Chapter 26: Grantor retained interest trusts (GRAT, GRUT, QPRT).
A grantor retained interest trust is an irrevocable trust to which a grantor can transfer a personal residence, closely held business, and other assets which generate income and have substantial value and appreciation potential, while retaining an interest for a period of years and reducing future estate taxes. Principal, at the end of the specified period of years, will pass to a noncharitable beneficiary, such as a child or grandchild of the grantor. Three types of trusts that are especially useful in which the grantor retains an interest are: grantor retained income trust (GRIT), grantor retained annuity trust (GRAT), and grantor retained unitrust (GRUT).
A GRIT, which was commonly used for income property before the adoption of IRC Section 2702, is now generally limited to transfers of a personal residence or certain tangible property, such as a painting, in situations where the grantor retains the use of the property during the term of the trust. In the case of the personal residence GRIT, the trust will usually be a qualified personal residence trust (QPRT).
In a GRAT, the grantor retains a right to payment of a fixed amount for a fixed period of years. In a GRUT, the grantor retains a right to payment of a fixed percentage of the value of the trust property (determined annually) for a fixed period of years.
In all of these types of trusts, the grantor is essentially making a current gift of the right to trust assets to the remainder person at a specified date in the future. If the grantor survives the term selected, significant tax as well as other transfer cost reductions may be realized with the GRAT, GRUT, and QPRT. However, with respect to most GRITs, a grantor will now be treated as making a gift of the entire property transferred to trust (rather than a gift of the discounted value of the remainder) if certain family members are designated as the remainder beneficiaries. A GRIT holding a personal residence (such as a QPRT) is a notable exception to this rule.
WHEN IS THE USE OF SUCH A DEVICE INDICATED?
1. A GRAT, GRUT, or QPRT is particularly useful where the client is single and has a substantial estate upon which federal estate taxes are certain to be paid. Wealthy widows or widowers, divorced individuals, or other unmarried persons can use such a trust as a "marital deduction substitute."
2. A married couple with an estate in excess of the couple's combined unified credit equivalent can use a GRAT, GRUT, or QPRT to eliminate or reduce taxes on the death of the second spouse to die. The larger and more rapidly appreciating these estates are, the more effective such a trust would be.
3. A GRAT, GRUT, or QPRT is effective where income producing property is located in more than one state and unification and probate savings are desired. The GRAT, GRUT, or QPRT would serve to transfer ownership in a manner that would avoid ancillary administration.
4. A GRAT, GRUT, or QPRT will protect assets from a will contest, public scrutiny, or an election against the will if the grantor survives the trust term.
5. IRC Section 2702 effectively eliminates GRITs where the remainder interest passes to a member of the grantor's family. A member of the family includes the grantor's spouse, ancestors and lineal descendants of the grantor and the grantor's spouse, brothers or sisters of the grantor, or any spouses of the above. A GRIT can still be effective if the remainder interest of the GRIT passes to someone other than those listed, such as a niece, nephew, or unrelated friend.
6. A GRAT, GRUT, or QPRT can serve as an alternative to (or be used in conjunction with) a recapitalization or other freezing technique that has the added advantages of gift tax leverage and possible estate tax savings.
7. When there is a high probability that the client will outlive the trust term that is needed to obtain a low present value gift to the remainder person.
8. When the client has assets so substantial that a significant portion can be committed to a remainder person without compromising his own personal financial security.
9. When the client has a high risk tolerance and a strong incentive to achieve gift and estate tax savings (rather than taking the safer but more costly approach of making an immediate gift).
WHAT ARE THE REQUIREMENTS?
A few requirements are summarized here. The requirements of Section 2702 are discussed in detail below.
1. An irrevocable trust must be established. A GRAT or GRUT must provide that the grantor retains the right to annuity or unitrust payments for a specified number of years (there is no limit to how few or how many years, although some have suggested that a one year term might not be permissible). Payment of the greater of an annuity or unitrust amount is permissible. As noted below, the longer the specified term of the trust, the greater the value of the retained interest and therefore the lower the taxable gift the grantor is making to the ultimate beneficiaries.
2. Evidence should be obtained of the value of the assets placed in the GRAT or GRUT. It is recommended that one or more qualified appraisers value the property shortly before it is placed into trust.
