GRAT planning with S corp. stock.

• Author: Sunderman, Teri L.
• Position: Grantor retained annuity trusts

EXECUTIVE SUMMARY

* GRATs leverage the donor's lifetime exemption by discounting the value of the future interest.

* Funding GRATs with S stock involves unique planning twists and opportunities.

* For a stock-funded GRAT, a planner should consider appropriate discounts to the transferred stock's FMV, to reduce transfer taxes on the GRAT's value.

A grantor retained annuity trust (GRAT) can be very a powerful tool in leveraging the lifetime exemption for a business owner who wishes to relinquish control of stock, in return for a certain period of annuity payments. This article explains how GRATs work and focuses on the requirements and planning opportunities for GRATs funded with S corporation stock.

The grantor retained annuity trust (GRAT) has long been just "another tool" in the experienced estate planner's arsenal. However, with the decline in interest rates and a favorable Tax Court case, (1) it has taken on new significance in long-term tax strategies, particularly for challenging family owned business-succession scenarios.

A GRAT allows a donor to leverage the $1 million taxable gift lifetime exemption, while creating a stream of cash payments for a certain period. At the same time, the donor can irrevocably relinquish control of the asset, so that its value and all future appreciation remain permanently outside his or her taxable estate. This article explains how GRATs work and focuses on the requirements and planning opportunities for GRATs funded with S corporation stock.

What Is a GRAT?

A GRAT has two parts--the annuity recipient (the grantor) and the assets' future owner (the remainder beneficiary). The trust assets' total value is effectively bifurcated: one piece is the annuity payments' present value; the other is the remaining value after taking the payments into account. Under Regs. Sec. 25.2702-1(b), the taxable gift is the remainder interest's present value. However, because the gift is a transferred future interest, the annual gift tax exclusion is not available, under Regs. Sec. 25.2503-3(a), although the lifetime exemption can be used. The GRAT's purpose is to leverage the lifetime exemption by discounting the value of the future interest.

Qualified Retained Interest

Sec. 2702 governs GRATs and is titled, "Special Valuation Rules in Case of Transfers of Interests in Trust." It is critical that the grantor's retained interest meet the Sec. 2702(b) definition of a qualified interest, because a nonqualified retained interest always has a zero value, under Sec. 2702(a)(2)(A). Consequently, the remainder interest (or taxable gift) would be valued at 100% of the transferred property's value.

To meet the qualified interest requirements, the governing instrument has to be drafted with extreme care and the trustee has to follow all provisions diligently. The trust terms have to provide the grantor with an irrevocable right to receive fixed payments (not just the trust's net income) at least annually, and the annuity payments have to be in cash or property to, or "for the benefit of," the grantor/holder of the retained interest. Under Regs. Sec. 25.2702-3(b)(1)(i), a mere "right of withdrawal," or the issuance of notes, debt instruments or options in satisfaction of the annuity amount, does not constitute payment. Accordingly, the property actually has to be transferred to meet the fixed payment definition.

A qualified interest is valued under Sec. 7520. The taxable gift is determined by subtracting the retained interest's value from the value of the trust property. The retained interest's value is the net present value (NPV) of the annual payments over the term of the annuity, using the published Sec. 7520 discount rate and tables found in Pub. 1457, Actuarial Values, Book Aleph, in effect at the time of the transfer. (2) A donor can elect to use the Sec. 7520 rate in effect for either of the two months preceding the transfer date. This allows the donor to select a more beneficial interest rate and, thus, the lowest taxable gift.

Planning Annuity Terms

Under Regs. Sec. 25.2702-3(d)(3), the annuity's fixed term must be for the grantor's life, or for a specified number of years, or for the shorter (but not longer) of those periods. The trust's term should be set so there is a reasonable prospect of the grantor surviving beyond the end of the term--otherwise, the grantor's death before the end of the term will cause at least a portion of the amount transferred to be included in the grantor's estate, under Secs. 2039 and 2036(a)(1). (3) The grantor's lifetime exemption will be restored accordingly; however, there is no restoration mechanism for the grantor's spouse's lifetime exemption. Consequently, a gift-splitting election is not a viable option. (4)

Annual Payments

The payments must be either a fixed dollar amount or a fixed percentage of the trust property's fair market value (FMV). The fixed percentage method may be advantageous if the property's valuation is uncertain or challengeable; use of a fixed dollar amount may result in an annuity payment set either too high or too low. For example, if a GRAT is funded with S stock and the company's valuation report fails to consider a key customer's bankruptcy proceedings, the stock's value may be overstated. In this case, a downward adjustment to the value is appropriate. However, if the payment to the grantor is fixed, the company may have difficulty generating the cash needed to pay the annuity following loss of a major revenue source. If the annuity were a percentage (e.g., 8% of the stock value), an adjustment could be made to both the overstated value and the annuity amount payable. (5)

Conversely, if an IRS examination finds that a minority or marketability discount was overstated, and increases the stock's FMV, the fixed annuity payments may be low in relation to the stock's value, as finally determined. In such case, the taxable gift (i.e., the remainder interest) could be higher than desired and result in significant gift tax. Thus, an annual payment set as a percentage may be prefereable, so that a payment can be adjusted based on the property's FMV as finally determined for Federal tax purposes.

Under Regs. Sec. 25.2702-3(b)(1)(ii), although an annuity based on a stated dollar amount can...