Shelfing The Shelf GRAT? Not So Fast

By: Randall A. Denha, J.D., LL.M.

A GRAT is a trust to which the Grantor transfers property in exchange for an annuity to be received for a period of time selected by the Grantor.  The transfer to the GRAT is reported as a gift at the fair market value of the property reduced by the annuity. A transfer is assumed to grow at a rate of interest set by the IRS.  Taxpayers hope the property transferred will appreciate in value or earn more income than the assumed interest rate, which is 2.08% in July. Where a GRAT earns income or appreciates in value in excess of 2.08%, the excess is not taxed as part of the gift. If $100 is assumed to grow, at 2.08%, to $104.21 in two years, any increase in value in excess of $104.21 escapes the gift tax calculation.  It is easy to understand why Treasury dislikes GRATs; however, the irony is that GRATs are creatures of regulation drafted by Treasury. If a grantor dies during the initial term, the property in the GRAT is restored to the estate of the grantor.

With this planning technique, the value of the assets sold to a trust are frozen for estate tax purposes, but the grantor retains certain interests causing the grantor to be responsible for paying taxes on the trust income. The assets grow tax-free, the trust beneficiaries avoid gift tax, and the grantor’s estate is no longer exposed to the increase in the assets’ value. Note that Biden’s tax plan may eliminate discounts, a key component of this transaction, so those who wish to use this strategy should consider acting soon.

A taxpayer could create a number of cash-funded GRATs today with different terms, for example a series of zeroed-out GRATs each funded with say $3,000,000, with terms of 2, 3, 5, 7 and 10 years, and the GRATs would be “locked-in” based upon the current historically Section 7520 rates. No taxable gift would be triggered currently since the GRATs are all zeroed-out.

A Zeroed-Out GRAT comes into play when the value of what the grantor gets back in the form of the annuity (actually the present value of the annuity interest) is equal to the value of the property transferred. In this situation the grantor makes a large gift of property to the GRAT, but sets the annuity at an amount so that, for gift tax purposes, there will be nothing left to pass to the heirs at the end of the term. However, if the trust’s assets appreciate above the hurdle rate, or 7520 rate as it’s commonly referred (currently 1.2% for July 2021), there will be value and appreciation that will pass tax free to the children. By utilizing a Zeroed-Out GRAT, a grantor can pass large amounts of value to their children gift and estate tax free.

These GRATs could be held “on the shelf” initially, meaning that they would simply be maintained in cash until some point in the future if it is decided by the Trustee to “activate” the Shelf GRATs. If the Shelf GRATs are never activated, then they would simply maintain the cash in an account and pay back the annuity payments in cash to the Grantor over the term of years; thus, the assets would essentially be returned to the Grantor over time.

However, if the Trustee determines the GRAT should be “activated,” for instance by the Grantor swapping assets with assets likely to appreciate in value with the cash already inside the GRAT.  The assets being swapped have to be appraised and a fair market value established for the appreciating assets as determined by a qualified appraiser. Once value is established, it is critical that the swap be done for fair market value in order to avoid violating IRS rules and causing the assets to be taxed in the estate. The good news with a GRAT is that it is treated as a grantor trust and a swap can be made without triggering built-in capital gain. The appreciating assets in the GRAT will thereafter grow inside the GRAT, and partial interests therein would be paid in-kind to satisfy the annuity payments required under the terms of the GRAT for the remaining annuity term.  If the assets inside the GRAT appreciate at an amount greater than the required annuity payments then all of the appreciation will pass to the remainder beneficiaries so long as the Grantor survives the annuity term, gift tax free. Thus, the activation of the GRAT essentially allows for the “creation” of a GRAT for the remaining annuity term. It is our hope that any changes in the tax laws will recognize the already created Shelf GRAT(s) and treat it as being “grandfathered.”