3. The grantor should be given a mandatory annuity or unitrust interest. The trust should specifically provide that the trustee has no discretion to withhold payments from the grantor (or possession of the trust property from the remainder person). Payments should be made annually or more frequently.
4. The grantor should be given only the annuity or unitrust interest (or possibly a noncontingent reversion). There is no requirement that the fixed annuity amount be the same for each year. The only requirement is that the annuity paid in a given year not exceed 120% of the amount paid the prior year. In any case, the exact amounts must be specified in the trust instrument itself. The trustee should generally be specifically prohibited from making distributions in excess of the annuity or unitrust amounts. While a GRAT or GRUT can provide for payment of income in excess of the annuity or unitrust amount to the grantor, the value of the gift of a remainder interest is not reduced by the value of such an excess income provision.
5. In the case of a QPRT, a written lease should be entered into after the specified term expires. That lease should require the grantor to pay a fair market rental to the remainder person. Terms of the lease should be strictly enforced by the remainder person. (1)
6. While it is not a requirement, the trustee should generally be someone other than the grantor or the grantor's spouse, especially after the grantor's retained interest has ended. Retention of an interest as a trustee could lead to additional income tax (but see Chapter 27 on Defective Trusts) or estate tax exposure.
WHAT ARE THE ADVANTAGES?
1. GRATs, GRUTs, and QPRTs work so well because GRATs, GRUTs, and QPRTs are based on two basic principles:
a. Gift taxes are based on the value of the gift to the donee and a gift (and therefore the gift tax) must be "discounted" by the cost of waiting. The longer the donee must wait, the lower the gift tax value of the asset placed in trust and therefore the lower the cost of the gift. With discount rates that fluctuate from month to month, there can be wide swings in gift tax cost. For instance, if the IRC Section 7520 rate is 6.0%, the taxable gift in the example below would be $111,679 (.558395 x $200,000). At a 4.0% rate it would be $135,113 (.675564 x $200,000). (See Appendix B for valuation tables.)
b. The federal estate tax doesn't reach a property interest unless the decedent owned it when he died or unless he held a "string," a property right strong enough to cause it to be pulled back into his estate. In a GRAT, GRUT, or QPRT, once the grantor lives longer than the specified term, he neither owns the property in the trust nor any rights thereto. It therefore escapes estate taxation.
2. GRATs, GRUTs, and QPRTs are the closest thing to a "no lose" situation; it is a "what have we got to lose?" technique.
a. If the client doesn't use a GRAT, GRUT, or QPRT and purchases property in his sole name, the property and any growth on the property will be in his estate.
b. If the client who sets up a GRAT, GRUT, or QPRT dies during the specified term, the result is that the property plus any appreciation will be includable in his estate (the same result as if the client had done nothing).
WHAT ARE THE DISADVANTAGES?
The downside risks, costs, or disadvantages of a GRAT, GRUT, and QPRT include:
1. Attorney fees and the other transaction costs, such as appraisal fees and property titling costs of establishing the trust.
2. Lost opportunity cost. The GRAT, GRUT, or QPRT is an irrevocable trust. So, once assets are placed into the trust, the grantor is precluded from taking other planning measures. If the grantor has used up a sizable part of the unified credit to offset the gift of the remainder interest in the GRAT, GRUT, or QPRT, then the grantor is not in a position to make large gifts of other assets that may substantially appreciate in value. If the grantor dies during the term, the gamble will have been lost. This may be especially true in light of EGTRRA 2001 which limits the amount a person can give tax free during life to $1,000,000, but which allows the limit on the amount that can be transferred tax free at death to rise to $3,500,000 by 2009.
3. If the grantor does die during the specified trust term, his executor may be liable for tax on the includable assets--but the property itself might not be available to pay that tax. (Solutions to this issue are discussed further below.)
HOW IT IS DONE--AN EXAMPLE
Assume a widow in a 48% gift tax bracket. Assume the IRC Section 7520 rate is 5.0%. She places her $200,000 personal residence into an irrevocable trust. The trust provides that she will live in the personal residence for a 10 year term. At the end of that time, the personal residence will pass to her children.
