The benefits of GRITs.

A grantor retained income trust (GRIT) is an irrevocable trust into which the grantor places cash or other assets. The grantor retains the income or use of the property until the assets pass to a beneficiary on a set date. Income-producing assets, such as cash, publicly traded stocks, bonds or real estate with substantial appreciation potential, are the best to use.

Three advantages of GRITs are

* Gift tax on the transfer is based on the future, discounted right to trust assets.

* Large federal and state estate tax savings, as well as other transfer cost reductions and benefits, are possible if the grantor doesn't die during the trust term.

* They can escape the broad reach of Internal Revenue Code section 2036(c).

CHOOSING TO USE A GRIT

GRITS are best for clients who

* Are single and have estates above the $600,000 unified credit equivalent.

* Are married and have a growing estate in excess of the couple's combined unified credit equivalent. The trust can eliminate or reduce taxes on the death of the second spouse. CPAs should remember that the unified credit of the grantor's spouse is lost if the couple makes a gift to a single GRIT and the grantor dies during its term. (The grantor's credit is restored.) Spouses should split assets and establish separate GRITs.

* Own a number of out-of-state assets. GRITs can streamline asset management and estate administration and reduce costs.

Newly created GRITs fall into two categories for federal transfer tax purposes:

* Statutory safe-harbor GRITs. Those established on or after June 21, 1988, that meet these section 2036(c) requirements aren't included in the grantor's estate unless he or she dies during the GRIT term:

1. The grantor's income from the GRIT must come solely from trust property.

2. The grantor can't retain income for more than 10 years.

3. The grantor and his or her spouse can't be trustees.

4. Only someone who transferred property to the trust can receive income from it.

* "Outlaw" GRITs. Those that don't meet section 2036(c) safe-harbor requirements. Assets are considered transferred at the creation of the GRIT and again when the trust term ends. The grantor makes a gift of appreciation on trust assets when they are given to the remaindermen.

Outlaw GRITs have all the advantages of statutory GRITs but don't avoid federal transfer tax. They can last more than 10 years, pay income to someone other than the grantor, provide the grantor capital as well as income, allow the grantor or the grantor's spouse to be the trustee or violate any of the GRIT safe-harbor requirements since federal estate tax savings are not possible anyway. CPAs should consider state death tax potential and the nontax planning objectives these GRITs achieve before dismissing them.

GIFT TAXES

A client makes a gift to the remaindermen when assets are placed in the GRIT, but the remaindermen don't get GRIT property until the end of the trust term. The grantor's gift of a future interest doesn't qualify for the annual gift tax exclusion.

Because gift taxes typically are based on the gift's worth to the donees, the size of the taxable gift depends on

* The value of the assets transferred to the trust.

* The discount rate (120% of the applicable federal midterm rate) for that month.

* The trust term.

* The grantor's age, if the GRIT terminates and pays out principal at the earlier of the grantor's death or the specified term.

For example, assume a widower in a 50% estate tax bracket places $1 million into a 10-year GRIT. At a 9.6% discount rate, the value of what he retains--the present value of his right to trust income--is $600,152.

The client thus makes a taxable gift of $399,848, the difference between the value of assets placed in trust ($1 million in this example) and those retained ($600,152). No gift tax is payable on the transfer due to the unified credit. This leaves $200,152 of his unified credit.

If the $1 million grows at a 5% aftertax rate, the property will be worth $1,628,895 by the end of the 10-year term. At a 50% estate tax rate, the federal estate tax savings alone would be $814,447.

INCOME TAXES

All GRIT income is taxed to the grantor. If he dies during the trust term, GRIT assets included in his estate receive a step up (or down) in basis. Basis is adjusted to the estate tax value of the portion of the trust property included in the grantor's estate attributable to the beneficiary's remainder interest.

If the grantor survives the trust term, the remaindermen would have a carryover basis in the assets they receive. The beneficiary's income tax basis in the trust property is the grantor's basis adjusted for any gift tax paid and other changes to basis during the trust term.

If appreciated property is transferred to a GRIT, the tax on any gain eventually is paid by the grantor, the trust or the remaindermen. If the trustee sells appreciated property within two years of its transfer to the trust, the grantor is taxed on the gain but avoids transfer tax.

ESTATE TAXES

If the grantor dies before the GRIT ends, the property's estate tax value is included in his gross estate under either IRC section 2033 or section 2036(a).

If the grantor survives a statutory GRIT term, all assets are removed from his estate. For outlaw GRITs, a gift tax is imposed when the grantor's income interest terminates.

