Keys to a successful GRAT

So, your estate exceeds the Federal Estate Tax Exemption; or, maybe you’ve exhausted your Federal Estate Tax Exemption or Generation Skipping Transfer Tax Exemption. What can/should you do now?

One option that is attractive in today’s low-interest rate environment is a GRAT.  The acronym “GRAT” stands for Grantor-Retained Annuity Trust. GRATs are estate planning devices that are used by wealthy people to pass large amounts of money or other assets to their heirs without triggering gift, estate, or generation skipping transfer taxes.

As of November 1, 2016, the IRS’s 7520 rate, the approved rate used by the IRS for discounting present values, annuities and future interests, had fallen to 1.6%.  That makes GRATs an especially attractive estate planning vehicle for transferring assets, because any returns your GRAT earns above 1.6% will go to your heirs tax-free!  The 7520 rate is sometimes referred to as the “hurdle rate” or the “discount rate.”

Financial planners say clients with a net worth so large that they need to concern themselves with estate and gift taxes – at least $5.45 million as of this writing — are pushing to establish and fund GRATs while the rate remains so low.  

So, how does a GRAT work, you ask: Let’s say, for example, you transfer $1 million in marketable securities (e.g., stocks, bonds, etc.) into a GRAT, and you make the trust term two years. You name your children as principal beneficiaries of the GRAT.  After the first year, you would receive a payment back from the GRAT valued at $512,032 — half the principal, plus 1.6% interest. You can get paid back in either stock or cash. After the second year, you would receive another identical payment.

Now, let’s suppose the securities that you transferred to the GRAT climb 8% during that time. In that case, your heirs would get $101,371, the amount the securities climbed in value above the total of the two annuity payments to yourself. There would be no estate or gift taxes on the distribution to the beneficiaries. Additionally, because a GRAT is a “grantor trust,” you, the grantor, would pay the income tax on the 1.6% interest, which further facilitates the tax-free transfer of assets from your estate to your heirs.

One of the keys to a successful GRAT is the interest rate set by the government. With the hurdle rate being close to its all-time low, there is a better chance than ever for investments to beat the benchmark and make GRATs worthwhile.  

If you are leaving your heirs interests in a closely held business like a family LLC or FLP, a GRAT might work even better because the IRS may allow you to discount the value of the business interests to account for minority interest, lack of control or lack of marketability because these minority interests are usually much harder to sell. These discounts could be has high as 35% in some instances.

The cost of creating a GRAT typically ranges from $2,000 to $20,000, or higher, depending on legal fees where you live, the work involved in valuing and transferring the assets, and whether you set up a separate trust to hold any gains created by the GRAT. That may seem high, but remember the purpose in creating the GRAT is to save hundreds of thousands, or even millions, of dollars in gift and estate taxes.

There are some risks in establishing a GRAT.  First, you don’t want to set up a GRAT unless you are in relatively good health. If you die during its trust term, the whole trust is voided, and the assets come back into your estate. Also, if the trust assets fail to yield a total return in excess of the hurdle rate (1.6%), you will have gone through all the trouble and expense of setting up the GRAT for nothing. You will get the asset back but your beneficiaries will get nothing.

GRATS are nothing new.  They have been used for a long time to minimize or avoid gift and estate taxes. But a court ruling a decade or so ago involving Sam Walton’s heirs paved the way for the trusts to avoid gift taxes altogether. Before that, grantors had to leave at least a small amount of the original asset in the trust, and that small residue was sometimes subject to gift tax. Now, grantors are allowed to take back everything they put in, leaving the trust empty — except for the tax-free appreciation. This is what is known in estate planning circles as a “zeroed-out GRAT.”

GRATs are only one of several estate-planning techniques that benefit from the current low interest rates. People who are charitably inclined might benefit from the use of a CLAT (Charitable Lead Annuity Trust). This device is similar to a GRAT, but instead of getting the annuity income yourself, the income stream goes to charity. At the end of the term, whatever appreciation is left still goes to your family, again, tax-free.

If you are interested in a GRAT or CLAT, or numerous other estate planning tools that take advantage of today’s low rates, you should act fast because interest rates will most likely not stay this low for very long.  And, once you’re ready to take this step to providing for your heirs, the experienced lawyers of the Estate Planning and Probate Group of Sessions, Fishman, Nathan & Israel, LLC are here and ready to help.  Call us at 504 582-1500.

Computationally, the 7520 rate is pegged monthly at 120 percent of the mid-term AFR rate and rounded to the nearest two-tenths of a percent.