The present value of her right to live in the personal residence for 10 years is $77,217 (.386087 x $200,000). (See Appendix B for valuation tables.) Since the entire value of the personal residence placed in trust is $200,000 and the income interest retained by the grantor is $77,217, the value of the future interest gift being made at that point to the remainder person is the difference, $122,783. This entire amount ($122,783) is a taxable gift, because the gift tax annual exclusion is allowed only for gifts of a present interest. Of course, $1,000,000 can be sheltered by the gift tax unified credit equivalent, which means that the widow will pay no gift tax. Assuming the unified credit has already been used and a 48% gift tax rate, the gift tax would be $58,936. [Clients considering making taxable gifts in excess of the unified credit equivalent should be advised that EGTRRA 2001 has increased the estate tax unified credit equivalents and lowers the gift and estate tax rates for 2002 to 2010, and repeals the estate tax for one year in 2010.]
If the $200,000 property appreciates at an after-tax rate of 5%, the property will be worth $325,779 by the end of the 10 year term.
Should the widow die before the term expires, the trust assets would be included in her estate at their values as of her date of death. So there would be no federal death tax savings.
But if the widow survived the 10 year period (no matter by how short a period of time), none of the trust assets would be in her estate. At a 50% estate tax rate, the savings would be approximately $103,954 [(50% x $325,779) - $58,936]. If the estate tax were discounted to reflect that it would be payable 10 years later than the gift tax, then the savings, on a time value of money basis, would be less than that shown. For example, at a 5% discount rate, the savings would be $41,064, on a time value of money basis [or (50% x $200,000) - $58,936, since a 5% growth rate was also used]. Furthermore, because the property would not pass through probate, probate costs on $325,779 would be avoided.
GRATs and GRUTs can provide similar gift, estate, and generation-skipping transfer tax discounts. A married couple could each establish GRATs and GRUTs (or split gifts--see Chapter 22) so as to utilize both spouse's unified credits and marginal gift and estate tax brackets.
WHAT ARE THE TAX IMPLICATIONS?
1. If the grantor outlives the specified term, none of the trust's assets should be included in the grantor's estate. This is because the grantor has retained no interest in trust assets at death. IRC Section 2036 (retained life estates) applies only if the grantor retained the right to possess or enjoy the property or the income it produces (a) for life, or (b) for a period not ascertainable without reference to the grantor's death, or (c) for any period which does not, in fact, end before the grantor's death.
2. The gift to the remainder person is a gift of a future interest. It therefore cannot qualify for the gift tax annual exclusion.
3. Since a GRIT is a grantor trust, the grantor will be liable for income tax on ordinary income earned by the trust. (2)
4. If the grantor lives beyond the specified term, there should be no further transfer tax since the gift was complete upon the funding of the trust.
5. The taxable portion of post-'76 gifts is considered an "adjusted taxable gift." Because the entire present value of the gift to the remainder person is taxable, that amount is considered an adjusted taxable gift. This will push up the rate at which the other assets in the grantor's estate, if any, will be taxed.
But a rapidly growing asset will have been transferred at an extremely low transfer tax cost. This results in a significant "leveraging of the unified credit."
Perhaps more importantly, 100% of post-gift appreciation in the property's value escapes estate, gift, and generation-skipping transfer tax. This makes a GRAT, GRUT, or QPRT an excellent "estate freezing" device with respect to post-transfer appreciation.
6. At the grantor's death beyond the specified term of years, no step-up in basis for the property will be allowed. This is because the property was not acquired from a decedent. The property was acquired by gift when the trust was created, so the basis of the donee/remainderperson is generally the same as in the hands of the grantor/donee (i.e., carryover basis). It would appear that the donee's basis is increased by gift tax attributable to the gift in the proportion that the net appreciation (fair market value of gift--basis) bears to the value of the gift.
7. If the grantor dies before the specified term expires, the date of death value of the property will be includable in the grantor's gross estate. (3) EGTRRA 2001 repeals the estate tax for one year in 2010. [It is possible, although uncertain, that the value of a GRAT or GRUT included in the grantor's estate could be less than 100% of the value of the property in the trust.] If there is an estate tax inclusion, (a) there would be no adjusted taxable gift (4), and (b) the unified credit utilized in making the gift would be restored to the estate. Note that if the spouse of the grantor "split the gift," the unified credit of the nongrantor spouse would not be restored. This could be solved if both spouses in fact are grantors. In other words, have each spouse create a separate GRAT or GRUT.
