GRAT planning with S corp. stock.

EXECUTIVE SUMMARY

* GRATs leverage the donor's lifetime exemption by discounting the value of the future interest.

* Funding GRATs with S stock involves unique planning twists and opportunities.

* For a stock-funded GRAT, a planner should consider appropriate discounts to the transferred stock's FMV, to reduce transfer taxes on the GRAT's value.

A grantor retained annuity trust (GRAT) can be very a powerful tool in leveraging the lifetime exemption for a business owner who wishes to relinquish control of stock, in return for a certain period of annuity payments. This article explains how GRATs work and focuses on the requirements and planning opportunities for GRATs funded with S corporation stock.

The grantor retained annuity trust (GRAT) has long been just "another tool" in the experienced estate planner's arsenal. However, with the decline in interest rates and a favorable Tax Court case, (1) it has taken on new significance in long-term tax strategies, particularly for challenging family owned business-succession scenarios.

A GRAT allows a donor to leverage the $1 million taxable gift lifetime exemption, while creating a stream of cash payments for a certain period. At the same time, the donor can irrevocably relinquish control of the asset, so that its value and all future appreciation remain permanently outside his or her taxable estate. This article explains how GRATs work and focuses on the requirements and planning opportunities for GRATs funded with S corporation stock.

What Is a GRAT?

A GRAT has two parts--the annuity recipient (the grantor) and the assets' future owner (the remainder beneficiary). The trust assets' total value is effectively bifurcated: one piece is the annuity payments' present value; the other is the remaining value after taking the payments into account. Under Regs. Sec. 25.2702-1(b), the taxable gift is the remainder interest's present value. However, because the gift is a transferred future interest, the annual gift tax exclusion is not available, under Regs. Sec. 25.2503-3(a), although the lifetime exemption can be used. The GRAT's purpose is to leverage the lifetime exemption by discounting the value of the future interest.

Qualified Retained Interest

Sec. 2702 governs GRATs and is titled, "Special Valuation Rules in Case of Transfers of Interests in Trust." It is critical that the grantor's retained interest meet the Sec. 2702(b) definition of a qualified interest, because a nonqualified retained interest always has a zero value, under Sec. 2702(a)(2)(A). Consequently, the remainder interest (or taxable gift) would be valued at 100% of the transferred property's value.

To meet the qualified interest requirements, the governing instrument has to be drafted with extreme care and the trustee has to follow all provisions diligently. The trust terms have to provide the grantor with an irrevocable right to receive fixed payments (not just the trust's net income) at least annually, and the annuity payments have to be in cash or property to, or "for the benefit of," the grantor/holder of the retained interest. Under Regs. Sec. 25.2702-3(b)(1)(i), a mere "right of withdrawal," or the issuance of notes, debt instruments or options in satisfaction of the annuity amount, does not constitute payment. Accordingly, the property actually has to be transferred to meet the fixed payment definition.

A qualified interest is valued under Sec. 7520. The taxable gift is determined by subtracting the retained interest's value from the value of the trust property. The retained interest's value is the net present value (NPV) of the annual payments over the term of the annuity, using the published Sec. 7520 discount rate and tables found in Pub. 1457, Actuarial Values, Book Aleph, in effect at the time of the transfer. (2) A donor can elect to use the Sec. 7520 rate in effect for either of the two months preceding the transfer date. This allows the donor to select a more beneficial interest rate and, thus, the lowest taxable gift.

Planning Annuity Terms

Under Regs. Sec. 25.2702-3(d)(3), the annuity's fixed term must be for the grantor's life, or for a specified number of years, or for the shorter (but not longer) of those periods. The trust's term should be set so there is a reasonable prospect of the grantor surviving beyond the end of the term--otherwise, the grantor's death before the end of the term will cause at least a portion of the amount transferred to be included in the grantor's estate, under Secs. 2039 and 2036(a)(1). (3) The grantor's lifetime exemption will be restored accordingly; however, there is no restoration mechanism for the grantor's spouse's lifetime exemption. Consequently, a gift-splitting election is not a viable option. (4)

