When to use a "zeroed out" GRAT.

A grantor retained annuity trust (GRAT) is an irrevocable trust to which a grantor transfers property in exchange for the right to receive a fixed annuity for either a set number of years or for life. The annuity payment is usually a fixed percentage of the original value of the assets transferred. For example, if $100,000 is put into the trust and the fixed percentage is 8%, the trust would pay $8,000 each year, regardless of the assets' value in any subsequent year.

When the trust term expires, the assets remaining in the trust pass tax-free to the beneficiaries. A gift tax obligation may occur when a GRAT is created, for the amount of the "residual assets" that will pass to the beneficiaries. The residual is determined using the subtraction method: the fair market value of the property contributed less the actuarial value of the annuity retained. The trust is a grantor trust, because it may use income or principal to satisfy the annuity payments. Thus, all items of income and deduction will be reported on the grantor's Form 1040.

In a "zeroed out" GRAT, the annual annuity payments are set so high that the trust assets will be depleted before the expiration of the trust's term; see Rev. Rul. 77-454.

GRATs carry the risk that the grantor will die during the trust's term. If this happens, the entire GRAT is includible in the grantor's estate. Thus, GRATs are an effective tool only if the grantor outlives the term. This can be mitigated in older grantors by setting a lifetime term.

A GRAT is a superb estate planning vehicle for taxpayers who need an income stream from their assets, but not the assets themselves.

Example: G, age 60, transfers $1 million of assets into a GRAT for a 7% annuity for 10 years. B is the trust's beneficiary. In the month that G funds the GRAT, the Sec. 7520 rate is 5%, resulting in a $459,481 current gift from G to B. G will receive $70,000 per year, paid at least annually from the trust. At the end of year 10, B will receive the residual. The trust assets earn 8% per year; the residual at the end of year 10 is $1,144,866.

In the example, the $1 million asset will pay $700,000 to the grantor over 10 years. The gift's value is approximately $460,000, yet the grantor moves more than $1.1 million out of his of her estate. If the grantor has not used his or her $1 million lifetime gifting exclusion, the gift goes untaxed. Because all the income and appreciation that exceed the required annuity stream remain in the trust for the beneficiaries, the grantor can transfer value far in excess of the value of the gift of the transferred assets. This shows that a GRAT can be a relatively inexpensive way to move rapidly appreciating assets out of an estate.

The "Zeroed Out" GRAT

A disadvantage of using a GRAT is in the use of the lifetime gifting exclusion. Until recently, there was no way to avoid such use. In Example 5 of Regs. Sec. 25.2702-3(e), the IRS took the position that the gift portion of a GRAT could not be zero. According to Example 5, if any amount of the annuity could be payable to a grantor's estate, the value of that contingent annuity interest had to reduce the amount of the grantor's retained trust value. This trust provision would then increase the gift portion, because it decreases the amount of the grantor's retained value. In Audrey J. Walton, 115 TC 589 (2000), the grantor transferred approximately $100 million of Wal-Mart stock to each of two two-year GRATs and claimed no gift on the transaction. Under each trust's terms, the grantor would receive an annuity equal to 49.35% of the initial value for the first year, and 59.22% for the second year. If she died within those two years, the annuity amounts would be payable to her estate. At the end of the two-year term, each trust's remainder would be payable to one of her two daughters. The gift was reported as zero, because the grantor retained an interest of approximately 100% of the trust's initial value.

The IRS argued that the estate's contingent annuity value was approximately $3.8 million per GRAT; it assessed gift tax on that amount, plus the calculated value of each remainder interest (approximately $6,000). The taxpayer argued that the estate's contingent interest should not be considered in the calculation, resulting in a $6,000 gift to each beneficiary. The Tax Court agreed with Walton and invalidated Example 5. In Notice 2003-72, the IRS acquiesced. For a zeroed-out GRAT to work, the trust has to provide that in the event of the grantor's death, the remaining annuity payments are payable to the estate.

Using the facts of the example, to zero out the 10-year GRAT and avoid the gift tax on $1 million of assets transferred to it, a $129,505 annuity would need to be paid annually. As the trust assets earn 8%, the remainder amount to the beneficiary is $282,841, resulting in only a 47-cent gift to the beneficiary. As the value of the gift decreases, the value moved from the estate also decreases. The question becomes: Which goal is the planner trying to accomplish?

In the case of a small estate in which the taxpayer has not used his of her lifetime gifting exemption, a regular GRAT is likely more attractive. However, when the gifting exemption has been fully used, the zeroed out GRAT is the choice. If the taxpayer has partially used his or her exemption, an annuity payment somewhere between what the taxpayer needs to live on and the zeroed-out percentage could achieve the needed results.

A GRAT also becomes more attractive when the assets used to fund the trust can be discounted. This could occur by using limited partnership units or closely held stock. The same $1 million value put into a 10-year zeroed-out GRAT, at a 20% discount for lack of control or lack of marketability, increases the remainder value to $658,058. The drawback to the discounted assets is that the trust may need to pay the annuity with the partnership units or stock (because the grantor would not want them to be sold); they would need to be valued each year to determine how many are needed to meet the annuity payment requirement. The cost of the annual valuation may outweigh the benefit of the discounted value; for a detailed discussion, see Sunderman, "GRAT Planning with S Corp. Stock," p. 502, this issue.

Conclusion

GRATs remain a viable estate planning and wealth transfer option. Other benefits include privacy on the transfer of assets and possible asset protection against creditors' claims. Choosing the right GRAT type, term and annuity structure depends on the different goals and needs of each taxpayer.

FROM ALANE L. BOFFA, CPA, MT, COHEN & COMPANY, LTD., CPAs, AKRON, OH