It is appropriate for a beneficiary to purchase insurance on the life of the grantor and carry that life insurance during the period of time in which the death of the grantor would cause estate tax inclusion. The insurance proceeds, received estate tax free, could then be used to purchase assets from the grantor's estate and thereby provide the estate with the liquidity to pay the estate tax.
8. If appreciated property is transferred to a GRAT, GRUT, or QPRT, the tax on any gain will eventually be paid by (a) the grantor, or (b) the trust, or (c) the beneficiaries. Having taxes paid by the grantor may not, however, be a disadvantage, since the purpose of the trust is to "defund" the grantor's estate and shift as much wealth as possible to the remainder person with minimal gift taxes.
9. GRITs, GRATs, and GRUTS are generally subject to IRC Section 2702.
In valuing a transfer in trust to or for the benefit of a member of the transferor's family, Section 2702(a) provides that all retained interests in trusts that are not "qualified interests" are valued at zero. The amount of any gift is then determined by subtracting from the value of the property the value of the retained interest. (5) The valuation of retained interests in trust under Section 2702 specifically does not apply to incomplete gifts (determined without regard to whether there is consideration); personal residence trusts (see heading below); charitable remainder annuity trusts and pooled income funds; charitable lead trusts (if the only interest other than the remainder or a qualified annuity or unitrust interest is the charitable lead interest); and certain charitable remainder unitrusts (if the CRUT provides for simple unitrust payments; or in the case of a CRUT with a lesser of trust income or the unitrust amount provision, the grantor and/or the grantor's spouse are the only noncharitable beneficiaries).
Section 2702 also does not apply to assignment of remainder interests in trusts if the only retained interest is distribution of income in the sole discretion of an independent trustee, as defined in IRC Section 674(c), and certain property settlement agreements. (6)
The following definitions apply under Section 2702:
1. In determining whether a remainder beneficiary is a "member of the transferor's family," such term includes such individual's spouse, any ancestor or lineal descendant of such individual or such individual's spouse, any brother or sister of the individual, and any spouse of any such individual. (7)
2. An interest is retained by the transferor if it is payable to the transferor or transferor's spouse, the ancestor of the transferor or the transferor's spouse, and the spouse of any such ancestor. (8)
3. A transfer in trust includes a transfer to a new trust or an existing trust and an assignment of an interest in an existing trust, but not a transfer resulting from exercise of a power of appointment that would not constitute a taxable gift (e.g., lapse of "Crummey" power which does not exceed "5 or 5" limitation); or a disclaimer. (9)
4. A retained interest is one held by the same individual both before and after the transfer to the trust. (10)
Qualified interests are valued under IRC Section 7520 (i.e., at approximately 120% of the applicable federal midterm interest rate under IRC Section 1274(d)(1) for the month into which the valuation falls).
A qualified interest is:
1. a qualified annuity interest,
2. a qualified unitrust interest, or
3. a qualified remainder interest. (11)
Qualified Annuity Interests (GRATs)
A qualified annuity interest is an irrevocable right to receive a fixed amount at least annually, payable to or for the benefit of the holder of the term interest (i.e., the transferor or an applicable family member). A withdrawal right, whether or not cumulative, does not qualify, and neither does the issuance of a note or other debt instrument. (12)
The annuity payment can be a fixed dollar amount or a fixed percentage of the initial value of the trust. (13) Income in excess of the fixed amount can be distributable to the transferor, but is not considered in valuing the retained interest. (14) Subsequent contributions are prohibited. If the annuity is based on a percentage of the value of the trust, there must be a provision to adjust for incorrect valuation similar to the rules of Treas. Reg. [section]1.664-2(a)(1)(iii). (15) Payment can be made after the close of the taxable year of the trust if made by the filing date for the trust income tax returns, determined without regard to extensions. The annuity can be based on a fixed dollar amount or percentage of the value of the trust, and cannot vary except to the extent the amount (or percentage) in any year does not exceed 120% of the amount (or percentage) from the preceding year. (16)
Qualified Unitrust Interests (GRUTs)
A qualified unitrust interest is an irrevocable right to an annual payment of a fixed percentage of the net fair market value of the trust assets, to be determined annually. (17) Rules similar to those applicable to annuity trusts also apply here. Combinations of annuity and unitrust payments are not permitted. However, the trust may permit payment of the greater of an annuity or unitrust amount, to be valued at the higher of the two values. (18)
As to both annuity and unitrust transfers, any payments to other persons are prohibited; the term of the trust must be stated either as a period of years or the term holder's life, or the shorter of the two; successive term interests for the same individual are permitted; and there must be no provision for commutation of any interest. (19) The transferor can retain a reversionary interest in either the GRAT or GRUT, contingent upon death during the trust term, but the reversion is valued at zero for gift tax purposes.
