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Transferring ownership interests is a snap with a GRAT

December 19, 2013

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If you’re at the age when it’s time to consider retiring from the real estate business, make sure you look at the advantages of a grantor retained annuity trust, also known as a GRAT. It can provide substantial estate planning benefits.

The nitty-gritty of GRATs

A GRAT is an irrevocable trust funded by a one-time contribution of assets by the “grantor.” For example, if you’re the owner of a real estate development company, you can transfer some or all of your ownership interests in the business to the GRAT. The GRAT pays you, as the grantor, an annuity for a specific term.

The amount of the annuity payment is a fixed percentage of the initial contribution’s value or a fixed dollar amount; either way, the payment must be made at least annually. You maintain the right to the payments regardless of how much income the trust actually produces.

When the GRAT’s term expires, the assets remaining in the trust (known as the “remainder”) transfer to designated beneficiaries. But the amount of the gift for gift tax purposes is determined when the GRAT is funded and is equal to the “present value” of the remainder interest.

The remainder interest’s present value hinges in part on the IRS Section 7520 rate at the time of the GRAT’s creation, as well as on the value of the assets transferred to the GRAT. The value of an asset such as an ownership interest in a closely held real estate business should be determined by a valuation expert.

If the Sec. 7520 rate is low and the trust assets can generate a higher rate of return, the assets will be worth more when the trust terminates than the remainder interest’s gift tax value. So, the excess asset appreciation over the term of the trust passes to the beneficiaries free of gift and estate taxes.

In addition, if your business’s value is currently lower than it has been, the interests will have a lower value for gift tax purposes. And GRATs work particularly well with interests in closely held businesses because valuation discounts can reduce a gift’s value for tax purposes even more.

You must report the income, gains and losses from the trust assets on your individual income tax return. But paying income tax on the trust asset income and gains is actually beneficial for estate planning purposes. Why? By paying the taxes yourself (rather than the GRAT paying them), you’re preserving the trust’s assets for the beneficiaries — essentially making additional tax-free gifts to them — and further reducing the size of your taxable estate.

Other items of note

If the grantor doesn’t survive to the end of the GRAT term, the gift is effectively “undone” for tax purposes, and the GRAT assets are included in the grantor’s estate at their current value. The benefit of transferring the appreciation out of the grantor’s estate will be lost. So to reduce this mortality risk, it’s generally beneficial to make the GRAT’s term relatively short.

However, Congress has introduced several bills in recent years that would limit the benefits of GRATs by, for example, requiring a minimum term of 10 years. It’s likely that any successful legislation would apply only prospectively, though, leaving existing GRATs intact. So if you think a GRAT may be right for your family, you may want to set it up soon.

While the IRS accepts GRATs as valid vehicles for transferring assets, it does impose some rules on the trust instrument used to create a GRAT. The instrument must prohibit additional contributions to the GRAT, commutation (prepayment of the grantor’s annuity interest by the trustee), and payments to benefit anyone other than the grantor before the grantor’s retained interest expires.

Moreover, issuing a note, other debt instrument, option or similar financial arrangement to satisfy the annuity obligation isn’t allowed.

Is it time to go with a GRAT?

If you’re a baby boomer, succession planning might not be on the top of your to-do list. But it should be. Talk to your financial advisor about whether a GRAT should be part of your plan.

For more information contact Dan Lacey at [email protected]

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.

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