A BETTER GRIT

One of the drawbacks to a GRIT is, if the grantor dies during the trust term, the cash needed to pay federal and state death tax on the assets often isn't available if the remaindermen aren't estate beneficiaries. Life insurance on the grantor's life is the simplest and most obvious solution to ensure the tax savings. A change in the GRIT terms can further increase the net amount passing to heirs. Here's how it works.

The trust provides that if the grantor dies before the income interest term expires, assets revert to his estate instead of going to the remaindermen. This change

* Provides estate liquidity.

* May lower gift tax costs significantly because the grantor can regain the entire corpus of the trust. The gift's tax value to the beneficiaries is thus significantly diminished.

* Allows the grantor to use a much shorter term or use the same term and make a much larger gift without incurring a much higher gift tax.

EXHIBIT 1

Modified GRIT results

Trust term                                           10 years
Capital placed in trust                              $1,840,000
Grantor's age when trust term ends                   70
120% applicable federal midterm rate                 9.68%
Discount rate                                        9.6%
Valuation factor                                     0.67406
Nontaxable interest retained by grantor              $1,240,270
Taxable gift (present value of remainder interest)   $599,730
Aftertax groth rate                                  4%
GRIT value at end of term                            $2,723,649
Amount taxable at GRIT termination                   0
Combined federal and state death tax bracket         50%
Potential death tax savings                          $1,361,825
Courtesy: NumberCruncher Software

For example, suppose a 55-year-old client sets up an irrevocable trust that lasts 10 years and then pays assets over to his children. If he retains no reversionary interest, assuming a 9.6% discount rate, the gift is about 40% of the value of the assets placed in the GRIT. If he puts $1 million into the trust, his taxable gift is $399,848. But if he retains his estate's right to recover the assets should he die within the 10-year period (or the right to name the recipient), the actuarial value of his taxable gift drops to about 35%, or $348,970, a reduction of $50,878. At a 50% gift tax bracket, this means saving $25,439.

Exhibit 1 on page 122 shows the estate tax savings potential of a 10-year GRIT used by a 60-year-old client. The illustration assumes a 9.6% discount rate. Each spouse could use these GRITs and, even with 4% growth, the combined estate tax savings could exceed $2,700,000; yet no gift tax would be paid on the transfer.

25% REVERSION TEST

IRS notice 89-99 established that a contingent reversionary interest or general power of appointment likely would not violate the section 2036(c) safe-harbor rules and cause a deemed gift of GRIT assets at the termination of the income interest.

This assurance comes at a cost, however. The value of the reversionary interest can't exceed 25% of the

[TABULAR DATA OMITTED]

value of the retained income interest (ascertained without regard to the value of the reversion or power). As exhibit 2 above shows, the actuarial value of the reversion must be divided by the actuarial value of the retained income interest.

Unfortunately, this 25% rule can make contingent reversions and powers of appointment prohibitive when a grantor reaches his mid-60s, just when such instruments are most needed. Conventional GRITs with contingent reversions fail the test if the grantor is older than the age indicated at the given terms and discount rates (see exhibit 3 below).

For strategies can help pass the 25% test. All attempt to reduce the reversion's actuarial value if the grantor dies before the end of the trust term.

1. Fractional reversions. For instance, half of the reversion is payable to the grantor's estate and half to the remaindermen.

2. Deferred reversions. Payment of principal to the estate is deferred until the end of the trust term.

3. Conditional reversions. Reversion is conditioned on factors such as the grantor's spouse surviving the grantor, on another person's life or on the last death of the grantor and another person.

4. Limited reversions. The reversion period is shorter than the trust term.

AN IMPORTANT TOOL

A GRIT is one of the most important financial and estate planning tools available for transferring wealth. Some of the factors CPAs should consider before using them include

* Legal fees, trustee's fees, cost of preparing tax returns for the trust and other transaction costs, such as appraisal fees and property titling costs of establishing the GRIT.

* The trust's restrictions. Income can't be shifted during the income term--and there will be estate tax on any property purchased with that income. Also, the principal can't be touched by the client and the client's income from the trust ends when the GRIT terminates.

* Once assets are placed into the trust, the grantor can't make absolute gifts of trust assets or use other planning measures.

* State gift tax, imposed by a few states.

The risks and costs generally are low compared with the potential rewards, however. Benefits can be enhanced using the modification described here and ensured using life insurance owned by an irrevocable trust or adult beneficiaries.

It is highly likely that future tax law changes will end the federal gift and estate tax savings advantages of GRITs. As a result, time is of the essence in establishing a GRIT.