Qualified Remainder Interests
A qualified remainder interest is the right to receive all or a fractional share of the trust property on termination of all or a fractional share of the trust, and includes a reversion. It must be noncontingent, i.e., payable to the beneficiary or the beneficiary's estate in all events. All interests in the trust (other than the noncontingent remainder interests) must be qualified annuity interests or qualified unitrust interests. Payment of income is not permitted in excess of the annuity or unitrust amount to the holder of the qualified annuity or unitrust interest. The right to receive a pecuniary amount or the original value of the corpus does not qualify. (20)
The retention of a remainder interest is a relatively rare estate planning technique, because any increase in the value of the transferred property is included in the transferor's taxable estate, and unless the remainder (reversion) is valued at less than 5% of the value of the transferred property, the grantor will be taxed on the income in any case. (21)
Personal Residence Trusts (PRTs)
A grantor retained income trust can still be utilized effectively where the transferor transfers an interest in a personal residence to a trust and the transferor retains the right to use the property for residential purposes for a term of years. Section 2702 carves out an exception for a personal residence trust. The regulations require such a trust to be limited to holding a single residence, or a fractional interest in a residence--in no case can the term holder hold interests in trust in more than two residences. (22)
The residence may not be occupied by any person other than the grantor, a spouse, or dependent; must be available at all times for such use; and cannot be sold or used for any other purposes. However, merely because the grantor allows a friend to reside there with the grantor occasionally, allows house guests to use the residence rent-free, or leases a portion of the property to an unrelated third party will not result in disqualification, as long as it remains the grantor's personal residence. Under IRC Section 280A(d), if the grantor uses the residence (or portion of it) for personal purposes for a number of days which exceeds the greater of 14 days or 10% of the number of days during the year for which the residence is rented at a fair rental, it qualifies as a personal residence.
The residence may include appurtenant structures and adjacent land reasonably appropriate for residential purposes, may be subject to a mortgage, but does not include any personal property, such as furnishings. Residential use includes activities described in IRC Sections 280A(c)(1) or 280A(c)(4) (i.e., limited use for business or day care if only secondary); and excludes providing transient lodging and substantial services (i.e., a hotel or bed and breakfast).
Interests owned by spouses in a residence, including community interests, can be transferred to the same trust so long as only the spouses hold the term interest. If there is an involuntary conversion, such as destruction of the residence by fire, or its condemnation, the trust can hold the proceeds of such a conversion, such as insurance proceeds or a condemnation award, so long as there is a qualified replacement under IRC Section 1033. However, both the proceeds of the involuntary conversion and any income from those proceeds must be invested in a new residence within two years of when the proceeds were received.
Qualified Personal Residence Trust (QPRTs)
Recognizing the lack of statutory guidance for the implementation of the personal residence trust, the regulations carve out a safe harbor called a qualified personal residence trust. (23) The terms are not as restrictive as the personal residence trust, but do contain provisions substantially the same as applicable to personal residence trusts. However, while the regulations seem to require that no assets other than an interest in a personal residence (or the proceeds of an involuntary conversion) can ever be held in a personal residence trust, and the interest in the residence cannot be sold during the term of the trust, the qualified personal residence trust permits both under limited circumstances. It is conceivable this trust could have income. If it does, it must be distributed to the term holder; no distributions can be made to any other person.
The qualified personal residence trust must prohibit the holding of any property other than the personal residence, and contain the following provisions:
1. No distributions to other persons are permitted.
2. Cash can be held for the initial purchase of the residence within three months, or purchase of a replacement residence within three months of the date the cash is added to the trust.
3. Cash can also be held for up to six months for payment of trust expenses, including mortgage payments, and for improvements.
4. If the property is sold or insurance proceeds are received, a two year replacement period is permitted. Excess cash must be distributed at least quarterly or at the termination of the trust to the term holder.
