GRATs represent a significant opportunity, particularly for S shareholders.

Clients with interests in closely held businesses--whether S corporation, C corporation or partnership--can benefit from grantor retained annuity trusts (GRATs) if they expect the total return (i.e., current income and appreciation) on their investment to exceed the adjusted Federal rate (AFR) used as the assumed asset appreciation rate for valuing gifts to these trusts. Because this AFR (set under Sec. 7520) is at a historic low of 6.0% for transfers in October and November 1993, clients with assets expected to average an annual return (growth and/or income) in excess of 6.0% over the next few years can achieve dramatic transfer tax savings with a GRAT.

In a GRAT transaction, the grantor transfers property to a trust, retaining the right to receive a fixed annuity payment for a specified number of years. At the end of the trust term, the property remaining in the trust goes to the grantor's children or other named beneficiaries, or remains in trust for their benefit.

When S stock is used in the GRAT, the cash distributions from the corporation to the trust can be used to satisfy the annuity payment. Therefore, when the S corporation produces a strong net cash flow or has a large accumulated adjustments account, all or a large portion of the grantor's annuity may be satisfied on a current basis with cash that is paid to the GRAT by the company.

To the extent that the annuity can be satisfied with cash, more of the stock will pass to the grantor's children at the end of the trust term. Because the annuity is fixed, as S earnings increase over the trust term, it will become easier to generate cash to satisfy the annuity. If each year's entire annuity can be satisfied with cash distributions from the S corporation, all of the stock transferred to the GRAT will pass to the children virtually free of estate and gift tax.

The fact that a GRAT should in all cases be set up as a grantor trust for income tax purposes makes it an eligible shareholder of S stock. As a grantor trust, the grantor owes income tax on the entire amount of S earnings reported to the GRAT, even if not distributed by the S corporation, and even if it exceeds the grantor's fixed annuity. Thus, added estate benefits would be produced to the extent that part of the grantor's annuity is used to pay this tax liability on earnings that will ultimately benefit the grantor's children. However, the tax adviser needs to determine whether taxing the grantor on this "phantom income" (and capital gains in the event of a sale) is appropriate in the client's circumstances. It is also necessary to check local law to see whether there are rules on reimbursing the grantor out of trust assets for taxes paid on trust income in excess of the annuity amount. The IRS ruled, in Letter Ruling 9345035, that when such a reimbursement provision is contained in the GRAT document, the trust still meets the requirements of Regs. Sec. 25.2702-3. It remains unclear whether the Service would challenge a provision that waives a state law-provided reimbursement right.

Letter Ruling 9345035 also addressed the issue of includibility of the trust property in the grantor's estate if the grantor dies during the trust term. Commentators had previously speculated that Rev. Rul. 82-105 (relating to estate inclusion on the death of a charitable remainder trust annuitant) would provide support for partial inclusion of the GRAT assets on the death of the grantor. However, in the ruling, the IRS relied on Sec. 2039 and Example (1) of Regs. Sec. 20.2039-1(a)(2) to conclude that the entire value of the trust corpus at the time of the grantor's death was includible in his estate.

Also significant to the GRAT is the fact that the IRS has ruled in Rev. Rul. 93-12 that valuation discounts for minority interests were appropriate in a family context. Recent court decisions have upheld discounts for lack of marketability and minority interests in the 30% to 40% area. The use of valuation discounts will not only reduce the gift tax value of the shares transferred to the GRAT, but will also serve to reduce the annuity amount required to virtually "zero out" the value of the GRAT remainder gift. By reducing the amount required to be paid annually to the grantor, the amount passing to the beneficiaries for the trust is maximized.