On Sunday, March 15, the Federal Reserve lowered the Federal Funds Rate to near zero. Designed to ease the burden on financial markets by making borrowing easier, the action – at a time of lowered stock values – created an opportune time to establish a Grantor Retained Annuity Trust as part of an overall estate plan.
A GRAT is an irrevocable trust with a fixed term – most frequently between two to ten years – to which a grantor transfers assets, in return for a fixed annual annuity. At the end of the trust term, after the grantor has received the annuity stream, any assets remaining in the trust are distributed to beneficiaries specified by the grantor. The transfer of assets to the GRAT is a gift, whose value is determined by the amount given to the trust, the amount the grantor receives and, crucially, the prevailing interest rate when the gift is made. When interest rates drop to unprecedented levels, the GRAT presents an opportunity.
The value of the grantor’s annuity stream is based on the federal funds rate. The tax code assumes that the value of the assets in the GRAT will grow at that rate. The lower the interest rate when a GRAT is established, the likelier it is that the GRAT will outperform the interest rate and assets can be transferred to the beneficiaries in a tax-free gift.
Therein lies the magic of a GRAT. By transferring assets with appreciation potential, one may transfer significant value out of the taxable estate without making a taxable gift. If the interest rate is low, and if the assets are transferred to the GRAT when they are at an abnormal, likely temporary dip, a GRAT offers heightened potential.
The effectiveness of the GRAT is best demonstrated using an example.
Grantor contributes $1,000,000 to a GRAT with a term of 2 years, and will receive an annuity of $500,000 each of those years. The terms of the trust provide that upon termination of the GRAT at the end of the 2 year term, the assets remaining in the GRAT will be distributed to the Grantor’s daughter. Using the interest rate issued by the IRS (currently1.2%), the present value of the Grantor’s annuity stream is $982,300. The difference between the fair market value of the property transferred to the GRAT ($1,000,000) and the value of the Grantor’s annuity stream ($982,300) is the value of the taxable gift ($17,700).
If the assets in the GRAT appreciate at a rate of 10% per year, the Grantor’s daughter will receive a distribution of $160,000 when the GRAT terminates, but at a gift tax value of $17,700.
The risk in establishing a GRAT is nil. The worst result is that the assets underperform the IRS interest rate, and all return to the grantor. If the GRAT is properly structured, the grantor will have used little or none of his or her lifetime exemption.
An environment of low interest rates and temporarily-depressed stock values is a time to consider establishing a GRAT.
We help clients to create GRATs, and stand ready to provide advice about other estate planning ideas.