5. If the property is no longer used as a personal residence, the trust must terminate and its assets must be distributed to the term holder within 30 days, unless it is converted into a qualified annuity trust.
In the case of a qualified personal residence trust, it is possible to sell a residence, reinvest only part of the proceeds in a new residence, and convert the rest to an annuity. The governing instrument must prohibit the commutation (prepayment) of the term interest.
The IRS has issued a sample qualified personal residence trust document. (24) However, many practitioners feel the form is lacking, particularly since it does not provide for the retention of a reversion right in the event the grantor dies before the end of the term.
Subsequent Transfers of Retained Interests
A reduction of taxable gifts or adjusted taxable gifts is permitted if the individual subsequently transfers an interest in a trust that was valued under Section 2702. The amount of the reduction is the lesser of the increase in taxable gifts resulting from the application of Section 2702, or the increase in the transferor's subsequent taxable gifts, or taxable estate, which results from the subsequent transfer. (25) The rule applies to testamentary transfers only if a term interest in the trust is included in the transferor's taxable estate solely by reason of the operation of IRC Section 2033, or a remainder interest is included in the transferor's taxable estate, and such interest was valued under Section 2702. Where spouses have split gifts, the adjustment is allocated one-half to each spouse, but one spouse may assign this adjustment to the other.
IMPLICATIONS AND ISSUES IN COMMUNITY PROPERTY STATES
If a husband and wife transfer community property to a GRAT or GRUT, each may reserve the right to the payment for the trust term as to his or her respective community interest. It would apparently be possible for them to retain a joint payment for the term. If either dies during the term, the value of his or her community interest in the trust would be included in his or her taxable estate, either in whole or in part. If either or both spouses survive the term, his or her community interest in the trust should not be included in his or her estate. Note that in the case of the personal residence trust and qualified personal residence trust, the spouses can transfer community interests in one or two personal residences to the trust and retain the right to live in the residence for its term.
QUESTIONS AND ANSWERS
Question--Assume a husband makes a large transfer to a GRAT, GRUT, or QPRT. To reduce the potential gift tax on the value of the remainder person's interest, his wife consents to "split" the gift and use her unified credit to reduce or eliminate the gift tax. If the husband dies before the specified term expires, will the wife's unified credit be restored?
Answer--No. Although the husband's unified credit is restored if he dies within the specified income term, his wife's unified credit is not restored. A potential solution to this inequity is for the husband to make a gift to his wife. She then could make her own actual contribution to the GRAT, GRUT, and QPRT. (Obviously, the IRS could consider this a step transaction, but this logic presumes that the gift to the wife (assuming the facts indicate it was an outright and unconditional gift) was per se a transfer to an agent of the husband. This presumption is at odds with the trend of constitutional and even tax law, i.e., recognition of a female as an independent person and the trend of antipathy to sexual bias.)
Question--What are the best assets to place into a GRAT or GRUT?
Answer--Assets that possess substantial appreciation potential are the best assets to place into a GRAT or GRUT.
Question--Can the IRS revalue a transfer to a GRAT, GRUT, or QPRT many years after the GRAT, GRUT, or QPRT is funded?
Answer--A gift made after August 5, 1997, cannot be revalued for estate or gift tax purposes if the gift was adequately disclosed on a gift tax return and the gift tax statute of limitations (generally, three years) has passed. (26) Therefore, a gift tax return with an adequate disclosure of valuation should be filed with respect to a transfer to a GRAT, GRUT, or QPRT to start the statute of limitations with respect to valuation of the gift.
Question--Is there an "escape mechanism" that could redirect the remainder interest if the grantor dies during the term? For instance, is there a way to provide that if the grantor's estate has to include GRAT, GRUT, or QPRT assets, funds in the trust return to the grantor's estate rather than going to the remainder person?
Answer--A reversion to the grantor (or better yet to a revocable trust the grantor established during lifetime to avoid probate), conditioned on the grantor's death within the specified term, would create the funds to pay the estate tax. However, the value of a contingent reversion will not reduce the value of the taxable gift to the remainder person in the case of a GRAT or GRUT subject to IRC Section 2702.
Question--Is there a cutoff age after which the GRAT, GRUT, or QPRT no longer is mathematically logical?