Annual Payments

The payments must be either a fixed dollar amount or a fixed percentage of the trust property's fair market value (FMV). The fixed percentage method may be advantageous if the property's valuation is uncertain or challengeable; use of a fixed dollar amount may result in an annuity payment set either too high or too low. For example, if a GRAT is funded with S stock and the company's valuation report fails to consider a key customer's bankruptcy proceedings, the stock's value may be overstated. In this case, a downward adjustment to the value is appropriate. However, if the payment to the grantor is fixed, the company may have difficulty generating the cash needed to pay the annuity following loss of a major revenue source. If the annuity were a percentage (e.g., 8% of the stock value), an adjustment could be made to both the overstated value and the annuity amount payable. (5)

Conversely, if an IRS examination finds that a minority or marketability discount was overstated, and increases the stock's FMV, the fixed annuity payments may be low in relation to the stock's value, as finally determined. In such case, the taxable gift (i.e., the remainder interest) could be higher than desired and result in significant gift tax. Thus, an annual payment set as a percentage may be prefereable, so that a payment can be adjusted based on the property's FMV as finally determined for Federal tax purposes.

Under Regs. Sec. 25.2702-3(b)(1)(ii), although an annuity based on a stated dollar amount can be set to increase, it cannot exceed 120% of the stated dollar annuity from the prior year. However, Regs. Sec. 25.27023(e), Example 3, seems to imply that the stated dollar amount can be set to decrease; the allowable decrease in the annuity amount from the preceding year appears to be unlimited.

Additional planning opportunities are available if the annuity payments are set to increase over the term (graduated GRAT). This entails setting the annuity payments to increase 120% or less over the prior year, which still sets the GRAT payout so that the annuity's present value is equal, or close to, the transferred property's value. A smaller annuity payment can be made during the earlier years of the term, but the payout can still be structured to minimize gift tax consequences, while at the same time maximizing the future appreciation kept outside of the grantor's tax able estate.

Trust Restrictions

A trust's terms n-rust prohibit additional contributions, as well as distributions, to any person other than the grantor during the trust term. (6) However, the terms may allow the trustee to make discretionary payments to the grantor. Although additional discretionary withdrawal rights cannot be used in valuing the qualified retained annuity interest under Regs. Sec. 25.2702-3(b)(1)(iii), sometimes they are appropriate or desirable, because the grantor is taxed on the trust's income (grantor trust). Additional funds may be needed to pay income taxes when the income earned on the trust property is unusually high, or when the trust assets generate significant capital gains. Alternatively, if the grantor wants to transfer more wealth to the remainder beneficiaries, free of gift and estate taxes, he or she might prefer to pay the income taxes from other assets, thereby reducing the gross estate.

Mortality Risk

In Regs. Sec. 25.2702-3(e), Example 5, the Sec. 7520 valuation considers the mortality risk, as well as the trust's term. The valuation is illustrated in Exhibit 1 at left. The annuity factor has been adjusted to reflect the statistical mortality factors for the grantor's age at the beginning and end of the term; however, the IRS lost a key Tax Court case involving the annuity factor. In Walton, (7) the taxpayer was allowed to value the taxable gift using the annuity factor for the trusts' terms and was not restricted to statistical mortality factors, as in Example 5 of the regulations. The IRS has acquiesced in Walton, conceding that Example 5 is invalid. (8)

Exhibit 1: Example at Regs. Sec. 25.2512-5(d)(2)(v)(A) (valuation of Regs. Sec. 25.2702-3(e), Example 5)

Donor is age 60

FMV of property transferred to trust = $100,000 Annual annuity amount = $6,000 Trust term = 10 years Donor's age at end of term = 70 Applicable Federal Rate (AFR) = 9.8%

Table S value at 9.8%, age 60 = 0.21669 Table S value at 9.8%, age 70 = 0.34762 Table 90CM value at age 70 = 71357 Table 90CM value at age 60 = 85537 Table B value at 9.8%, 10 years = 0.392624 Table K value at 9.8% = 1.0239

Annuity factor for an annuity beneficiary's interest, at 9.8%:

[(1.00 - 0.21669) - (0.392624 x (71357/85537) x (1.00 - 0.34762))]/0.098 = 5.8126

Present value of the annuity (income) beneficiary's interest:
($6,000 x 5.8126 x 1.0239) =                 $ 35,709

