Planning for Grats

• Jurisdiction: Maryland

VII. PLANNING FOR GRATS

A. What Makes a Grantor Retained Annuity Trust (GRAT) Work

In order for a GRAT to be successful, the rate of total return on the assets transferred to the GRAT must, during its term, exceed the I.R.C. § 7520 rate used to value the grantor's annuity interest. The amount represented by that excess will flow to the remaindermen, resulting in the present value of the amount received by them at the time of the gift actually being higher than the taxable gift.

On the other hand, if the GRAT assets underperform the I.R.C. § 7520 rate, the grantor's fixed annuity will necessarily be funded in part from the portion of the GRAT which would otherwise have passed to the remaindermen (i.e., from the grantor's taxable gifts). Under these circumstances, not only is the present value of what the remaindermen ultimately receive less than the grantor's taxable gift, the full amount of those taxable gifts are adjusted taxable gifts which will be taken into account in calculating the grantor's estate tax liability.

B. The Theoretical Ideal GRAT

The best GRAT is one in which the grantor's retained annuity equals the value of the property transferred to the trust. In that case, the taxable gift is zero. As a result, if the trust assets outperform the I.R.C. § 7520 rate, the entire "appreciation" passes to the remaindermen. On the other hand, if the trust underperforms that rate, all of the assets of the trust will be exhausted in satisfying the grantor's annuity. Since the grantor has not made a taxable gift, the GRAT represents a transfer where he or she has everything to gain and nothing to lose. This type of GRAT is known as a "zeroed-out GRAT."

Actually, the GRAT does not really have to out-perform the I.R.C. § 7520 rate to be successful. The GRAT will be successful if it yields, over a two-year period, anything in excess of approximately one and one-half times the I.R.C. § 7520 rate. The following table shows the total annuity payments from a zeroed-out GRAT established with $100 at various I.R.C. § 7520 rates:

Section 7520 rate:	Total annuity payments for 2 years:
4.0%	$105.64
6.0%	$108.74
8.0%	$111.82
10.0%	$114.92

Anything left over in the GRAT after making the two annuity payments passes to the beneficiaries tax-free.

These calculations assume two equal annual payments. The second payment may be up to 20% larger than the first, which would make it easier for the GRAT to be successful, if appreciation is steady over the two-year period. Keep in mind that the grantor is paying the income tax as well, and it becomes even easier for a GRAT to be successful.

C. Zeroed-Out GRATs: IRS Position Successfully Challenged

1. The position of the Internal Revenue Service
At one time, the IRS took the position that a GRAT cannot be zeroed-out. Former Treas. Reg. § 25.2702-3(e), Example 5, without reference to any authority, indicated that a retained interest is a Qualified Interest only to the extent of the grantor's right to receive an annuity for the trust term or until the grantor's prior death. Since the grantor may die during the trust term, the value of his or her retained interest could never equal 100% of the trust property. For this purpose, the IRS did not treat the payment of the annuity to the grantor's estate as a retained interest.
2. Taxpayer victory
In December 2000, the Tax Court ruled in Walton v. Commissioner²⁷that Example 5 is invalid. The case involved $100 million of WalMart stock transferred to a two-year zeroed out GRAT. The IRS acquiesced to the Walton result.²⁸ On February 25, 2005, the IRS issued final regulations in which annuity payments made to the grantor's estate must be treated as having been made to the grantor for purposes of calculating the value of the grantor's retained annuity interest.²⁹
3. No taxable gift
It is now possible to make a GRAT with no current taxable gift. This is very useful, especially for taxpayers who have used their entire $12.92 million lifetime exemption from gift tax.
4. Qualifying for the marital deduction with a Walton GRAT
As noted above, most or all of the GRAT assets will be included in the grantor's estate under I.R.C. § 2036 if he dies during the trust term. Therefore, it is important that the GRAT assets pass to the grantor's surviving spouse and qualify for the marital deduction.

a. Annuity payments
As discussed above, the GRAT should provide that the annuity payments pass to the grantor's estate in order to qualify as a Walton GRAT. In order for the annuity payments to qualify for the marital deduction, the grantor's will should be revised to bequeath the annuity payments to the surviving spouse or a qualified terminable interest property (QTIP) trust.
b. Remainder
The GRAT should provide that if the grantor dies during the trust term, the GRAT remainder (after making the annuity payments to the grantor's estate) passes pursuant to a general testamentary power of appointment exercisable by the grantor. The attached GRAT form contains sample language in which the grantor reserves a general power of appointment over that portion of the GRAT includible in the grantor's estate (Item SECOND). The grantor's will should be revised to exercise the general power of appointment in favor of the surviving spouse or QTIP trust. Alternatively, the GRAT could provide that the GRAT remainder passes directly to the spouse or QTIP trust. It is NOT advisable for the GRAT remainder to pass to the grantor's estate because the IRS could aggregate the annuity payments and the remainder, and then claim that the entire GRAT was a reversionary interest that must be valued at zero.

