GRATsGRATs

Presented by:Presented by:Michael W. Halloran CFPMichael W. Halloran CFP®®, AEP, ChFC, AEP, ChFC®®, ,

CLUCLU®®

October 28, 2010October 28, 2010Chattanooga Estate Planning CouncilChattanooga Estate Planning Council

Grantor-Retained Grantor-Retained Annuity TrustAnnuity Trust

What is a GRAT?What is a GRAT?

A GRAT is an irrevocable trust in which A GRAT is an irrevocable trust in which the grantor can transfer property to a the grantor can transfer property to a beneficiary at a reduced gift tax cost beneficiary at a reduced gift tax cost while retaining an annual annuity for while retaining an annual annuity for life (or the joint lives of the grantor and life (or the joint lives of the grantor and others) or for a term of years.others) or for a term of years.

Grantor-Retained Grantor-Retained Annuity TrustAnnuity Trust

Why create a GRAT?Why create a GRAT?

The grantor retains an interest in the The grantor retains an interest in the trust property, the grantor’s gift is the trust property, the grantor’s gift is the fair market value of the property fair market value of the property transferred, less the present value of transferred, less the present value of the retained annuity payments.the retained annuity payments.

An estate owner may use the GRAT to transfer An estate owner may use the GRAT to transfer assets andassets and

future appreciation to his or her children.future appreciation to his or her children.

Parent transfers remainder interest in an asset to trust

Grantor (parent)

Parent retains right to receive a Fixed payment (at least annually) for 10 years.

GRATIrrevocable trust

At the end of the designated time period, the At the end of the designated time period, the remainderremainder

passes to the grantor’s children.passes to the grantor’s children.

Annual Payment Annual Payment to the Grantorto the Grantor

First-Year First-Year Payment as a Payment as a

Percentage of the Percentage of the AssetAsset

Value of the Value of the Retained InterestRetained Interest

Gift Tax Value of Gift Tax Value of the Remainder the Remainder

InterestInterest

$30,000$30,000 6%6% $243,327$243,327 $256,673$256,673

$40,000$40,000 8%8% $324,436$324,436 $175,564$175,564

$50,000$50,000 10%10% $405,545$405,545 $94,455$94,455

$60,000$60,000 12%12% $486,654$486,654 $13,346$13,346

The value of the transferred asset minus the value of the retained annuity interest will equal the value of the remainder interest that is subject to gift taxation.

Assumptions:Value of asset placed in GRAT: $500,000

Age of grantor: 65Type of payment: End of year

Term of payment: 10 yearsFederal discount rate (changes monthly): 4.0%

When is a GRATs use When is a GRATs use indicated?indicated?

Where the client is single and has a substantial Where the client is single and has a substantial estate which federal estate taxes are certain to estate which federal estate taxes are certain to be paid.be paid.

A wealthy widows or widowers, divorced A wealthy widows or widowers, divorced individuals, or other unmarried persons can use individuals, or other unmarried persons can use as a “marital deduction substitute.as a “marital deduction substitute.

A married couple with an estate in excess of the A married couple with an estate in excess of the couples combined unified credit equivalent, can couples combined unified credit equivalent, can use a GRAT to eliminate or reduce taxes on the use a GRAT to eliminate or reduce taxes on the death of the second spouse to die.death of the second spouse to die.

Protects assets from a will contest, public Protects assets from a will contest, public scrutiny, or election against the will if the grantor scrutiny, or election against the will if the grantor survives the trust term.survives the trust term.

When is a GRATs use When is a GRATs use indicated?indicated?

As an alternative to a recapitalization or other freezing As an alternative to a recapitalization or other freezing technique that has the added advantages of gift tax technique that has the added advantages of gift tax leverage and possible estate tax savings.leverage and possible estate tax savings.

When the client will outlive the trust term that is When the client will outlive the trust term that is needed to obtain a low present value gift to the needed to obtain a low present value gift to the remainder person.remainder person.

The clients assets are so substantial that a significant The clients assets are so substantial that a significant portion can be committed to a remainder person portion can be committed to a remainder person without compromising his own personal financial without compromising his own personal financial security.security.

When the client has a high risk tolerance and a strong When the client has a high risk tolerance and a strong incentive to achieve gift and estate tax savings.incentive to achieve gift and estate tax savings.

RequirementsRequirements An irrevocable trust must be established.An irrevocable trust must be established.

Evidence should be obtained of the value of the Evidence should be obtained of the value of the assets placed in the GRAT.assets placed in the GRAT.

The grantor should be given a mandatory annuity The grantor should be given a mandatory annuity or unitrust interest.or unitrust interest.

