Using GRAT Trusts in New York

GRAT trust is a tool used by well-to-do families to save money on estate taxes and pass on more of their hard-earned wealth to the next generation. The acronym GRAT stands for “grantor retained annuity trust.” That’s a hard line to digest! What is should really stand for is “gift returns, appreciation is transferred!” This is because the gift that you give to the trust is returned to you, while the appreciation of the gift is transferred to your heirs free of gift tax or estate tax.

To form a GRAT, you transfer assets into a trust for the benefit of your children, while retaining an annuity for yourself. The annuity will be at the rate set by the government for GRATs, known as “the 7520 rate,” which is currently about 1% per month. Any interest or gain in value over the 7520 rate can be kept by the trust beneficiaries tax-free.

A GRAT works like this: you sell your stock to your trust in exchange for an annuity, which is a stream of payments. For example, two years’ worth of payments. Whatever is left goes to beneficiaries.

You also pay income taxes on the trust, which leaves more of the money for your children. This is because this is a grantor trust. As long as the lifetime value of the annuity is equal to the amount of money in the trust, and you get your annuity, the IRS will not ask your children for the gift tax or estate tax.

GRATs are a good way to save gift taxes on assets that appreciate at a high rate, such as startups, IPOs and high-growth stocks. You can set up a GRAT, use it to hold some of your highly appreciating stock for a year or two, and then have your children reap the benefit of the growth of the startup or the IPO without having to pay gift or estate taxes. This is even true if there is a stock that you believe will shoot up, such as a promising tech stock in a field that you believe in.

There is one downside to a GRAT. Unfortunately, if you die before the term of the annuity expires, the trust will be taxable at the full estate tax rate, which can be up to 55%. That’s why it’s important to not set the term too high.

A Grantor Retained Annuity Trust (GRAT) is an irrevocable trust established by a person called the grantor. The grantor transfers property with high appreciation potential to the GRAT for a number of years (called the “term”). In return for this transfer, the grantor receives an annuity payment (at least once every year) for the term of the GRAT. If income from the property in the GRAT is insufficient to pay the annuity payment, the property may be used to pay the annuity payment. After the term, any remainder property left in the GRAT is transferred to the grantor’s designated beneficiaries, estate and gift-tax free.

Why is it transferred to the remainder beneficiary estate and gift-tax free? Because the grantor pays gift tax on the transfer of property on the taxable year when the GRAT is established by reporting the gift in IRS Form 709 Gift Tax Return. The tax is computed using the formula provided under 26 USC § 2702: (Value of property transferred in trust) less (value of any qualified interest retained by the grantor) equals (value of gift). The value of the qualified interest retained by the grantor is the total amount of annuity payments to be received by the grantor from the trust, which is computed by IRS based on the §7520 rate. Thus, at the end of the term, if the property in the GRAT appreciated more than the total annuity payments, that difference is transferred to the beneficiary tax-free (since payment of the gift tax was already made at the start of the term). In order to not pay (or reduce payment of) any tax, the total annuity payments would be equal or almost equal to the value of the property. This is called the zeroed-out GRAT which was used in the case of Walton v. Commissioner, 115 T.C. 589 (2000).

Property in the GRAT is not included in the grantor’s probate estate (if the grantor did not die during the GRAT’s term) and is protected against claims of the grantor’s creditors. If the grantor, however, died during the GRAT term, the estate will retain the right to receive the annuity payments and this will be included in the grantor’s taxable estate under 26 USC §§ 2036 or 2039. The grantor, however, can transfer the right to receive the annuity payments to his surviving spouse under an estate tax marital deduction in order to eliminate estate tax.

Special rules in computing the annuity interest apply when the designated beneficiary in a GRAT is a family member.

Examples of using GRATs

For example, you own 10,000 shares of stock with a total current fair market value of $1,000,000. You put your stocks in a GRAT, with an annuity payment to you of $205,000 per year for 5 years. You designate your son as your remainder beneficiary who will receive whatever is left in the GRAT at the end of the 5 years. The current §7520 rate for October 2021 is 1%.

