By: Randall A. Denha, JD, LL.M.
A Grantor Retained Annuity Trust (“GRAT”) is one of the estate planning techniques based primarily on interest rate assumptions. Clients create GRATs using assets that are likely to earn more than the Internal Revenue Service’s measuring standard commonly referred to as the section 7520 rate (“hurdle rate”) during the GRAT term in an effort to pass the appreciation in the assets to the beneficiaries of the trust free of gift and estate tax. Put another way, a GRAT is a form of irrevocable trust that allows the grantor to take a calculated risk to lower the grantor’s taxable estate.
Here’s how the GRAT works: The grantor transfers specific assets or property into the GRAT. The language in the GRAT stipulates that every year the grantor will receive a fixed payment, i.e. an annuity payment, back from the trust over a fixed number of years. A typically time period for a GRAT is 2 to 5 years or longer. If the grantor survives this period-a condition for this tool to work-any remaining property left in the trust will pass to family members or to a trust for their benefit (known as remainder beneficiaries.) At the end of the term, the remainder beneficiaries get whatever is left. If the assets in the GRAT appreciate at a rate greater than the hurdle rate, all the excess passes to the beneficiaries. If it doesn’t then the GRAT can satisfy its payout obligation by returning the GRAT assets back to the grantor. If structured properly, a grantor can establish a GRAT with little to no use of his/her gift tax exemption.
Given the current low interest rate environment, the April 2012 hurdle rate is 1.40%. This is extremely low and increases the amount a grantor can pass to beneficiaries free of gift tax. In fact, most GRAT are calculated to have a gift value of zero or an amount very close to zero. These are called Zeroed-Out GRATS or Walton GRATS after the Walton family created this sort of trust with millions of dollars and reported a near zero gift tax cost. You must report the annuity payments on your individual income tax return, but any investment growth in excess of the Section 7520 interest rate passes to the trust’s beneficiary free of gift tax.
So how does Facebook and GRAT technique have any commonality? Well, for starters, Mark Zuckerberg and Dustin Moskovitz, founders of the social media giant, Facebook, have created GRATs to transfer their pre-IPO stock into a GRAT that should explode in value when the company goes public. In fact, all of the post-gift appreciation will pass outside the clutches of the estate and gift tax system.
So how much will these Facebook billionaires wind up shifting? If the gifted stock grows at a modest 3.6% for the first four years and the term of the GRAT is five years and the shares of Facebook go public at $40.00 per share, Mark Zuckerberg will have transferred $37,315,513 free of gift and estate taxes!
Upon expiration of the GRAT term, the remainder beneficiaries can either be an individual, another trust or a charity. My recommendation is to always name a continuing trust for the benefit of the beneficiaries so that controls can still be maintained on their behavior and motivation.
What can you learn from the Facebook billionaires? The GRAT is a terrific tool for shifting assets that you expect to suddenly increase in value. With property that is difficult to value, as may be the case with closely held stock or real estate, a GRAT offers an additional benefit. By expressing the annuity as a percentage of the initial value of the GRAT, you permit the trust to simply pay a larger annuity if the IRS determines the property is worth more than you initially figured. This minimizes the additional gift tax the IRS might try to impose if it audits the value of the gift.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.