By Elizabeth Nesmith

With the current combined gift and estate tax exemption for 2013 at $5,250,000, a couple can transfer up to $10,500,000 while avoiding federal estate tax. An important question now is how to get the most out of this increased exemption. With appropriate leverage, a gift of $10,500,000 can become substantially more through use of key estate planning tools.

An important and popular tool is the grantor retained annuity trust or “GRAT”. GRATs are irrevocable trusts from which the grantor retains a right to receive a series of fixed payments for life or a term of years. The balance left after the end of the annuity stream is transferred to the remainder beneficiaries. This can be extraordinarily powerful as a gift or estate transfer tool when combined with discountable assets.

GRATs can be effective tools that can allow for large transfers of wealth with significant discounts. The gift portion of the GRAT can be valued as low as zero.

The advantages of GRATs are focused on the increased value that can be transferred out of the grantor’s estate for a smaller percentage of the gift and estate tax exemption. Future appreciation is removed from the grantor’s estate. The gift is substantially beyond that which otherwise would have been achieved through transfers at death.

For example, transferring $20,000,000 of privately-held company stock with a 2% income rate and a 3% principal rate can return over $6,000,000 to the grantor and transfer over $20,000,000 to the remainder beneficiaries with a taxable gift of $7,712,180.

One disadvantage to a GRAT is that the transfer is irrevocable. This is mitigated somewhat in that the grantor will receive a stream of payments for the term of the trust.

The trust income will generally be taxed to the grantor. This can a be a benefit in that paying income tax for the assets that stay in the trust is not considered an additional gift. However, the grantor is paying tax for income that no longer belongs to them.

GRATs do provide potential protection from creditors and privacy through avoidance of probate at death. The benefits of creditor protection vary by state. It is helpful to consider the differences in state law when considering the best state in which to establish the trust.

One of the most important disadvantages is that the grantor must survive the term of the trust or the assets in some proportion will come back into the grantor’s estate. For this reason, it is important to consider the grantor’s age and health when deciding on the term of the trust.

The use of GRATs to transfer wealth is a bit more complicated for transfers to grandchildren. While the gift tax is determined at the time of the gift, generation skipping transfer tax (GSTT) on transfers to individuals more than one generation below the grantor cannot be applied until the end of the term. The benefits of the GRAT are lost for purposes of allocating GSTT exemption against appreciating assets.

One of the most effective uses of the GRAT is in combination with transfers of ownership interests in young companies (Start-ups). Start-ups generally have a lower value in the beginning and may have a strong appreciation rate. If the projected rate of growth of the company exceeds the interest rate the IRS uses in the GRAT calculation, the GRAT is assured of success. The current tax rate used in the GRAT calculation is 2%. An initial gift with a low valuation can be discounted even further through the use of a GRAT. When the company takes off, the growth can be exponential.

With the low interest rate environment, now is a good time to consider a grantor retained annuity trust. This is especially true for appreciating assets and for those assets that are most important to assure transfer into the next generation.

The effect of planning with GRATs is even more important for those domiciled in Washington State. There is no gift tax, but there is estate tax in Washington and the estate tax exemption is only $2,000,000 per person. There is no impact in making gifts through trusts such as GRATs at the state level. However, holding the assets until death can be particularly expensive with a top tax rate in 2014 of 20%.

Use of grantor retained annuity trusts in estate planning can amplify the benefits otherwise seen in gifting outright to beneficiaries.

© Clark Nuber PS, 2013.  All Rights Reserved

This article contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.