Based on this information, the total annuity payments you will receive in 5 years is $1,025,000 ($205,000 multiplied by 5), which will have a present value of $994,953.40. Based on this amount, you will file Form 709 Gift Tax Return on the taxable year you establish the GRAT (which is 2021), providing for a taxable gift of $1,000,000 less $994,953.40 or $5,046.60. Since the taxable gift in a GRAT is not a completed gift, it is not covered by the annual gift tax exclusion. You will have to pay a gift tax, which rate is based on the taxable gift of $5,046.60.

If your stock previously valued at $1,000,0000, at the end of five years, has grown to have a fair market value of $3,000,000, your son, the designated beneficiary, will receive the remainder property less the annuity payments you received, tax-free, since tax was already paid at the beginning of the GRAT term.

What if the assets appreciated slowly than the §7520 rate? In this case, there is no asset to transfer to the remainder beneficiary. The grantor is in the same situation as he was before he executed the GRAT. He simply got back his principal through annuity payments. However, he lost out on the nominal costs of establishing and administering the GRAT, such as legal fees paid to the attorney to draft the trust, the filing of the gift tax return, and the administrative cost of making the annuity payments yearly.

GRAT’s Tax Consequences

Aside from reducing gift and escaping estate tax, below are some tax considerations one must know in establishing a GRAT.

First, even if the GRAT is an irrevocable trust, the trust does not require its own taxpayer identification number. All the income of the GRAT is reported under the grantor’s social security number and income tax will be paid based on the grantor’s taxable income for the taxable year, based on the rates in the income tax bracket. The annuity payments, however, are not considered as income because they are considered merely as a transfer of principal between the same taxpayer.

In the example above, if the 10,000 shares received dividends of $10 per share, the grantor needs to report the income of $100,000 in his IRS Form 1040, Schedule B.

Second, there is a risk that IRS will value the trust asset higher than you have valued it in the gift tax return. This may result in a larger taxable gift and a higher gift tax liability. However, the GRAT can be drafted with an automatic adjustment in annuity payments in case IRS assesses a higher value for the property.

Third, if the term of the GRAT is completed, the designated beneficiaries do not receive a stepped-up basis of the property. In the example above, if, after the end of 5 years, the value of the 10,000 shares is $3,000,000, which is $300 per share, the beneficiaries do not get to use this basis in case they sell the shares they receive in the future. They will use the basis of $100 per share ($1,000,000 divided by 10,000 shares), based on the fair market value of the property when the GRAT was established and the gift tax was paid. Thus, if the beneficiary sells one share at market value of $300 after he receives it, he will need to pay capital gains tax on his profit of $200 (selling price of $300 less the basis of $100).

Other Considerations

Other GRAT points to consider are:

• The trustee and the grantor can be the same person.
• The GRAT must comply with the requirements of 26 USC § 2702 in order for the retained interest to not be valued at zero. Thus, the grantor’s interest must consist of the right to receive a fixed amount annually or a fixed percentage of the fair market value of the property annually. If the annuity payment is a fixed amount, it can also be graduated but the succeeding annuity payment cannot be more than 120% of the previous annuity payment.
• The trust instrument must require that the trustee actually pay the annuity amount to or for the benefit of the grantor. Just having the right to withdraw the annuity payment is not sufficient.
• The trust instrument should prohibit:
  1. Additional contributions to GRAT;
  2. Payments to another person other than the grantor before the expiration of the term; and
  3. Issuance of a note or other debt instrument to pay the annuity payments.
• It is better to have separate GRATs for different kinds of assets, so that the increase and decrease in value don’t cancel out. For example, if you put a stock that is decreasing in value together with a stock that is increasing in value in one GRAT, the corresponding increase and decrease in value will cancel each other out. However, if they are in separate GRATs, one GRAT can be successful, transferring to the beneficiary the appreciation, while the other GRAT can be unsuccessful, losing out on the nominal costs of GRAT establishment administration.

GRATs are an effective and almost risk-free way of transferring wealth to the next generation. It has been used by several billionaires to transfer property to their children, saving billions in taxes. If you are interested in establishing a GRAT, we at the Law Offices of Albert Goodwin are here for you. We have offices in New York City, Brooklyn, NY and Queens, NY. You can call us at 212-233-1233 or send us an email at [email protected].