Special report on estate planning for farmers: Part 5 of 7

In a special report prepared in conjunction with a presentation at the University of Iowa College of Law's 2011 Spring Tax Institute, David Repp takes in in-depth look at estate planning considerations for farmers and other landowners.  Part 5 of 7, below, discusses the use of grantor retained annuity trusts. Grantor Retained Annuity Trusts Today's low interest rates create an estate tax planning opportunity.    A grantor retained annuity trust (GRAT) is a method of "freezing" the value of the grantor's estate by giving remainder interests in certain property, such as bank stock, to family members or loved ones and retaining an income interest (either all the income from the property, an annuity amount or a unitrust amount) for a period of years.  When the trust is established, a gift of the remainder is made to the beneficiaries and a gift tax return must be filed.  When properly structured, the value of the gift is equal to the actuarial value of the remainder interest.  A drawback to this estate freeze method is that the grantor must outlive the term of the trust.  Otherwise, the value of the trust assets are included in the grantor's estate.  Thus, a dilemma for the grantor is created in determining the proper length of the trust.  The grantor should want the trust term to be as long as possible, because the longer the trust term, the smaller the remainder interest and thus, the smaller the taxable gift.  Alternatively, the grantor must outlive the trust or the entire estate planning scheme is all for naught.  A form of grantor retained annuity trust is included at the end of these materials. GRATS should be funded with assets that preferably are high yielding and have a high basis.  The size of the gift that is deemed made by the creation of a GRAT is a direct result of the interest rate that is used in valuing the retained annuity.  The annuity is valued using Table H of the Internal Revenue Service valuation tables that can be found in I.R.S. Publication 1457.  Within Table H, the appropriate table to use depends on the interest rate in effect under Code Section 7520 for the month the trust is created.  For September, 2008, the rate is 4.2 percent (up from 3.2% in May).  A GRAT is effective to transfer wealth to a second generation at less than the normal gift or estate tax rates only if the trust assets produce at a rate higher than the Section 7520 rate in effect at the creation of the trust. If the trust assets of a GRAT grow at a rate higher than the applicable Section 7520 rate, the remainder interest will be undervalued when the trust was created – that is, the present value of the remainder interest for gift tax purposes will be $X, and the present value of the property the younger generation actually receive when the trust terminates will be greater than $X.  The greater the rate by which the trust assets outperform the applicable Section 7520 rate, the greater the value of the property that will be transferred to the younger generation free of transfer tax.

Caution: The opposite holds true if the trust assets do not perform to the same level as the applicable Section 7520 rate.  In such case, the grantor essentially pays gift tax (or uses up unified credit) on property that is never transferred to the second generation.

GRATS should also, preferably, be funded with assets that have a high basis.  If the grantor survives the term of the trust, the basis of the assets in the hands of the grantor will be the basis in the hands of the children.  Therefore, if the children sell the property after the trust terminates, they will have to pay income tax on any appreciation in the value of the property over the original basis.  This would not be the case if the grantor died with the property and if the property's basis were stepped up to its fair market value.  However, for wealthy grantors, it is better in most cases to have the children pay income tax on the appreciation of the property than subject the property to high estate tax. Other considerations and planning aspects of using GRATS include:

• Factor in a minority discount if the trust property is a family business or is otherwise nonpartitionable.  A minority discount, as discussed infra, can only be used if a beneficiary receives an asset worth less than the proportionate share of the whole asset.  This is commonly the case when less than a majority share of a business is transferred to another individual.  It will also work occasionally for interests in real estate that is difficult or costly to partition.

• Purchase insurance on the grantor's life during the term of the trust.  One way to protect against the risk that the grantor will die prior to the term of the GRAT is to purchase insurance in a sufficient quantity that will cover the amount of additional estate tax due on the GRAT assets included in the grantor's estate.

• If a question exists as to the likelihood of a grantor surviving the term of a GRAT, an alternative may be to reduce the GRAT term to a short period such as two years and increase the size of the annuity payout.  Two years is probably the shortest possible term of a GRAT.  Each annuity payment can then be rolled over into successive GRATs with similar terms.

Illustration The table below illustrates how a GRAT may pass wealth on to descendants without paying a gift tax.  At the recent hurdle rate of 3.2%, for May, 2008, the grantor would need to choose an annuity payment of about $1.2 million and a term of ten years to avoid paying a gift tax on a $10 million GRAT.  Assuming, for simplicity's sake, that the assets within the GRAT return 5% each year (actual returns, of course, will vary from year to year), the tax-free gift when the trust expires in ten years would be $1.4 million.  With each additional 1% of return, the remainder value in the GRAT would increase; if returns approach 9%, $5.7 million would pass free of tax to the heirs.  

The material in this blog is not intended, nor should it be construed or relied upon, as legal advice. Please consult with an attorney if specific legal information is needed.