Written by Lia Momtsios

There are not many things to be thankful for during the time of COVID-19, but Grantor Retained Annuity Trusts (or “GRATs”) are one of them.  GRATs are a tax planning vehicle that allows the donor to transfer income-producing assets into a trust and out of his or her estate (thereby reducing or eliminating the imposition of estate tax upon death), while retaining the right to receive each year from the GRAT a fixed percentage of the initial value of the assets transferred to the GRAT.  If the donor survives the prescribed trust term chosen by the donor, then the appreciated asset is transferred to the ultimate “remainder beneficiary” (e.g. the donor’s children), and the asset’s appreciation will not be included in the donor’s gross estate at his or her death.  The value of the gift, for purposes of computing gift tax due, is the value of the asset reduced by the value of the annuity interest retained by the donor over the reserved term.  The donor’s retained interest takes the form of annuity payments made with cash from the asset’s income or in-kind, with a portion of the asset itself.  With a GRAT, one can thus retain access to a portion of the asset’s cash flow and/or its principal.

While the donor must pay gift tax or use gift tax/estate tax exemption on the transferred property at the trust’s inception (unless utilizing a zeroed-out GRAT, discussed below), the planning strategy is that the transferred property will appreciate at a rate that will ultimately exceed the interest rate used to compute the value of the gift.  For this reason, the most important factor in selecting assets to transfer to a GRAT is the potential investment return – that is, one should fund the GRAT with assets that are expected to increase in value in the near future, or produce substantial cash flow, or both.  For example, this could include closely-held stock that is expected to go public in the near future.  The desired return also can be increased by gifts to GRATs of minority interests in family limited partnerships or business interests that are valued at a discount.

To determine the annuity amount the donor will receive during the trust term, one looks at the IRS’s “Section 7520” interest rate, which fluctuates on a monthly basis.  The lower the Section 7520 interest rate, the greater the chance for tax savings.  Thus, GRATs are a fantastic tool in times of low-interest rates, such as now.  In fact, August’s 7520 interest rate is a mere 0.4%, meaning that if transferred assets produce a total return better than 0.4% during the trust term, the excess total return is delivered to one’s beneficiaries free of estate or gift tax.

There is a lot of flexibility available in structuring GRATs to produce the intended results.  For example, there are two main types of GRATs.  In a “zeroed-out” GRAT, the annuity stream the donor retains is calculated so that the present value of the donor’s annuity payments exactly equals the value of the asset transferred to the trust, resulting a zero gift upon transfer (thus, any return in excess of the Section 7520 rate in effect at the time of the gift passes to the next generation without even using any estate/gift tax exemption, much less any gift tax).  A zeroed-out GRAT is unworkable if the projected growth or income from the asset is less than the annuity stream the donor must retain (that is, 100% of the GRAT assets will be returned to the donor).  A zeroed-out GRAT is best if the expected growth is immediate and income of the asset greatly exceeds the annuity stream, allowing the excess growth and income to pass to one’s beneficiaries free of tax.

A non-zeroed-out GRAT, on the other hand, reserves a smaller annuity stream for the donor, thus potentially increasing the likelihood that assets will be passed to the donor’s beneficiaries.  In exchange, however, the donor uses more exemption because the present value of the donor’s income stream does not fully equal the value of the asset transferred.  But, so long as the property appreciates at a rate higher than the relevant 7520 interest rate, the value of the property received by the beneficiaries will exceed the value on which the donor used exemption.

To illustrate the current tax savings opportunity resulting from the historically low interest rates, consider an example where a donor funds a 2-year, zeroed-out GRAT with $10 million when the Section 7520 interest rate was 3% (the not-so-distant April 2019 rate).  After paying out the annual annuity due to the donor, and if the contributed assets produced an annual rate of return of 5%, only $311,649 remains in the GRAT at its expiration, and passes estate and gift tax-free to the donor’s heirs.  That same GRAT, if funded in August 2020 with the applicable 7520 rate of 0.4%, will yield $713,648 remaining in the GRAT at the end of the term – more than doubling the amount passing to the donor’s heirs estate and gift tax-free!

August’s 0.4% 7520 interest rate is the lowest the rate has ever plummeted since it went into effect in May 1989, so if there was ever a time to establish a GRAT, the time is now. 

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