Taxable gift:
Amount transferred to trust                  $100,000
Less: annuity interest retained by grantor    (35,709)

Taxable gift                                 $ 64,291

Exhaustion of Trust Property

The IRS has maintained that a retained interest's value cannot be greater than the present value of the annual annuity payments to be received before exhausting the trust assets. If the trust sets the annual annuity payments so high as to delete the assets before the trust's expiration, the IRS may challenge such a "zeroed-out GRAT," as it did in Rev. Rul. 77-454 (9); that ruling concluded that the interest retained by the grantor has to be limited to the present value of the grantor's right to receive the annuity until death or until exhausting the trust assets, whichever comes first. The ruling describes a special method for computing the annuity's present value when the property transferred to the trust will be exhausted before the end of the term.

The estate planner and client should be aware of the Service's position when establishing the term and the annual payments to be made from the GRAT. Software programs exist for calculating the optimum or "suggested GRAT payout." (10) These programs allow the planner to "toggle on or off" the applicability of Rev. Rul. 77-454 in calculating the suggested payout and the taxable gift.

S Stock and GRATs

Eligible S corporations present some unique twists and opportunities in GRAT planning. In general, S shareholders are individuals who are U.S. citizens or residents. Corporations and most irrevocable trusts are not eligible shareholders, under Sec. 1361(b)(1). However, Sec. 671 provides that in circumstances described in Secs. 673-679, the grantor is treated, for Federal income tax purposes, as the owner of part or all of the trust. (11) The grantor's treatment as the owner of the whole trust is critical when he or she proposes to transfer S stock to a GRAT; otherwise, the S election could be terminated. (12) The IRS has issued several favorable letter rulings in which the S election did not terminate in this circumstance. (13)

When a grantor is treated as the owner of the entire trust for Federal income tax purposes, a transfer of trust assets to the grantor is not a sale or exchange for income tax purposes. (14) As a result, the trust does not recognize gain if it uses property in lieu of cash to satisfy the annual required annuity, payments. For example, if a distribution to a trust from a corporation is insufficient to meet an annuity payment, the corporation can instead use a portion of the stock held in trust, without recognizing gain or loss on the distribution of the shares to the grantor.

Protecting an S Election

A GRAT is an eligible shareholder of S stock far the trust's term, as long as the donor (and the remainder beneficiary) are eligible shareholders. If not, the S election risks termination. To further protect S status, transferability restrictions on the remainder beneficiary (via a shareholder agreement) would prevent the S stock from inadvertently falling into the hands of unqualified shareholders (such as creditors), either by prohibiting certain transfers and stock pledges, or granting a right of first refusal to the corporation and/or the other shareholders. Transferability restrictions will also protect the company if the remainder beneficiary gets divorced.

Tax ramification: Because an S corporation is treated as a flowthrough entity for income tax purposes, S earnings are taxed at the shareholder level. Cash distributions can be made tax free from the S corporation's accumulated adjustments account (AAA), (15) so that the GRAT can fund the annual annuity payments with distributions of cash or property from this account. The grantor trust's share of S income is reported on Schedule K-1, and on his or her individual income tax return, as if the grantor still owned the shares. The grantor would be taxed on the trust's proportionate share of S earnings, not just on the annuity payments. If the S corporation distributes appreciated property, there would be taxable gain under Sec. 311. If the S stock is sold during the trust term, the grantor would recognize gain or loss on the sale.

Distributions, to the extent of a positive AAA balance, can be made to shareholders (including the GRAT) without incurring a second level of tax. Under Sec. 1368, distributions in excess of the AAA are either dividends (if the S corporation has C corporation earnings and profits (E&P)) or a return of basis, generating capital gain. The GRAT can use the cash from the AAA distributions to finance the required annuity payments to the grantor.

Distributions from the AAA must be prorated, in strict accordance with the shareholders' underlying stock ownership. Disproportionate distributions could constitute a preferential dividend and create a second class of stock, causing termination of the S election under Regs. Sec. 1.1361-1(1).

To preserve the S election, annuity payments should be set so that the corporation can comfortably make payments proportionately to all shareholders from current or accumulated earnings. If the corporation needs to retain earnings to finance future growth, incurs early losses or does not have a comfortable AAA balance, the required annuity payments may place an undue hardship on operations. As a result, the company may have to use cashflow needed for operations to meet the distribution requirements, or the trust may have to make annuity payments by transferring a portion of the stock back to the grantor.