The grantor should be given ONLY the annuity or The grantor should be given ONLY the annuity or unitrust interest.unitrust interest.

Not a requirement but the trustee should be Not a requirement but the trustee should be someone other than the grantor or the grantor’s someone other than the grantor or the grantor’s spouse, especially after the grantor’s retained spouse, especially after the grantor’s retained interest has ended. interest has ended.

A 61 year-old affluent individual creates a 10-year A 61 year-old affluent individual creates a 10-year GRAT with anGRAT with an

annuity payout of 13.33%.annuity payout of 13.33%.

• The individual’s property, valued at $2,297,320 is The individual’s property, valued at $2,297,320 is gifted to the GRATgifted to the GRAT

• The property earns an annual income of 3%The property earns an annual income of 3%

• The property’s value grows at a rate of 10.18%The property’s value grows at a rate of 10.18%

• The IRC Section 7520 discount rate is 5.6%The IRC Section 7520 discount rate is 5.6%

• The individual has an estate tax liability of $20 The individual has an estate tax liability of $20 million.million.

Economic ScheduleEconomic ScheduleYearYear Beginning Beginning

PrincipalPrincipal10.18%10.18%

GrowthGrowth3% 3%

Annual Annual

IncomeIncome

Annual Annual

PaymentPaymentRemaindeRemainde

rr

11 $2,297,320$2,297,320.00.00

$233,867.1$233,867.188

$72,427.61$72,427.61 $306,243.7$306,243.788

$2,297,371$2,297,371.01.01

22 $2,297,371$2,297,371.01.01

$233,872.3$233,872.377

$72,429.22$72,429.22 $306,243.7$306,243.788

$2,297,428$2,297,428.82.82

33 $2,297,428$2,297,428.82.82

$233,878.2$233,878.255

$72,431.04$72,431.04 $306,243.7$306,243.788

$2,297,494$2,297,494.33.33

44 $2,297,494$2,297,494.33.33

$233,884.9$233,884.922

$72,433.10$72,433.10 $306,243.7$306,243.788

$2,297,568$2,297,568.57.57

55 $2,297,568$2,297,568.57.57

$233,892.4$233,892.488

$72,435.44$72,435.44 $306,243.7$306,243.788

$2,297,652$2,297,652.71.71

66 $2,297,652$2,297,652.71.71

$233,901.0$233,901.055

$72,438.10$72,438.10 $306,243.7$306,243.788

$2,297,748$2,297,748.08.08

77 $2,297,748$2,297,748.08.08

$233,901.7$233,901.755

$72,441.10$72,441.10 $306,243.7$306,243.788

$2,297,856$2,297,856.15.15

88 $2,297,856$2,297,856.15.15

$233,921.7$233,921.766

$72,444.51$72,444.51 $306,243.7$306,243.788

$2,297,978$2,297,978.64.64

99 $2,297,978$2,297,978.64.64

$233,934.2$233,934.233

$72,448.37$72,448.37 $306,243.7$306,243.788

$2,298,117$2,298,117.46.46

1010 $2,298,117$2,298,117.46.46

$233,948.3$233,948.366

$72,452.75$72,452.75 $306,243.7$306,243.788

$2,298,274$2,298,274.79.79

SummarySummary $2,297,32$2,297,320.000.00

$2,339,01$2,339,011.351.35

$724,381.$724,381.2424

$3,062,43$3,062,437.807.80

$2,298,27$2,298,274.794.79

Most people would gladly choose to pay $229,732 in premiums rather than the full $20 million in estate tax.

Tax ImplicationsTax Implications If the grantor outlives the specified term, none of If the grantor outlives the specified term, none of

the trust’s assets should be included in the the trust’s assets should be included in the grantor’s estate. This is because the grantor has grantor’s estate. This is because the grantor has retained no interest in trust assets at death.retained no interest in trust assets at death.

The gift to the remainder person is a gift of a The gift to the remainder person is a gift of a future interest. It cannot qualify for the gift tax future interest. It cannot qualify for the gift tax annual exclusion.annual exclusion.

If the grantor lives beyond the specified term, If the grantor lives beyond the specified term, there should be no further transfer tax since the there should be no further transfer tax since the gift was complete upon the funding of the trust.gift was complete upon the funding of the trust.

The taxable portion of post- ’76 gifts is The taxable portion of post- ’76 gifts is considered an “adjusted taxable gift”.considered an “adjusted taxable gift”.

Tax ImplicationsTax Implications At the grantor’s death beyond the specified term At the grantor’s death beyond the specified term

of years, no step-up in basis for the property will of years, no step-up in basis for the property will be allowed. Instead, basis is fractionalized.be allowed. Instead, basis is fractionalized.

