Low Interest Rates Create Unique Opportunity to Use a GRAT
January 1, 2008
Today's low interest rates provide a tremendous opportunity to take advantage of several effective estate planning techniques, one of which is known as a grantor retained annuity trust ("GRAT"). A GRAT is particularly compelling when interest rates are low because it is designed to allow an individual to transfer the difference between the growth rate of investment assets and the applicable statutory interest rate imposed by the Internal Revenue Service to younger generations without the payment of gift or estate taxes. A GRAT is specifically sanctioned by the Internal Revenue Code and will be most effective when used in conjunction with other estate planning tools.
What is a GRAT?
A GRAT is an irrevocable trust into which an individual (the "Grantor") transfers assets and retains the right to receive a payment of an annual amount for a specified number of years. The annual annuity payment is based on an interest rate, known as the 7520 rate, which is linked to auctions of U.S. Treasury notes and is calculated monthly by the Internal Revenue Service (the "IRS Rate"). At the end of the GRAT term, when all of the annuity payments to the Grantor have been made, the remaining assets in the GRAT pass to designated beneficiaries (i.e. children) outright or in trust. The assets transferred to the GRAT, ideally assets expected to appreciate significantly over the term of the GRAT, may consist of cash, stocks, mutual funds, real estate, or other investment and income producing property. In order for the GRAT to be successful, the assets transferred to the GRAT must earn a rate of interest higher than the IRS Rate. Therefore, with the current IRS Rate set very low, it is easier for a GRAT to outperform the IRS Rate and transfer the excess appreciation in investment assets to designated beneficiaries.
On June 1, 2008, a 60 year old Grantor contributes stock worth $1,000,000 to a GRAT with a five-year term that is designed to have a minimal taxable gift upon creation. The annual annuity required to be paid to the Grantor is $223,145. The table below illustrates how today's low IRS Rate allows a Grantor to pass significant wealth to designated beneficiaries without a taxable gift. If the stock grows in value at 5% per year, the designated beneficiaries will receive over $43,000 at the end of a five-year term and if returns reach 20%, over $827,000 will pass to designated beneficiaries without the payment of gift tax.
ANNUAL RETURN ON TRUST ASSESTS
TAX FREE GIFT TO DESIGNATED BENEFICIARIES
No Real Risks
There are two risks inherent in the creation of a GRAT. The first risk is that the trust assets will not generate a return in excess of the IRS Rate. If the trust assets fail to produce a high enough rate of return, all of the trust assets will be returned to the Grantor. While the benefit of assets being passed to lower generations at no transfer tax cost will not have been achieved, the only "loss" is the transaction cost required to set up the GRAT. The second risk is that the Grantor does not survive the GRAT term and the trust assets will be considered part of the Grantor's taxable estate. Again, in that event the Grantor's estate would be no worse off and the only "loss" is the transaction cost required to set up the GRAT. Additionally, a GRAT is usually considered a grantor-type trust which alleviates any complications for income tax purposes. In essence, there are no adverse tax consequences in either so-called risk situations.
The IRS Rate has fluctuated between 3.0% and 11% since 1989. The IRS Rate for June, 2008 is 3.8%. The current low interest rate environment provides a great atmosphere for the use of a GRAT. This low IRS Rate allows the Grantor to maximize the difference between the growth rate of investment assets and the IRS Rate while transferring the difference to designated beneficiaries. If the GRAT fails because of poor performance or the Grantor passes away prior to the end of the GRAT term, it is essentially no different than if the assets were held outside of the GRAT for the same time period. A GRAT is really a win-win proposition and an excellent wealth transfer option in this low interest rate environment.