Generally, an S corporation in its early growth stage may not be a good candidate for a GRAT transfer. However, it might be, because the stock will be worth less at that time and the annuity payments could be set at a low level. A risk is that if the S corporation's cashflow is insufficient to make the payments, the grantor would have to use stock. That strategy generally works better for a mature business with a predictable and steady flow of cash and income, and an AAA reserve from which to make annual tax-free shareholder distributions. This protects the business from the risk of an economic downturn, when annual income may be insufficient to increase the AAA.

C vs. S Stock

When gifting C stock to a GRAT, the annuity payments to the grantor must be satisfied through dividends, or distributions of a portion of the stock held in trust, unless the GRAT holds other liquid assets. Because C dividends are taxed at both the corporate and shareholder levels, the directors may not wish to set the annual dividend in an amount sufficient to meet the grantor's required annuity payment. Unless there is a preferred class of stock, they would have to treat the shareholders alike in distributing dividends. However, the shareholders may not want the tax consequences of the dividend (although the new 15% tax rate may help) and the company may need to retain the E&P to finance future growth.

The trust can meet the annual annuity payment by distributing stock to the grantor. In such case, the company has to be revalued to determine the appropriate value at the time of each payment; the trust has to apply any applicable minority and marketability discounts in determining the amount of stock to be transferred. This can negate the benefits of establishing a GRAT. Further, if the corporation's value declines, the annual payments could conceivably deplete the trust assets before the expiration of the term. If this happens, the remainder beneficiary would receive nothing; the stock's value will be in the grantor's gross estate, as if the GRAT had never existed.

Stock Valuation

One key estate planning goal is to reduce transfer taxes based on the value of assets transferred to heirs, either through gift or inheritance. Transfer taxes on the value of a GRAT can be reduced by appropriately discounting the transferred stock's FMV. Discounts will reduce the value of the property transferred to the trust and the value of the taxable gift of the remainder interest. The value of the stock to be held in trust may be subject to a discount, but such discount would not be applied to the projected stream of annual cash payments (the retained interest).

Generally, the value of a closely held business interest transferred for either estate or gift tax purposes is determined under the applicable regulations. (16) The FMV of a business interest is defined by Regs. Sec. 20.2031-3 as the "net amount which a willing purchaser, whether an individual or a corporation, would pay for the interest to a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of the relevant facts." Under Regs. Sec. 20.2031 2(f) and 25.2512-2(f), some of the relevant factors include the company's position in the industry, its management and the degree of control of the business represented by the block of stock to be valued.

Appropriate Discounts

In determining the value of stock to be transferred to a trust, a valuation discount is an option if the shares represent a minority interest. Rev. Rul. 93-12, (17) which revoked earlier positions and held that family attribution is not an appropriate rationale for denying a minority discount, has allowed greater availability of discounts in family owned enterprises.

Additional discounts for lack of control may be appropriate if the stock has no voting rights. S corporations may have only one class of stock, under Sec. 1361(b)(1)(D). This means no stock can have preferred rights as to distributions and liquidation proceeds. However, differences in voting rights among shares in a corporation are disregarded in determining whether it has more than one stock class. Regs. Sec. 1.1361-1(1)(1) provides that, if all shares have identical rights to distribution and liquidation proceeds, the corporation can have both voting and nonvoting common stock, or it can have a class of common that can vote only on certain issues, or other limits.

A minority shareholder normally cannot control dividend payments, has no authority over corporate policy and no power to compel liquidation, establish salaries or appoint managers, nor any power to negotiate a sale of business assets. Nonvoting minority share holders, because they have no vote, cannot combine their voice with others to direct corporate policy and ongoing corporate affairs.

In many cases, a business owner with both voting and nonvoting stock has several children, not all of whom are active in the business. The owner will likely wish to provide for all of his or her children, perhaps through financial equality, but does not want the inactive child or children to control the business's management or direction. In this case, separate GRATs would benefit each of the children. For example, the GRAT for the active children can be funded with voting stock, while the GRAT for inactive children can be funded with nonvoting stock.

