Grantor trusts and the zero valuation rules.

In the estate planning process, many clients run into the conflicting goals of transferring assets to reduce their estate tax liability while retaining control of both the asset and its cash flow. Grantor trusts can provide a solution.

The ultimate goal in estate planning is to provide an individual with sufficient cash flow to support his chosen lifestyle, without his assets ending up being taxed in his estate at death. The zero valuation ruses of Sec. 2702, effective for transfers after Oct. 9, 1990, were designed to prevent this. The primary victim was the grantor retained income trust (GRIT).

Using a GRIT, an individual would transfer assets to a trust, retaining the income for life with the remainder going to a beneficiary. Prior to Oct. 9, 1990, the value of the gift of the remainder interest would have been reduced by the retained income interest. After Oct. 8, 1990, the zero valuation rules state that the value of the income interest is zero and the gift is the current value of the transferred asset. Although the GRIT will still remove the appreciation of the asset from the individual's estate, the current gift tax is typically large enough to make this vehicle impractical for most people.

Exceptions to the Zero Valuation Rules

However, there are some exceptions to the zero valuation rules: the charitable remainder trust and the nonfamily member transferee exception.

* Charitable remainder annuity trust (CRAT) or charitable remainder unitrust (CRUT): A CRAT or CRUT allows a taxpayer to provide annual income to a specified beneficiary for a specific number of years and a charitable contribution to the specified charitable organization(s). The grantor receives a current-year charitable deduction on his tax return.

Example: Taxpayer G contributes $1,000,000 to a charitable remainder trust. The trust provides that G will receive an annual annuity payment of $25,000 for the next 10 years. At the end of the trust term, the remaining trust assets will be distributed to four of G's favorite charities. Assuming the present value of the retained interest by G is $200,000 (using the appropriate IRS valuation table), the gift of the remaining interest would be $800,000. G is allowed a charitable contribution of $800,000 on his individual return.

* The nonfamily member transferee exception: If the beneficiary of the trust is the transferor, his spouse, ancestors, descendants or siblings, the transferor will not be allowed a present value reduction for the retained interest. However, if the transferor designates his niece (for example) as beneficiary, the present value of the transfer would reduce the amount of the gift.

Other Planning Vehicles

There are yet other ways in which a taxpayer may transfer assets to a trust and receive annual distributions and still escape both estate and gift taxes. These include the grantor retained annuity trust (GRAT), grantor retained unitrust (GRUT) personal residence trust (PRT) and the qualified personal residence trust (QPRT). Each of these planning vehicles applies in specific circumstances and has special requirements.

* Grantor retained annuity trust: A GRAT is a trust in which the grantor receives a fixed annuity for a specified number of years as determined in the trust document. Individuals who create a GRAT are usually trying to reduce gift and estate taxes.

A factor to be considered is that the grantor is not willing to make an outright gift today, but is willing to, at a stated date in the future, give up his interest in the property. Finally, the grantor must be in good health and have a strong likelihood of outliving the trust term. If the grantor dies before the end of the trust term, the initial gift is included in his estate.

Grantors must comply with several tax rules for the GRAT to avoid the zero valuation rules. The annuity paid to the grantor must be an irrevocable right to receive a fixed amount payable for each year of the GRAT. The annuity amount can be a fixed dollar amount or a stated percentage of the fair market value (FMV) of the property transferred to the trust. Grantors need to be cautious if the annual annuity is based on FMV, as the IRS may question this value if it believes it is misstated. Once a contribution is made to the trust, no additional contributions may be made to the trust. Finally, the trust document must prohibit distributions to anyone except the holder of the annuity interest.

* Grantor retained unitrust: A GRUT is a trust in which the grantor receives annually, for a specified number of years, an amount determined as a percentage of the trust's value. This valuation must be done annually.

GRUTs are used less frequently than GRATs; the potential benefits and required annual valuation make it a less favorable tool. For instance, if a taxpayer contributes significant amounts of appreciating assets to a GRUT, the annual valuation results in a significant appreciation of the trust's value. As a result, the trust's required distribution increases, ultimately putting more value back into the hands of the grantor. If the trust holds closely held company stock or family limited partnership interests, the annual valuations can be quite costly. However, gifts of publicly traded stock are easy to value and the grantor's objectives in making a gift (reducing potential estate taxes and continuing to receive annual income) can be met.

* Qualified personal residence trust: For many people, their home is the largest asset they own. A QPRT can also be used to escape the zero valuation rules. It allows the grantor to transfer one personal residence to a trust and retain the right to use the residence and receive the trust income for a fixed number of years. At the end of the trust term, the residence will transfer to the beneficiary. If the grantor passes away before the term of the trust is completed, the value of the home is included in his estate.

The purpose of making such a gift is to pass the value of real property likely to appreciate to the beneficiary at a discounted value, and avoid future estate taxes on any appreciation (as long as the grantor outlives the trust term).

The main advantage of a QPRT is the ability to transfer property at a discounted value, thereby saving estate taxes; disadvantages include the loss of the outright ownership of a residence during the grantor's life. The carryover basis may be a large problem for the ultimate beneficiary; on an eventual sale there could be serious capital gain consequences. Finally, if the grantor needs cash after creating the QPRT, the property is not available as collateral for a mortgage or home equity loan.

The remainder interests in a GRAT, GRUT or QPRT are not considered present value gifts, because the grantor is going to continue to "hold" the asset until the end of the trust term. Consequently, no exclusion is allowed for the net present value of the gift to the trust. But by carefully planning to use a maximum trust term and annual annuity amount, the gift taxes on the transfer can be minimized.

Conclusion

There are many different trust vehicles taxpayers can use to maximize their tax objectives, and grantor trusts are one type (see the summary chart on page 76). Whether the taxpayer's estate is Worth $500,000 or $3 million, consideration and careful planning should be exercised to meet the taxpayer's goals. If an individual currently holds assets that appear tO be appreciating at a rapid rate, proper planning now can ease the blow of estate taxes later. Because grantor trusts allow the individual to retain an income flow through the annuity or distribution of trust income, the trusts are a great tool to help individuals meet their estate planning goals.

Grantor Trusts in Estate Planning

                     A
                     t
                     t
                     r
                     i
                     b     Gift
                     u     taxes                 Retain
                     t     due on                cash
                     e     transfer              flow

Device

Grantor retained           Yes, unless           Yes, for
income trust               beneficiary           the term
(GRIT)                     is nonfamily          of the
                           member                trust

Grantor retained           Yes, but              Yes, for
annuity trust              can be                the term
(GRAT)                     minimized             of the
                                                 trust

Grantor retained           Yes, but              Yes, for
unitrust (GRUT)            can be                the term
                           minimized             of the
                                                 trust

Qualified personal         Probably              No, usually
residence trust                                  the only
(QPRT)                                           asset is a
                                                 residence

Charitable                 No,                   Yes
remainder                  receive a
trusts (CRAT               charitable
or CRUT)                   deduction on
                           personal
                           return

                                                     Basis
                                                     step-up
                             Reduce      Annual      at the
                             estate      valuation   time of
Device                       taxes       required    distribution

Grantor retained             Yes           No             No
income trust
(GRIT)

Grantor retained             Yes, if       No, unless     No
annuity trust                outlive       annual
(GRAT)                       the           annuity is
                             trust         based on
                             term          value

Grantor retained             Yes, if       Yes           No
unitrust (GRUT)              outlive
                             the trust
                             term

Qualified personal           Yes, if       No            No
residence trust              outlive
(QPRT)                       the trust
                             term

Charitable                   Yes           No            No
remainder
trusts (CRAT
or CRUT)