Tax Court decision increases usefulness of GRATs.

• Author: Bakale, Anthony
• Position: Grantor retained annuity trusts

In the current period of uncertainty about the future of the estate and gift tax system, the grantor retained annuity trust (GRAT) is a viable technique for passing wealth to future generations without creating a current tax liability for the grantor. A recent Tax Court decision has enhanced the GRAT'S attractiveness and provided an interesting insight into tax planning.

A GRAT typically involves the transfer of assets to a trust for a term of years. The transferor retains the right to fixed payments (the annuity) for the term, and the assets (if any) remaining in the trust at the end of the term pass to the intended donee (remainderperson) without any additional gift tax. To compute the value of the remainder interest, which is potentially subject to gift tax, the present value of the retained annuity stream is subtracted from the value of the assets initially transferred to the trust. To value the annuity stream, the IRS uses an interest rate; determined under Sec. 7520, in effect for the month that the assets are transferred to the trust. As a result of a recent Tax Court decision, a taxpayer can reduce the value of the remainder interest to a relatively small amount--even to zero--by varying the trust term and the amount of the annuity.

Exhibit 1 presents the projected results for a 60-year old person transferring $10 million to a three-year GRAT and retaining a $3,754,881 annual annuity, using a Sec. 7520 rate of 6.2% (the February 2001 rate) and yielding a 10% return over three years. The value of the remainder subject to gift tax is $185,867, while the amount transferred to the intended donee is $881,344. However, two caveats should be kept in mind:

Exhibit 1: GRAT Illustration Assumptions: Summary: Initial assets: $10,000,000 Amount transferred to Age of grantor: 60 children: $881,344 Annual annuity: $3,754,881 Amount of taxable gift: $185,867 Percent return: 10% Assumed tax rate: 40% Number of years: 3 IRS interest factor: 6.20% Beginning Annual Annuity to Ending Tax paid Year balance earnings grantor balance by grantor 1 $10,000,000 $1,000,000 $3,754,881 $7,245,119 $400,000 2 7,245,119 724,512 3,754,881 4,214,750 289,805 3 4,214,750 421,475 3,754,881 881,344 168,590 Net to Year grantor 1 $3,354,881 2 3,465,076 3 3,586,291 $10,406,248 * If the donor dies during the GRAT'S term, the assets will be taxed in his estate and no gift or estate tax savings will have been achieved.

* If the assets' rate of return does not exceed the Sec...