Restrictions: Marketability and transferability restrictions can also depress a stock's FMV. In the case of closely held companies, particularly if S shareholder agreements have stringent transferability restrictions, the stock is highly illiquid and, thus, discountable for lack of marketability. In Lauder, (18) the Tax Court allowed a 40% discount for lack of marketability when shareholders of a family corporation entered into an agreement that restricted a shareholder or his or her estate from transferring the stock to a third party without first offering the stock to the corporation or to the remaining shareholders. The Tax Court noted that the agreement could not be used to value the stock, but stated, "[t]he shareholder agreement affirmatively demonstrates the Lauders' commitment to maintain family control over [the corporation]." The court also noted, "[t]his element is properly accounted for ... as a component of the discount applied to reflect the lack of a public market for [the corporation's] stock."

A marketability discount should be viewed as separate and distinct from a minority interest discount, although frequently they are combined into one discount percentage reflecting "minority interest and marketability." For example, in Kosman, (19) the taxpayer gifted both voting and nonvoting stock in a bank holding company to her children. The court separately considered the discounts appropriate for a minority interest, lack of marketability and nonvoting shares, and allowed a 10% minority interest discount, a 15% marketability discount and an additional 4% discount for the nonvoting shares.

There are many court cases on minority or marketability discounts. The discount range varies widely, from 10%-70%. However, the tax adviser should not rely on an "average discount" based on a plethora of cases; an appropriate discount is based on the facts at issue. Qualified and competent business valuation experts are always available to help determine appropriate discounts.

Lifetime Exemption Leveraging

Leveraging the lifetime exemption through a GRAT funded with discounted stock can be very powerful.

Example 1: A is a 60-year-old S corporation owner. The business is a distributorship that does not have significant prospects for growth, either through increasing its territory or expanding its product line. The corporation has been in existence for many years, has a positive AAA and is expected to produce cashflow in excess of 6% of the company's undiscounted FMV. Stock with an undiscounted $450,000 FMV is transferred to a trust for a 15-year term. The taxable gift computation is shown in Exhibit 2 on p. 508. Exhibit 2 considers only the term of the trust, not the grantor's age or life expectancy. A combined 45% discount for a minority interest, lack of marketability, and voting and transferability restrictions, has been applied.

Exhibit 2: Example under Walton, ignoring Regs.
Sec. 25.2512-5(d)(2)(v)(A) *

Donor is age 60

Value of company's stock before applicable discounts        $450,000
Value after discounts for lack of marketability, minority
  interest and transferability restrictions (45%)            202,500
FMV of stock transferred to trust                           $247,500

Annual annuity amount = $20,730
Trust term = 15 years
Donor's age at end of term = 75
AFR = 3%

Table g annuity factor at 3%, 15 years = 11.9379
Table K value = 1.00

Annuity factor for an annuity beneficiazy's interest at
  3% = 11.9379

Present value of the annuity (income) beneficiary's
  interest: ($20,730 x 11.9379 x 1.00)                      $247,473

Taxable gift:
Amount transferred to trust                                 $247,500
Less: annuity interest retained by grantor                  (247,473)
Taxable gift                                                $     27

* Using discounted stock and lower interest rates.

In this example, the taxable gift is a fraction of the full, undiscounted value of the company's stock held in trust; only a small portion of the lifetime exemption is used for the gift due to the transfer of the future interest.

The power to leverage the gift increases as interest rates drop. The applicable interest rate used in valuing the discounted NPV of a stream of annuity payments is published monthly. (20) The lower the interest rate used in determining the NPV, the higher the value of the annuity stream (the qualified interest). Because the gift interest is the remainder--after subtracting the value of the annuity stream--it decreases as the income interest rises. The Sec. 7520 rate has recently been at a historical low, which presents a planning opportunity.

Example 2: The facts are the same as in Example 1, except that interest rates are in the 5% to 6% range. The taxable gift would be approximately $10,000 higher; the annuity payments would have had to be set at approximately $4,000 more per year to keep the taxable gift at the same amount.

