Armanino Blog

GRATuitous Advice on Nursery Rhymes and Estate Planning

by John Karls
June 30, 2017

You may have heard the following nursery rhyme during your childhood.

Baa, baa black sheep,
Have you any wool?
Yes sir, yes sir,
Three bags full.
One for my master,
One for my dame,
One for the little boy
That lives down the lane.

Did you know that the sheep was forced to take a second job at a petting zoo to pay the gift tax incurred on those three bags of wool?  This unnecessary level of petting could have easily been avoided had the sheep contributed the bags of wool to a trust that paid it an annuity for a specific term.  That, my friends, is called a grantor retained annuity trust (GRAT).

If you’re at the age when it’s time to consider retiring, make sure you look at the advantages of a GRAT. It makes transferring ownership interests a snap and can provide substantial estate planning benefits.

The nitty-gritty of GRATs
A GRAT is an irrevocable trust funded by a one-time contribution of assets by the “grantor.” For example, if you’re the owner of a duck call company, you can transfer some or all of your ownership interests in the business to the GRAT. The GRAT pays you, as the grantor, an annuity for a specific term.

The amount of the annuity payment is a fixed percentage of the initial contribution’s value or a fixed dollar amount; either way, the payment must be made at least annually. You maintain the right to the payments regardless of how much income the trust actually produces.

When the GRAT’s term expires, the assets remaining in the trust (known as the “remainder”) transfer to designated beneficiaries. But the amount of the gift for gift tax purposes is determined when the GRAT is funded and is equal to the “present value” of the remainder interest.

The remainder interest’s present value hinges in part on the IRS Section 7520 rate at the time of the GRAT’s creation, as well as on the value of the assets transferred to the GRAT. If the Sec. 7520 rate is low and the trust assets can generate a higher rate of return, the assets will be worth more when the trust terminates than the remainder interest’s gift tax value. So, the excess asset appreciation over the term of the trust passes to the beneficiaries free of gift and estate taxes.

In addition, if your business’s value is currently lower than it has been, the interests will have a lower value for gift tax purposes. The value of an asset such as an ownership interest in a duck call business should be determined by a valuation expert. And GRATs work particularly well with interests in closely held businesses, because valuation discounts can reduce a gift’s value for tax purposes even more.

You must report the income, gains and losses from the trust assets on your individual income tax return. But paying income tax on the trust asset income and gains is actually beneficial for estate planning purposes. Why? By paying the taxes yourself (rather than the GRAT paying them), you’re preserving the trust’s assets for the beneficiaries—essentially making additional tax-free gifts to them—and further reducing the size of your taxable estate. This is important enough to mention twice using my outside voice: YOU ARE ESSENTIALLY MAKING ADDITIONAL TAX-FREE GIFTS TO YOUR BENEFICIARIES!  The payment of tax is not subject to either the annual exclusion or the lifetime exemption.

Other items of note
If the grantor doesn’t survive to the end of the GRAT term, the gift is effectively “undone” for tax purposes, and the GRAT assets are included in the grantor’s estate at their current value. The benefit of transferring the appreciation out of the grantor’s estate will be lost. So to reduce this mortality risk, it’s generally beneficial to make the GRAT’s term relatively short.

However, Congress has introduced several bills in recent years that would limit the benefits of GRATs by, for example, requiring a minimum term of 10 years. It’s likely that any successful legislation would apply only prospectively, though, leaving existing GRATs intact. So if you think a GRAT may be right for your family, you may want to set it up soon.

While the IRS accepts GRATs as valid vehicles for transferring assets, it does impose some rules on the trust instrument used to create a GRAT. The instrument must prohibit additional contributions to the GRAT, commutation (prepayment of the grantor’s annuity interest by the trustee), and payments to benefit anyone other than the grantor before the grantor’s retained interest expires. Issuing a note, other debt instrument, option or similar financial arrangement to satisfy the annuity obligation isn’t allowed.

Is it time to consider a GRAT?
If you’re a baby boomer, succession planning might not be on the top of your to-do list. It should be, however, so talk to your CPA about whether a GRAT should be part of your plan.

June 30, 2017

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John Karls - Partner, Tax - Dallas TX | Armanino
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