Grantor Retired Annuity Trusts

In our last blog, we wrote about GRAT’s – Grantor Retired Annuity Trusts and how these estate planning tools can eliminate estate tax. So, how does a GRAT work? Let’s refer back to our fictional business owner, George Delvecchio.
After first obtaining a professional valuation of his company George created a GRAT. A GRAT is an irrevocable trust into which the business owner transfers his stock. George transferred all of his non-voting stock--which represented 50 percent of the overall ownership interest in the company. 
The GRAT must make a fixed payment (annuity) to George each year for a pre-determined number of years. At the end of this time period, which is established when the trust is created (usually two to ten years) any stock remaining in the trust is transferred to his children. 
A GRAT is but one of many tools that a lot of clever minds—legal tax and insurance—have created to produce or eliminate estate tax. When these estate planning concepts and tools are combined with lifetime exit planning concepts and tools they work to achieve an owner’ s lifetime and estate planning objectives 
A gift is made when the stock is transferred into the GRAT. The amount of the gift is the value of the asset transferred minus the present value of the annuity that the owner will continue to receive. In George’s case, his advisors designed the value of the annuity to be equal to the value of the stock transferred into the trust. Therefore, George only made a small gift of a few thousand dollars when he transferred his stock to the GRAT. To calculate this present value the IRS requires the use of its federal midterm interest rate (currently about two percent). The owner acts as the Trustee (the person in charge of the management of the trust assets, in this case the stock of the company). 
Ideally, a GRAT includes an asset that appreciates in value and/or produces income (or grows in value) in excess of the Federal mid-term interest rate. This rate adjusts monthly, but is currently near historic lows. 
Most successful businesses, including George’s, easily exceed this IRS-mandated threshold. This is especially true when we design the gifting to take advantage of the additional leverage in the form of using a minority discount on the original transfer of the business interest to the GRAT. 
Here is where it really gets interesting: George’s advisors matched up the amount of the expected “S” distributions payable with respect to the stock transferred into the GRAT (over $1 million per year) with the annual annuity payment (also a bit over $1million per year). Thus, at the termination of the four-year GRAT, all of the stock originally transferred to it remained in the GRAT (only the “S” distributions with respect to the transferred stock were needed to satisfy the annuity payments). That meant that all of the stock remained and was distributed to Chad tax-free. George paid no gift taxes and his income tax liability during the four-year GRAT period was the same as if he had not made a gift to the GRAT. 
Let’s summarize what George did: 
1. He transferred one-half of a business with a fair market value of between $12 million and $15 million to Chad in four years without using his lifetime exemption. 
2. He continued to receive all of the income from the company during that four-year period. 
3. At the termination of the trust (four years) the trust assets, (all of the non-voting stock) were transferred to Chad. 
4. George incurred minimal gift tax consequences.
Epilogue to George’s Story
George’s business was eventually sold. He and his wife received far more than they required to maintain their relatively simple lifestyle (even though George had given away one-half of the business without gift tax consequences). Mr. and Mrs. Delvecchio subsequently made plans to establish a foundation and give additional wealth during their lifetimes to the charities of their choice.
This story illustrates how the effective use of GRATs and a host of other tax-saving and creditor-protection tools, depends on understanding your objectives: for the business and for your family. The goal of all these tools is to ensure your financial security while transferring—without tax consequence and while still alive—the rest of your estate to the persons you choose.