Answer--Since the GRAT, GRUT, and QPRT are "little to lose--a lot to gain" tools, even clients in their 80s may want to use such a trust. For instance, assuming an IRC Section 7520 rate of 5.0%, the value of the income interest retained in a five year QPRT is .216474 of the principal. Some clients, especially those who are in very good health, may want to gamble with a GRAT, GRUT, or QPRT. For example, if the 80-year-old client opted for a ten year term, the value of the income interest jumps to .386087 of the funds placed in the QPRT (and therefore the taxable gift to the remainder person drops accordingly). (See Appendix B for valuation tables.)
For clients with a slightly lower risk tolerance, consider staggered terms. For instance, an 80-year-old client could transfer some property into a five year GRAT or GRUT and other property into a ten year GRAT or GRUT.
Question--Are there problems with using closely held stock with a GRAT or GRUT?
Answer--The major problem with using a GRAT or GRUT which holds closely held stock or other similarly hard-to-value assets concerns valuation. If the asset is not properly valued and/or not properly disclosed to the IRS, there is a risk of having to pay additional gift tax, penalties, and interest, or of using up more of the unified credit.
Question--Are there special provisions that should be inserted into a GRAT, GRUT, or QPRT?
Answer--It is extremely important to document the "completeness" of the transfer at the date the trust is funded. Specifically, the trust must provide that the donor has given up all dominion and control over the property.
The grantor must specifically give up any power to revoke the gift of the remainder. The trust should also forbid the grantor to change any beneficial interests in the remainder. Therefore, the grantor can retain no power of appointment (other than, possibly, a power contingent on the grantor dying during the trust term).
The grantor should generally not be named as trustee (especially after the grantor's retained interest ends). An unrelated, independent trustee should be selected.
The trust should specifically deny the grantor any control over the manner or time in which the beneficiaries will enjoy the trust corpus (otherwise, that corpus will be pulled back into the grantor's estate).
Question--How should clients be advised who are concerned that if they transfer their personal residence into a trust for a term, and still want to live there at the end of the term, they will be unable to do so?
Answer--This is a concern to many clients, and there are planning ideas to help. A PRT or QPRT must prohibit the grantor or the grantor's spouse from repurchasing the personal residence from the trust. (27) However, one method to accomplish this goal is for the grantor to lease the residence from either the trust or the remainder person after the initial term of the PRT or QPRT. The IRS has privately ruled that if the residence is leased at fair market value, the grantor would not retain any economic benefit in the property. The IRS concluded that if the grantor survived the initial term of the trust and continued to live in the residence until death, leasing the residence for fair market value rent, the interest in the property transferred to the trust would not be includable in the grantor's gross estate under IRC Section 2036. (28)
Question--Can the QPRT be effectively used for a vacation home?
Answer--Possibly the most popular use of the QPRT is for a second or vacation home. Under the facts of one ruling (29), grantor and spouse jointly own two vacation homes that could be successfully transferred to a QPRT. They intend to retitle them so that each spouse owns one property; then each will transfer his or her vacation home to a QPRT until the death of that grantor or a term of ten years. Income, if any, will be distributed to each grantor, and each will have the right to live in his or her residence. If the residences are sold, an annuity will be paid during the remainder of the term. If a grantor survives, the property will remain in trust until the surviving grantor dies. However, income will be accumulated until the death of the surviving spouse and then distributed to children. There is a reversion if the grantor dies during the trust term.
Question--Can stock in an S corporation be placed into a GRAT or GRUT?
Answer--Under usual circumstances, a GRAT or GRUT does not qualify to hold S stock because not all of the trust income is payable to the beneficiary. See Chapter 46. However, because any trust as to which the grantor is treated as the owner for income tax purposes can hold S corporation stock, the solution has been to make the GRAT or GRUT "defective" for income tax purposes (i.e., taxable under the grantor trust rules). See Chapter 27. There are many examples of this technique in private letter rulings. (30)
Question--Assume a grantor age 60 established a GRAT for a term of 15 years, but with a provision that should she die before the end of the term, it will terminate at her death. The value of the property placed in the trust is $500,000, the annuity payout rate is 6%, and the IRC Section 7520 rate is 5.0%. What is the amount of the gift? What would the amount be if the gift was for a 15 year term certain?
Answer--See Figures 26.1 and 26.2.
