When to use a "zeroed out" GRAT.

• Author: Boffa, Alane L.
• Position: Grantor retained annuity trust

A grantor retained annuity trust (GRAT) is an irrevocable trust to which a grantor transfers property in exchange for the right to receive a fixed annuity for either a set number of years or for life. The annuity payment is usually a fixed percentage of the original value of the assets transferred. For example, if $100,000 is put into the trust and the fixed percentage is 8%, the trust would pay $8,000 each year, regardless of the assets' value in any subsequent year.

When the trust term expires, the assets remaining in the trust pass tax-free to the beneficiaries. A gift tax obligation may occur when a GRAT is created, for the amount of the "residual assets" that will pass to the beneficiaries. The residual is determined using the subtraction method: the fair market value of the property contributed less the actuarial value of the annuity retained. The trust is a grantor trust, because it may use income or principal to satisfy the annuity payments. Thus, all items of income and deduction will be reported on the grantor's Form 1040.

In a "zeroed out" GRAT, the annual annuity payments are set so high that the trust assets will be depleted before the expiration of the trust's term; see Rev. Rul. 77-454.

GRATs carry the risk that the grantor will die during the trust's term. If this happens, the entire GRAT is includible in the grantor's estate. Thus, GRATs are an effective tool only if the grantor outlives the term. This can be mitigated in older grantors by setting a lifetime term.

A GRAT is a superb estate planning vehicle for taxpayers who need an income stream from their assets, but not the assets themselves.

Example: G, age 60, transfers $1 million of assets into a GRAT for a 7% annuity for 10 years. B is the trust's beneficiary. In the month that G funds the GRAT, the Sec. 7520 rate is 5%, resulting in a $459,481 current gift from G to B. G will receive $70,000 per year, paid at least annually from the trust. At the end of year 10, B will receive the residual. The trust assets earn 8% per year; the residual at the end of year 10 is $1,144,866.

In the example, the $1 million asset will pay $700,000 to the grantor over 10 years. The gift's value is approximately $460,000, yet the grantor moves more than $1.1 million out of his of her estate. If the grantor has not used his or her $1 million lifetime gifting exclusion, the gift goes untaxed. Because all the income and appreciation that exceed the required annuity stream remain in the trust...