Grantor Retained Annuity Trusts – Friend or Foe

On day two of the 58^th Annual Heckerling Institute on Estate Planning, Diana Zeydel of Greenberg Traurig, P.A. discussed grantor retained annuity trusts and how a GRAT can provide significant estate and gift tax benefits at little or no gift tax cost.

Drafting and maintaining a GRAT can be tricky business.  That is why it is important to understand the basics and the economics of how they work.  Ms. Zeydel highlighted how to get the most out of a GRAT in her session titled “Grantor Retained Annuity Trusts – Friend or Foe.”

The goal of the GRAT is to make a tax-free gift.  Generally, as long as the assets in the GRAT can outperform the IRS Se. 7520 interest rate, the grantor will have made a tax-free gift.  Ms. Zeydel stated volatility can be a friend or foe of the GRAT’s performance.  GRATs are about capturing volatility and it is this volatility that can make a GRAT succeed brilliantly or fail miserably.

When funding a GRAT, the grantor contributes assets to the trust and takes back an annuity payment.  This annuity payment must be a “qualified interest” under IRC Sec. 2702; otherwise the retained interest is valued at zero and the grantor has made a gift of the entire interest.

In order for an annuity to be “qualified,” there are several requirements.  First, the annuity interest must be fixed or ascertainable at inception, based on the initial value, payable at least annually and only to the grantor.  This interest can be stated in terms of a fixed dollar amount, a fixed percentage or a formula defined in terms of the value of the remainder.  Ms. Zeydel said she prefers to state the annuity interest in terms of a formula, such as defining the remainder to be 0.01% of the fair market value as finally determined for tax purposes, since this takes uncertainty out of the equation both as to valuation and proposed legislation.  As part of the example, the formula would reset if there was a minimum required remainder or term.

The annuity payment can increase by up to 20% annually.  Also, it must be paid within 105 days of the anniversary date of the creation of the trust.  Other requirements of the GRAT are that the annuity payments cannot be accelerated or commuted, and the trustee can’t use a debt instrument to pay the annuity.  Furthermore, the regulations prohibit additional contributions to a GRAT.  Therefore, if there is concern that the funding of a GRAT with multiple assets over a few days or even on the same day could be considered separate contributions, the grantor should either first fund a single-member LLC and contribute the LLC to the GRAT or start with a revocable GRAT and make it irrevocable when fully funded.   

Transfer tax planning is always more complicated when it comes to hard-to-value assets.  Here, the GRAT acts as a friend since the use of a percentage or formula based on the initial fair market value of the property “as finally determined for Federal tax purposes” will always make the gift of the remainder interest equal to zero or the value as desired.  Discounting the asset also reduces the annuity payments that must be pulled back into the grantor’s estate.  A challenge arises when the trustee is forced to make the annuity payments with these hard-to-value assets.  Valuation discounts then become the GRAT’s foe since they either dilute the gift tax benefits or create risk that the annuity payments failed to equal the required amount and thus disqualifies the GRAT.  One solution would be to do a longer term GRAT and include easy-to-value assets when funding the trust to cover a payment or two as a hedge against a possible IRS challenge.    

Ms. Zeydel discussed several ways in which a GRAT can be administered to enhance performance.  One technique is to use a short-term GRAT since it must either succeed or fail during that time.  If it fails, the grantor can give it another shot and gift the asset to a new GRAT sooner rather than later.  Due to inconsistent performance, the two- year rolling GRAT may not always be best, and she states sometimes a steeply declining GRAT may be better.      

If assets in the GRAT have appreciated, swap powers can be used to substitute for less volatile assets and thus freeze the value of the GRAT.  In the alternative, a grantor can purchase the assets from the GRAT for a note.  Cases have held that this issuing of debt is a valid substitution.  The question is, what happens when the next annuity payment is due?  Does this violate the prohibition against using debt to pay the annuity?  The answer is no.  The prohibition only covers a trustee issuing debt to pay the annuity.  Best practice would be for the grantor to pay off a portion of the note so the trustee can make the annuity payment. 

There are many more issues to consider when setting up a GRAT, including who should be the recipient of the remainder interest after the annuity term.  Ms. Zeydel recommended the use of a dynasty trust that includes all necessary “machinery” to make it flexible.  She suggested making the annuity interest and the remainder interest transferable, granting a beneficiary a power of appointment to control the dispositive provisions, and including a decanting provision in case modifications are needed.   Just remember that the generation-skipping transfer (“GST”) tax exemption cannot be allocated until the end of the annuity term (called the estate tax inclusion period or ETIP).  Therefore, when preparing the gift tax return reporting the gift to the GRAT, it is best to opt out of the automatic allocation of GST exemption and to set a reminder to opt in (or not) at the end of the annuity term.  Furthermore, gift splitting is allowed if gifts to the remainder trust can be split (i.e., the spouse is not a beneficiary of the remainder trust).  If the GRAT fails, the assets are pulled back into the estate of the grantor.  But that’s OK since the value of the gift is $0 or close to $0.

There are many more issues to consider when setting up and maintaining a GRAT.  The rules are complicated.  Trust documents should be drafted to cover valuation uncertainty and administrative errors.  Sophisticated, nonconventional GRATs may sometimes work better.  Finally, during the GRAT term, financial performance should be reviewed regularly to improve outcome.