GRATs represent a significant opportunity, particularly for S shareholders.

• Author: Coplan, Robert B.
• Position: Grantor retained annuity trusts

Clients with interests in closely held businesses--whether S corporation, C corporation or partnership--can benefit from grantor retained annuity trusts (GRATs) if they expect the total return (i.e., current income and appreciation) on their investment to exceed the adjusted Federal rate (AFR) used as the assumed asset appreciation rate for valuing gifts to these trusts. Because this AFR (set under Sec. 7520) is at a historic low of 6.0% for transfers in October and November 1993, clients with assets expected to average an annual return (growth and/or income) in excess of 6.0% over the next few years can achieve dramatic transfer tax savings with a GRAT.

In a GRAT transaction, the grantor transfers property to a trust, retaining the right to receive a fixed annuity payment for a specified number of years. At the end of the trust term, the property remaining in the trust goes to the grantor's children or other named beneficiaries, or remains in trust for their benefit.

When S stock is used in the GRAT, the cash distributions from the corporation to the trust can be used to satisfy the annuity payment. Therefore, when the S corporation produces a strong net cash flow or has a large accumulated adjustments account, all or a large portion of the grantor's annuity may be satisfied on a current basis with cash that is paid to the GRAT by the company.

To the extent that the annuity can be satisfied with cash, more of the stock will pass to the grantor's children at the end of the trust term. Because the annuity is fixed, as S earnings increase over the trust term, it will become easier to generate cash to satisfy the annuity. If each year's entire annuity can be satisfied with cash distributions from the S corporation, all of the stock transferred to the GRAT will pass to the children virtually free of estate and gift tax.

The fact that a GRAT should in all cases be set up as a grantor trust for income tax purposes makes it an eligible shareholder of S stock. As a grantor trust, the grantor owes income tax on the entire amount of S earnings reported to the GRAT, even if not distributed by the S corporation, and even if it exceeds the grantor's fixed annuity. Thus, added estate benefits would be produced to the extent that part of the grantor's annuity is used to pay...