Creative split-interest trusts are one of the most favored estate-planning strategies for passing wealth to succeeding generations. As planning grows more sophisticated in reaction to the special valuation Sections 270 1-2704 rules for transfers to family members, a new problem has developed, which to some comes as little surprise. The problem is that the IRS has appeared to take a position which may reduce the benefits of this strategy.
One of the more interesting estate-planning techniques to come along in years is the short-term grantor retained annuity trust (GRAT). A GRAT is a trust that pays the grantor a fixed annuity for a term of years and at the end of the term the property is transferred to the remainder beneficiary. Section 2702 requires that the grantor receive a fixed amount regardless of the income earned by the trust so that the retained interest can be valued when there is a transfer in trust to certain family members. For a basic discussion of the GRAT concept, See The Practical Accountant, February 1993, p. 42.
The value of the income and re-mainder interests of a GRAT for gift tax purposes are determined under Table B of the Treasury tables, using the Section 7520 rate, (6.8% as of January 1994). As long as the property transferred to the trust earns a higher rate of return (including ap-preciation) than the Section 7520 rate, there is a distinct gift tax advan-tage. How much of a gift tax advantage depends on the ability to leverage the transfer and what IRS inter-pretation is to be believed.
To minimize the gift tax value of the remainder interest under Table B, the grantor has two options: either the term of the trust can be extended or the annuity rate can be increased. in other words, if the trust exists for a long enough term, or alternatively, if it pays a very high annuity for a shorter term, the value of the re-tained annuity will almost equal the value of the property transferred, thereby resulting in a gift of zero value; a.k.a., SUPERGRAT.
Unbelievable Result
One particularly effective permuta-tion of this technique, discussed in Lir. Rul. 9239015, is a short-term GRAT. There a two-year GRAT created by a 54-year old grantor provided for payments equal to 27.888% of trust on creation, 55.776% a year later and 27.888% on termination of the trust. When the GRAT was created, the Section 7520 rate was 8.4%. The ruling held that the value of the retained interest was 99.17 10/a (so the gift was valued at only .829%). The IRS cited Reg. 25.2702-3(e), Example 1 to support this conclusion, since the grantor had retained a reversion contingent on his death.
To see how to maximize the lever-age a GRAT can afford using this logic, assume that on January 1, Father transfers $5,000,000 worth of closely held stock to a two-year GRAT when the Section 7520 rate is 7%. The GRAT requires that a 55.3% annuity ($2,765,000) be paid to Father at the end of each year. Any remaining assets at the end of the two-year term will be paid to Daughter. The value of the gift for gift tax purposes is $880 assuming that no re-version is retained.
If the rate of return (including appreciation) is 10% each year the amount actually passing to Daughter is computed in the box on the next page. Daughter would receive the $243,500 free of gift tax to Father. If the rate of return were instead 20%, she would receive $1,117,000 free of gift tax. As long as the annual return exceeds the Section 7520 rate, the short-term GRAT presents leveraging opportunities that cannot be achieved with an outright gift.
The obvious question is that since the trust doesn't earn 55%, how will the trustee pay Father the required annuity? The trustee can simply use the trust property (i.e. the shares of stock) to satisfy this obligation as the trust would permit distributions of principal in kind. In our example. each year the trustee would distribute S2.765,000 worth of shares (applying appropriate valuation methods) back to Father. Since the trust is a grantor trust there would be no income tax consequences on the transfer.
Each year, Father can create a new GRAT for the succeeding two years and continue this rollover process of the stock, as long as it remains worth-while. Besides the ability to leverage. the short-term GRAT reduces the possibility that the grantor will die before a trust term ends with the re-sult that the trust property would be included in the grantor's estate and subject to estate tax.
Closer to Earth
Does it look too good to be true? It very well might be if one considers Example 5 of Reg. 25.2702-3(e) which states that a qualified annuity cannot continue after the death of the grantor. Therefore, even if a fixed term is used (which meets the qualified annuity interest requirement) the value of the retained interest will be based on the shorter of the term or the earlier death of the grantor. The effect of this can be a substantially greater value for the remainder interest. Many estate planners believe that the IRS interpretation represented by Example 5 is wrong.
Assuming that the reasoning of Ex-ample 5 was applied to the GRAT that the Father had created, the daughter's remainder interest would be valued at S45,950 (based on a male grantor aged 55) instead of S880, a significant difference. Howev-er, careful drafting could mitigate this unfavorable result. First, the trust should be drafted without providing for a reversion to the grantor's estate if he or she dies within the term. In addition, the trust, that could provide that if the grantor dies within the term of the trust, that the remaining annuity payments be made to his or her spouse. By adding a second life, the value of the retained interest in-creases significantly since there is a much greater chance that one of the two will survive the term. But since the spouse's interest would not be able to qualify for the marital deduc-tion (because it is terminable) the trust agreement should allow the grantor to revoke such spouse's inter-est in his or her will.
Although GRATs may be useful, they are not for every client with a large estate; only those individuals with assets generating above-average returns or assets having substantial ap-preciation potential should consider taking advantage of this technique.
- Year
- Beginning
Value - 10% Annual Return
(inc. appreciation) - Annuity
Payment - Ending
Balance - 1
- 5,000,000
- 500,000
- 2,765,000
- 2,735,000
- 2
- 2,735,000
- 273,500
- 2,765,000
- 243,500
- If this transfer is a minority interest, Father can also take advantage of the minority discount rules and take a further discount for gift tax purposes, gaining even further leverage. ('See The Practical Accountant, April 1993, p. 59 for a discussion of minority discounts involving family transfers).
- See Covey, Practical Drafting (April 1992) p. 2792, McCaffrey, Estate Planning With Split Interest Transfers: GRATs and QPRTs, NYU institute of Federal Taxation, Trusts and Estates, June 1993.
GIDEON ROTHSCHILD, CPA, J.D., practices law in New York City. He specializes in estate planning and tax matters.