Conclusion

In the right circumstances, a GRAT is an ideal option for a business owner who wishes to relinquish all or a portion of his or her corporate ownership interest before death, but needs or wants cashflow for a certain period. Separate GRATs of voting and nonvoting stock can be appropriate for the business owner with some children actively involved in the business and some children who do not participate. S stock may be attractive for funding a GRAT, if the business operations are expected to (1) produce a reliable and fairly predictable cashflow from which to make annuity payments and (2) earn a greater rate of return on the stock than the monthly AFRs.

(1) Audrey J. Walton, 115 TC 589 (2000), acq., Notice 2003-72. IRB 2003-44. 964.

(2) The Sec. 7520 rate is determined monthly and represents 120% of the applicable Federal midterm rate.

(3) See IRS Letter Rulings 9451056 (9/26/94), 9345035 (8/13/93), 9707027 (2/14/97), Rev. Rul. 82-105, 1982-1 CB 133, and IRS letter Ruling (TAM) 200210009 (11/19/01).

(4) The decedent's adjusted taxable gifts are defined in Sec. 2001(b) as "the total amount of the taxable gifts (within the meaning of section 2503) made by the decedent after December 31, 1976, other than gifts which after includible in the gross estate of the decedent." (Emphasis added.) In the case of a grantor dying before the end of the term, a portion of the GRAT is added to the value of the taxable estate under Secs. 2036(a)(1) and 2039; thus, the value of the GRAT includible in the gross estate would not be added to adjusted taxable gifts. The spouse who elects gift-splitting, however, cannot reduce adjusted taxable gifts, because the GRAT's value is includible in the donor's estate, not the spouse's. The value of the gift would be included in the spouse's Sec. 2001(b) adjusted taxable gifts, without reduction for the amount of the transfer included in the donor's estate due to death before the term.

(5) If the percentage method is used, Regs. Sec. 25.2702-3(b)(2) requires provisions in the governing instrument that reflect Regs. Sec. 1.664-2(a)(1)(iii)--adjustments for any incorrect determination of the FMV of the property in a charitable remainder annual trust. Regs. Sec. 1.6642(a)(1)(iii) generally requires an adjustment "in the amount equal to the difference between the amount which the trust should have paid the recipient if the correct value were used and the amount which the trust actually paid the recipient. Such payments or repayments must be made within a reasonable period after the final determination of such value."

(6) See Regs. Sec. 25.2702-3(b)(5) and -3(d)(2).

(7) Walton, note 1 supra,

(8) Notice 2003-72, note 1 supra.

(9) Rev. Rul. 77-454. 1977-2 CB 351.

(10) See BNA Estate and Gift Tax Planner (BNA Software, Tax Management, Inc.), Kugler Estate Analyzer[TM] (Brentmark Software) and NumberCruncher (Leimberg & LeClair, Inc.).

(11) The grantor would be treated as the owner of the trust under Regs. Sec. 1.671-3(b); accordingly, the trustee would report the S income, deductions and credits to the grantor as prescribed in Regs. Sec. 1.671-4(a) (i.e., in a separate statement). The grantor reports the items on his or her individual income tax return, under Regs. Sec. 1.671-3(a)(2). There appears to be no prohibition against the grantor being the trustee, although care should be exercised as to the grantor's control over the trust assets. In Letter Ruling 9707027, note 3 supra, the donor and his spouse were co-trustees; this did not affect the GRAT's qualified interests.

(12) See Secs. 1361(b) and 1362(d)(2) and Regs. Sec. 1.1362-2(b)(1).

(13) See, e.g., IRS Letter Rulings 9519029 (2/10/95), 9504021 (1/27/95), 9451056 (12/23/94), 9449012 (12/9/94) and 9449013 (12/9/94).

(14) See Rev. Rul. 85-132, 1985-1 CB 184.

(15) See Secs. 1368(e)(1) and 1367.

(16) See Regs. Secs. 20.2031-2(f) and -3 and 25.2512-2(f) and -3.

(17) Rev. Rul. 93-12, 1993-1 CB 202.

(18) Joseph H. Lauder, TC Memo 1994-527.

(19) Jane O. Kosman, TC Memo 1996-112

(20) See, e.g., Rev. Rul. 2004-54, IRB 2004-23, 1024, Table 5.

Teri L. Sunderman, CPA

Tax Manager

Lauren Davis & Co., CPAs, P.C.

Mishawaka, IN

For more information about this article, contact Ms. Sunderman at [e-mail].