February 3, 2005 -- Because estate planning is currently in a state of flux, planners are finding it difficult to structure estate tax savings strategies for their clients that will prove to be good decisions even in hindsight, regardless of the ultimate estate tax law provisions enacted over the next several years.

Estate tax repeal is uncertain, with looming questions about a potential rising estate tax exemption amount, frozen gift tax exemption amount and one year repeal.  Therefore, it is understandable that taxpayers don’t want to volunteer a current gift tax if ultimately the estate tax will be repealed in its entirety. One possible strategy to consider is the use of a short term Grantor Retained Annuity Trusts (GRAT).

How does a GRAT work?  A grantor transfers assets into a trust and retains an annuity interest for a period of time.  After the annuity term ends, any assets remaining in the trust are distributed to the beneficiary of the trust.  The amount of the gift is the present value of the expected remainder using IRS sanctioned interest rates (Section 7520 rates).  If the income and appreciation generated by the assets exceeds the Section 7520 rate, the remainder will exceed the amount initially calculated for gift tax purposes and the difference will pass to the beneficiaries free of gift tax. 

What should the term of a GRAT be and how much should the annuity payment be?  The GRAT should be structured so that the gift amount is low and can be sheltered by the applicable exclusion amount (currently $1 million per taxpayer).  Note that, because the beneficiary’s interest in the property is not a “present interest,” the gift will not qualify for the annual exclusion.  For example, a November 2004 GRAT, with a 3 year annuity term and an annual payment to the grantor of 36% of the initial deposit, would have a remainder value of  .4744% ($4,744 for a $1,000,000 initial deposit). 

A short term is suggested for this planning tool for two reasons.  First, if the grantor should die during the trust term, the assets will revert to his/her estate, thus negating the benefit of the trust.  Second, when marketable securities are used to fund a trust, the use of several short term trust over a period of years can produce a better overall result than a single longer term trust.  Because the trust assets have to outperform the Section 7520 rates to produce a benefit, even a relatively short decline in the overall market could cause the trust to underperform.   That trust would therefore fail to produce a benefit and the grantor would receive all of his/her assets back.  However, the next short term trust may produce much better results.  For the same reason, grantors would be advised to create separate trusts for different assets.  If one stock does not outperform the Section 7520 rate, and that single stock is the only asset in the trust, all of the trust assets will be returned to the grantor.  But the poor performance will not negatively impact the performance of a separate trust funded with a different marketable security.

Example:  Assume a Grantor creates two GRATS, each one funded with $500,000 of a single security.  GRAT 1 is funded  with ABC stock, which produces an annual return of 10%.  GRAT 2 is funded with XYZ stock, which produces a return of only 2% due to poor market performance.  Assuming an annuity of 36% for 3 years and a Section 7520 rate of 4.2%, GRAT 1 will have a remainder balance for the beneficiaries of approximately $70,000.  GRAT 2 will have returned all of its assets to the grantor.  If the assets had been combined into a single trust, the overall return would have been 6% and the trust would return only $45,000 to the beneficiaries.  The negative return from one stock would have offset the positive performance of the other.

Who should consider the use of GRATs in their estate planning?   Anyone who has a sizeable estate, so that unless the estate tax is completely repealed, they anticipate being faced with some liability should consider this planning tool. 

For more information on GRATs, contact Madeline Janowski at 215-564-1900 .

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