If the grantor dies before the specified term If the grantor dies before the specified term expires, the date of death value of the property expires, the date of death value of the property will be includable in the grantor’s gross estate.will be includable in the grantor’s gross estate.

If appreciated property is transferred the tax on If appreciated property is transferred the tax on any gain will eventually be paid by (a) the any gain will eventually be paid by (a) the grantor, or (b) the trust, or © the beneficiaries.grantor, or (b) the trust, or © the beneficiaries.

GRATs are generally subject to IRC Section GRATs are generally subject to IRC Section 2702.2702.

Section 2702Section 2702 States that all retained interests in trusts that are States that all retained interests in trusts that are

not “qualified interests” are values at zero. not “qualified interests” are values at zero. The amount of any gift is then determined by subtracting The amount of any gift is then determined by subtracting

from the value of the property the value of the retained from the value of the property the value of the retained interest.interest.

Those that do not apply:Those that do not apply:

Personal residence trusts

Charitable remainder

annuity trusts and

pooled income funds

Charitable lead

trustsCertain charitable remainder

unitrusts

Section 2702 InterestSection 2702 Interest

Qualified interests are valued under IRC Qualified interests are valued under IRC Section 7520Section 7520 Example: at approx. 120% of the applicable federal midterm Example: at approx. 120% of the applicable federal midterm

interest rate under IRC Section 1274(d)(1) for the month into interest rate under IRC Section 1274(d)(1) for the month into which the valution falls.which the valution falls.

A Qualified interest is:A Qualified interest is: A qualified annuity interestA qualified annuity interest A qualified unitrustA qualified unitrust A qualified remainder interestA qualified remainder interest

Section 2702 Rate is 2.4% - for September Section 2702 Rate is 2.4% - for September 20102010

Section 2702Section 2702 What applies under Section 2702?What applies under Section 2702?

A member of the family includes the spouse of an A member of the family includes the spouse of an individual, ancestor, lineal descendant, or the individual’s individual, ancestor, lineal descendant, or the individual’s spouse, the brother or sister, and the spouse of any such spouse, the brother or sister, and the spouse of any such person.person.

An applicable family member includes the spouse of an An applicable family member includes the spouse of an individual, the ancestor of the individual, or the individual’s individual, the ancestor of the individual, or the individual’s spouse, and the spouse of any such personspouse, and the spouse of any such person

A transfer in trust includes a transfer to a new trust or A transfer in trust includes a transfer to a new trust or existing trust or assignment of an interest in an existing existing trust or assignment of an interest in an existing trust, but not a transfer resulting from exercise of a power trust, but not a transfer resulting from exercise of a power of appointment that would constitute a taxable gift or a of appointment that would constitute a taxable gift or a disclaimer.disclaimer.

The retained interest is one held by the same individual The retained interest is one held by the same individual both before and after the transfer to the trust.both before and after the transfer to the trust.

Proposed Legislative Proposed Legislative ChangesChanges

GRATs minimum requirement to a term of GRATs minimum requirement to a term of at least 10 yearsat least 10 years

The amount of the GRATs taxable gift to The amount of the GRATs taxable gift to be greater than zero. No more “zeroed-be greater than zero. No more “zeroed-out GRATs”out GRATs”

Annuity payments must stay the same Annuity payments must stay the same each year during the annuity term and each year during the annuity term and cannot increase in subsequent years.cannot increase in subsequent years.

Advantages / Advantages / DisadvantageDisadvantage

• Gift taxes are based on the Gift taxes are based on the value of the gift to the donee value of the gift to the donee and a gift must be and a gift must be “discounted” by the cost of “discounted” by the cost of waiting.waiting.

• Once the grantor lives longer Once the grantor lives longer than the specified term, he than the specified term, he neither owns the property in neither owns the property in the trust nor any rights the trust nor any rights thereto. It escapes estate thereto. It escapes estate taxation.taxation.

• If the client dies during the If the client dies during the specified term, the result is specified term, the result is that the property plus any that the property plus any appreciation will be includable appreciation will be includable in his estate (same result as if in his estate (same result as if the client had done nothing).the client had done nothing).

• Attorney fees and other Attorney fees and other transaction costs, such as transaction costs, such as appraisal fees and property appraisal fees and property titling costs.titling costs.

• If the grantor does die If the grantor does die during the specified trust during the specified trust term, his executor may be term, his executor may be liable for tax on the liable for tax on the includable assets – the includable assets – the property itself might not be property itself might not be available to pay the tax. available to pay the tax.

• Lost opportunity cost. A Lost opportunity cost. A GRAT is an irrevocable GRAT is an irrevocable trust. trust.

Questions? Questions?