Rader and Coleman, P.L.

A grantor retained annuity trust (GRAT) may be an effective means for a person who wants or needs to retain all or most of the income from a high-yielding and rapidly-appreciating property to transfer that property to a child or other person with minimal gift tax cost and save estate tax.

GRATs are particularly attractive where you have one or more significant income-producing assets that you are willing to part with at some specified date in the future to save federal and state death taxes and probate costs, to obtain privacy on the transfer, and to protect the asset against the claims of creditors.

A GRAT is created by transferring one or more high-yield assets into an irrevocable trust and retaining the right to an annuity interest for a fixed term of years or for the shorter of fixed term or life. When the retention period ends, assets in the trust (including all appreciation) go to the named "remainder" beneficiary(ies). In some cases other interests, such as the right to have the assets revert back to your estate in the event of your premature death, may be included.

GRATs provide a fixed annuity payment, usually expressed as a fixed percentage of the original value of the assets transferred in trust.

Illustration. Eight year GRAT funded with $1,00,000, a 5% annuity payment, discount rate of 4%, life expectancy through 2012 and assume an 5% growth rate.

Eight year GRAT funded with $1,00,000, a 5% annuity payment, discount rate of 4%, life expectancy through 2012 and assume an 5% growth rate.

All income and appreciation in excess of $50,000 annuity accumulate for the benefit of the remainder beneficiary(ies). Consequently, it may be possible to transfer assets to the beneficiary(ies) when the trust terminates with values that far exceed their original values when transferred into the trust and, more importantly, that far exceed the gift tax value of the transferred assets. The gift tax value of the transferred assets is determined at the time the trust is created and funded using the "subtraction method." In other words, the value of the annuity interest you keep is subtracted from the fair market value of the assets you placed into the trust to determine the amount of your gift.

How the annuity interest and any other retained interests are valued depends on who the remainder beneficiary(ies) is (are) and who retains the annuity and other interests relative to the transferor. There is a more restrictive and less appealing set of valuation rules when family members are beneficiaries and certain family members retain interests in the property both before and after the trust is created than when unrelated parties are involved. The interest rate for discounting is published by the IRS at the beginning of each month.

The right to receive a "fixed amount" means the annuity must be a specified fixed dollar amount or a fixed percentage of the initial value of the trust payable each year rather than merely the income produced by the assets in the trust.

Since the GRAT permits payment of both income and trust principal to satisfy the annuity payments you have retained, the GRAT should be treated as a grantor trust for income tax purposes. This means you (the transferor-annuitant) are taxed on income and realized gains on trust assets even if these amounts are greater than the trust's annuity payments. This further enhances this tool's effectiveness as a family wealth-shifting and estate-tax-saving device. In essence you are effectively allowed to make gift tax-free gifts of the income taxes that are really attributable to assets backing the remainder beneficiary's interest in the trust.