] This $1 million exemption for gift tax purposes is scheduled to remain in effect even if the Federal estate tax is ultimately repealed for one year in 2010.

Attorneys in the Private Clients practice group:

Kathleen M. Citera
Robert H. Goldie
Kirk H. O’Ferrall
Monica J. Falcone
Marisa Guardo
Paul J. Powers, Jr.
Carolyn M. Glynn
Amy J. Guss
James W. Reid

This Advisory is provided as general information only. No action should be taken solely on the basis of its contents.  To ensure compliance with IRS requirements, we inform you that any tax advice contained in this communication was not intended or written to be used and cannot be used for the purpose of avoiding penalties under the Internal Revenue Code or promoting, marketing or recommending to another party any transaction of matter addressed herein.

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