To transfer wealth with minimal gift or estate tax consequences is a goal many of our clients have as part of their financial plan.
Based on the current low interest rate environment, you may be able to take advantage of a unique planning technique to transfer wealth to your beneficiaries with minimal to no gift or estate tax consequences: The Grantor Retained Annuity Trust (GRAT).
Right now, the estate and gift tax exemption of 11.7M per person is the highest it has ever been. Currently, the exemption is set to sunset at the end of 2025 back to the 2017 figure of $5 million adjusted for inflation. We could see a reduction in this exemption figure sooner, depending on potential tax law updates in 2021/2022. Should that occur, this technique could gain even more popularity.
Mechanics of a GRAT
So, how does a GRAT work?
You transfer assets to a GRAT, a type of trust, for a fixed period of time. This is referred to as the ‘term of the GRAT’. You can create a GRAT with a term as short as 2 years and as long as you would like to fit best in your financial plan.
During the term of the GRAT, you will receive an annual annuity payment based on a percentage chosen by the grantor of the actual value of the grantor’s contributions to the GRAT. The value you recognize as a gift is based on a calculation using an IRS interest rate referred to as the Section 7520 rate or “hurdle rate.” This rate is published monthly and is currently at 1.2 percent (May 2021). The month that the GRAT is funded will determine which hurdle rate you use for your calculation, and therefore determines the value of the gift made by the grantor. For comparison purposes, over the last decade the Section 7520 rate has been as high as 4 percent and in 2020 hit a low of 0.4 percent. Since the goal of a GRAT is to pass wealth to beneficiaries with the lowest gift tax consequences, a lower interest rate is actually more attractive for reducing the value of the gift.
If the investments that were transferred into the GRAT outperform the hurdle rate over the term of the trust, your beneficiaries will receive the remaining value in the account over the annuity payments distributed during the GRAT term without further gift tax consequences. So, the lower the hurdle rate, the higher the probability of the GRAT being successful as a tool to transfer wealth.
What are the tax consequences of these trusts?
From an income tax perspective, as the name suggests, a GRAT, during the GRAT term, is a “grantor” trust. So taxable capital gains and ordinary income generated by the trust will be recognized by the grantor who created and funded the trust, rather than the trust itself. The taxes due on this income will pass through to the grantor’s personal tax return and the grantor will be responsible for their payment, therefore the value of the trust is not diminished by taxes as it is used to transfer wealth.
The recognition by the grantor of this income and the payment of the taxes relating to it is not treated as an additional gift, and so it does not reduce your lifetime estate or gift exemption, which is yet another way to transfer wealth.
A gift tax return will be due in the year that the GRAT is funded; to report whatever gift value is determined by the aforementioned calculation. This will be considered a gift of future interest, which will reduce your lifetime unified credit exemption. Because of the calculation of the retained interest, you will not eat into your lifetime gift tax exemption.
The term of the trust will be very important when considering the estate planning aspects of a GRAT. For the GRAT to successfully transfer property entirely to the remainder beneficiaries, you need to outlive the GRAT term. The longer you make the GRAT term, the greater the risk that you may not outlive the GRAT.
When you do not outlive the GRAT, the entire remaining balance could be included back in your estate. This would be no different than not having gifted the assets to a GRAT and holding them in your estate hence generally the only additional costs in doing this technique, in that case, would be the legal and administrative costs of creating and operating the GRAT.
Maximizing GRAT Options
Based on mortality risk, it is common for individuals to create multiple GRATs in the same year with different terms associated with them. An example of this would be someone who creates and funds a 2-year, 4-year, and 6-year GRAT in the same year to lessen the mortality risk of not outliving one of these terms. This is particularly common for older grantors.
Another way that individuals may try to maximize the usage of these trusts would be to create rolling trusts. In a rolling GRAT, an individual could set up a 3-year GRAT (GRAT A) in the current year, then take the first year’s annuity payment and roll that into a new, 3-year GRAT (GRAT B) in the second year. Then, in the following year, take the 2nd annuity payment from GRAT A and the first annuity payment from GRAT B, to fund another 3-year GRAT (GRAT C). This can start to add up from a cost standpoint with the administrative work to create each GRAT, but it could be a nominal cost compared to the potential estate tax saved if these assets would otherwise be subject to estate taxes as a tool to transfer wealth.
The main cost to a GRAT is in its fees to draft the GRAT documents by an attorney and the ongoing compliance work from an accountant/CPA while the GRAT is in existence. Here are a few other key items to consider:
- Initial funding – You typically see grantors select assets with high appreciation potential. Those could include stock in S corporations or other pass-through entities where cash distributions from this entity can be substantial enough to pay the required annuity payments. Note that if there is not sufficient income from which to pay the annuity then principal will be required to be used. The grantor must be paid the required annuity.
- Time period – Common time periods for GRATS range from 2 to 10 years. As mentioned previously, to increase the likelihood of success, you can set up multiple GRATs with different time periods and assets.
- Asset allocation – Be strategic. A good example is if there are significant gains in the GRAT, it may make sense to lock them in and be more conservative with those investments as you approach the end of the GRAT term.
At the end of the day, a GRAT can be an interesting technique to help reach the goal of passing wealth on to your beneficiaries by maximizing the value of your estate and gift tax exemptions, based on the chosen assets, market volatility, timing, GRAT term, etc.
It’s important to keep in mind all of the factors discussed when considering creating and funding a GRAT. There are other complexities that could adjust your thinking and more complex methods that can be used in determining your annuity payments and taxable gift values. It is important to work with an estate attorney and a CERTIFIED FINANCIAL PLANNER™ Professional to assist with establishing the GRAT and managing a strategic approach.
At Domani Wealth, we focus on relationships. We listen, and help you simplify. If you or a loved one is interested in a GRAT, we’re happy to speak with you to help protect your legacy and family’s future. You can get in touch with us any time by calling 855-855-5455, emailing email@example.com, or scheduling an appointment with us!
Because of the potential ability to save gift and estate taxes through the use of a GRAT, they are often re-examined by Congress and federal administrations to minimize or limit the benefits. It is possible that legislation may be passed in 2021 or later that will impact the planning opportunities associated with GRATs. Therefore, it’s important to be proactive now and speak with a CERTIFIED FINANCIAL PLANNERTM Professional to see if this technique may be appropriate for your situation.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this article serves as the receipt of, or as a substitute for, personalized investment advice from Domani. A copy of Domani’s current written disclosure brochure discussing our advisory services and fees continues to remain available upon request.