Using GRATs in tax planning during troubled economic times.

• Author: Donchess, John P.
• Position: Grantor retained annuity trusts

Those who make a living providing tax planning services to clients are painfully aware of how difficult their jobs become in tough economic times. When times are good and profits are high, clients are (mostly) happy to pay for help in minimizing their tax liabilities. However, when profits are low or nonexistent, clients can be reluctant to focus on tax planning, let alone pay a professional to provide those services.

Understandable as this attitude may be, it is a mistaken and dangerous one. Conditions that typically exist during economically depressed times present opportunities for business owners to do things that may not work under more favorable economic conditions. The planning ideas presented in this item focus mainly on ownership interests in closely held businesses, although some of the techniques could work with publicly traded securities as well.

For a significant portion of the past year, the United States has experienced a low interest rate environment. This began with the Federal Reserve taking action to resolve the financial institution crisis and now looks as though it could last for a while longer. Such an environment has a direct affect on tax planning because lower interest rates make various planning strategies more attractive.

GRAT Planning

Grantor retained annuity trust (GRAT) planning is one such strategy. Taxpayers normally use GRATs to transfer to others property that they expect to appreciate in value. Essentially, the grantor funds a trust with this property, and the trust is required to pay an annuity back to the grantor during the trust's term.

The annuity that the trust pays back to the grantor is determined by reference to the Sec. 7520 rate, which the IRS publishes each month along with the applicable federal rates (AFR). This interest rate, the term of the trust (as decided by the grantor), and the value of the property at the time it is contributed to the trust are used to determine the amount of the annuity that must be paid. At the end of the GRAT's term, whatever is left in the trust is distributed to the trust's beneficiaries. The GRAT is then terminated.

The end result is that the grantor has transferred to the GRAT's beneficiaries any growth in the value of the trust's property that exceeds the Sec. 7520 rate. More often than not, these beneficiaries are family members of the grantor. If the maximum calculated annuity is paid, the transfer of this growth is done free of any gift tax implications. A...