ASRS: Sec. 55, 58.2.
(1.) Est. of Barlow v. Comm., 55 TC 666 (1971), acq. 1972 CB 1.
(2.) IRC Sec. 677(a)(1).
(3.) IRC Secs. 2036(a)(1), 2039; Est. of Fry v. Comm., 9 TC 503 (1947); FSA 200036012.
(4.) IRC Sec. 2001(b); Treas. Reg. [section]25.2702-6(a).
(5.) Treas. Reg. [section]25.2702-1(b).
(6.) Treas. Reg. [section]25.2702-1(c).
(7.) IRC Secs. 2702(e), 2704(c)(2).
(8.) IRC Secs. 2702(a)(1), 2701(e)(2).
(9.) Treas. Reg. [section]25.2702-2(a)(2).
(10.) Treas. Reg. [section]25.2702-2(a)(3).
(11.) IRC Sec. 2702(b); Treas. Reg. [section]25.2702-2(a)(6).
(12.) Treas. Reg. [section]25.2702-3(b)(1)(i).
(13.) Treas. Reg. [section]25.2702-3(b)(1)(ii).
(14.) Treas. Reg. [section]25.2702-3(b)(1)(iii).
(15.) Treas. Reg. [section]25.2702-3(b)(2).
(16.) Treas. Reg. [section]25.2702-3(b)(1)(ii).
(17.) Treas. Reg. [section]25.2702-3(c)(1). The trust assets are to be valued in accordance with Treas. Reg. [section]25.2522(c)-3(c)(2)(vii).
(18.) Treas. Reg. [section]25.2702-3(d).
(19.) Treas. Reg. [section]25.2702-3(d)(3).
(20.) Treas. Reg. [section]25.2702-3(f).
(21.) IRC Sec. 673.
(22.) Treas. Regs. [section][section]25.2702-5(a), 25.2702-5(b).
(23.) Treas. Reg. [section]25.2702-5(c).
(24.) Rev. Proc. 2003-42, 2003-23 IRB 998.
(25.) Treas. Reg. [section]25.2702-6(a).
(26.) IRC Sec. 2001(f).
(27.) Treas. Regs. [section][section]25.2702-5(b)(1), 25.2702-5(c)(9).
(28.) Let. Ruls. 9433016, 9735012, 9723030.
(29.) Let. Rul. 9441039.
(30.) Let. Ruls. 9416009, 9444033.
Figure 26.1 GRANTOR RETAINED ANNUITY TRUST (Term With Reversion--Table 90CM) Transfer to Trust: $500,000 Age: 60 Frequency of Payments: Annual Section 7520 Interest Rate: 5.0% Check Exhaustion of Trust Fund Ann. Factor (15 years, 5.0%): 10.3797 Annuity Test Value: $311,391 Valuation Ann. Factor (60, 15, 5.0%): 9.2583 Annuity Value: $277,749 Annuity Payment: $30,000 Term of Years: 15 Payments: End of Period Adj. Factor (Annual, 5.0%): 1.0000 Special Factors Not Required Adj. Factor (Annual, 5.0%): 1.0000 Remainder Value: $222,251 Source: Trust Calculator (part of The Ultimate Trust Resource, a National Underwriter Company publication). Figure 26.2 GRANTOR RETAINED ANNUITY TRUST (Term Certain) Transfer to Trust: $500,000 Term of Years: 15 Payments: End of Period Check Exhaustion of Trust Fund Ann. Factor (15 years, 5.0%): 10.3797 Annuity Test Value: $311,391 Valuation Ann. Factor (15 years, 5.0%): 10.3797 Annuity Value: $311,391 Annuity Payment: $30,000 Frequency of Payments: Annual Section 7520 Interest Rate: 5.0% Adj. Factor (Annual, 5.0%): 1.0000 Special Factors: Not Required Adj. Factor (Annual, 5.0%): 1.0000 Remainder Value: $188,609 Source: Trust Calculator (part of The Ultimate Trust Resource, a National Underwriter Company publication).
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|Title Annotation:||Part 5: Trusts|
|Publication:||Tools & Techniques of Estate Planning, 14th ed.|
|Date:||Jan 1, 2006|
|Previous Article:||Chapter 25: Section 2503(b) and 2503(c) trusts.|
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