D. Revocable Spousal Annuities

Prior to Walton, grantors often used a "revocable spousal annuity" to reduce the value of the gift. It was thought that continuing an annuity for a spouse in the event the grantor died before the end of the term would result in a smaller gift. The IRS ruled, however, in I.R.S. Tech. Adv. Mem. 9707001 (Feb. 14, 1997) that a spouse's right to receive an annuity for the balance of the grantor's retained term in the event the grantor died during the term was no different than the interest which would pass to the grantor's estate in the event of death during the term. The IRS reached the same result in I.R.S. Tech. Adv. Mem. 200230003 (July 26, 2002).

The Tax Court sustained the IRS's view in Cook v. Commissioner³⁰and Schott v. Commissioner,³¹because the spousal interest was contingent upon surviving the grantor. Since the interest might never take effect, it could not be valued. The Tax Court decision in Cook was upheld in the Seventh Circuit,³² but the decision in Schott was reversed in the Ninth Circuit.³³

On February 25, 2005, the IRS issued final regulations rejecting contingent revocable spousal annuity interests.³⁴ In Estate of Focardi v. Commissioner,³⁵the Tax Court again sustained the IRS's view, and noted the new final regulations.

E. Short-Term Trusts Are Better Than Long-Term Trusts

A series of short-term GRATs has a greater potential for success than a single longer-term GRAT. This is because assets do not grow or shrink in value at a constant rate.

In a longer-term GRAT, the remaindermen receive both the benefit of good investment performance and the consequences of bad performance over the entire length of the trust term.

By using a shorter-term GRAT, there is more likelihood that the "good" years will be isolated from the "poor" ones, with the result that more will pass to the remaindermen.

Moreover, by creating a series of shorter-term GRATs, a grantor has the flexibility of calling a halt to the process and keeping the trust assets in his or her pocket.

Minimum term. Many commentators believe that the minimum GRAT term must be two years in length. Neither I.R.C. § 2702 or the regulations mandate a minimum term, but the reference in I.R.C. § 2702(b)(1) to "fixed amounts payable not less frequently than annually" suggests that the GRAT produce at least two annual payments.

F. Single Asset Trusts Are Better Than Multiple Asset Trusts

For reasons similar to those set forth for short-term trusts, funding a series of nearly zeroed-out GRATs with one investment each is better than using multiple investments in a single GRAT. With multiple trusts, the remaindermen will reap the benefits of each investment which outperforms the I.R.C. § 7520 rate while receiving nothing from the trusts holding investments that underperform that rate. With a single trust, however, the poor investments will offset the good ones and the remaindermen will receive benefits determined by the average total return of all assets.

For someone concerned that the IRS would merge a series of single asset trusts, the client can provide for different remaindermen.

G. Layered GRATs

Some planners recommend creating a series of two-year GRATs using the annuity received from the existing GRATs to create a new one each year.

H. Paying the Annuity

How is the annuity satisfied if there is insufficient cash flow in the GRAT to do so? One way is to transfer assets to the grantor in satisfaction of the obligation to pay the annuity. Due to the grantor trust status of the GRAT, this does not constitute a taxable event.

In I.R.S. Tech. Adv. Mem. 9604005 (Jan. 26, 1996), the IRS held that the annuity could not be satisfied with a promissory note because Treas. Reg. § 25.2702-3(b)(1) requires that the annuity must be "paid" no less frequently than annually. For this purpose, the IRS found that delivering a promissory note was not payment. The IRS followed up this ruling by issuing new regulations requiring the governing instrument to prohibit the trustee from satisfying the annuity by issuing a note, other debt instrument, option, or other financial arrangement. Treas. Reg. § 25.2702-3(d)(6)(i). The preamble to the final regulations permits the trustee to borrow from another source (other than the grantor, either directly or indirectly) and to satisfy...