Monday, September 24, 2018
The Tax Cuts and Jobs Act (TCJA) significantly increased the federal estate and gift tax exemption to $11.18 million for deaths in or gifts made in 2018. That effectively makes federal estate and gift tax a non-issue for practically all farming and ranching operations, with or without planning. However, business succession planning remains as important as ever. Last month, I wrote about one possible strategy, the intentionally defective grantor trust. Today, I discuss another possible succession planning concept – the grantor-retained annuity trust (GRAT). It’s another technique that can allow the grantor to “freeze” the value of the transferred assets while simultaneously providing the grantor with a cash flow stream for a specified time-period.
Transferring interests in a farming business (and other investment wealth) to successive generations by virtue of a GRAT – that’s the topic of today’s post.
GRAT - Defined
A GRAT is an irrevocable trust to which assets (those that are likely to appreciate in value (such as real estate) at a rate exceeding the rate applied to the annual annuity payment the GRAT will make) are transferred and the grantor receives the right to a fixed annuity payment for a term of years, with the remainder beneficiaries receiving any remaining assets at the end of the GRAT term. The fixed payment is typically a percentage of the asset’s initial fair market value computed so as to not trigger gift tax. The term of the annuity is fixed in the instrument and is either tied to the annuitant’s life, a specified term of years or a term that is the shorter of the two. The annuity payment can be structured to remain the same each year or it can increase up to 120 percent annually. However, once the annuity is established, additional property cannot be added to the GRAT.
A GRAT can accomplish two important estate planning objectives. The GRAT technique “freezes” the value of the senior family member’s highly appreciated assets at today’s value, and it provides the senior family member with an annuity payment for a term of years. Thus, the GRAT can deliver benefits without potential transfer tax disadvantages. Clearly, the lower the interest rate, the more attractive a GRAT is.
A GRAT must make at least one annuity payment every 12-month period that is paid to an annuitant from either the GRAT’s income or principal. There is a 105-day window within which the GRAT can satisfy the annual annuity payment requirement. The window runs from the GRAT creation date, which is based on state law. Notes cannot be used to fund annuity payments, and the trustee cannot prepay the annuity amount or make payments to any person other than the annuitant during the qualified interest term.
A GRAT is subject to a fixed amount requirement that takes the form of either a fixed dollar amount or a fixed percentage of the initial fair market value of the property transferred to the trust. There is also a formula adjustment requirement that is tied to the fixed value of the trust assets as finally determined for gift tax purposes. The provision must require adjustment of the annuity amount.
From a financial accounting standpoint, the GRAT is a separate legal entity. The GRAT’s bank account is established using the grantor’s social security number as the I.D. number. Annual accounting is required, including a balance sheet and an income statement.
Tax Consequences of Creating, Funding, Administering and Terminating a GRAT
For income tax purposes, the GRAT is treated as a grantor trust because, by definition, the retained interest exceeds five percent of the value of the trust at the time the trust is created. I.R.C. §673. Thus, there is no gain or loss to the grantor on the transfer of property to the GRAT in exchange for the annuity. There can be issues, however, if there is debt on the property transferred to the GRAT that exceeds the property’s basis. Also, when a partnership interest is contributed there can be an issue with partnership “negative basis” (i.e., the partner’s share of partnership liabilities exceeds the partner’s share of the tax basis in the partnership assets).
Because the trust is a grantor trust, the grantor is taxed on trust income, including interest, dividends, rents and royalties, as well as pass-through income from business entity ownership. The grantor also can claim the GRAT’s deductions. However, the grantor is not taxed on annuity payments, and transactions between the GRAT and the grantor are ignored for income tax purposes. A significant tax benefit of a GRAT is that the sale of the asset between the grantor and the GRAT does not trigger any taxable gain or loss. The transaction is treated as a tax-free installment sale of the asset. Also, the GRAT is permitted to hold “S” corporation stock as the trust is a permitted S corporation shareholder, and the GRAT assets grow without the burden of income taxes.
For gift tax purposes, the value of the gift equals the value of the property transferred to the GRAT less the value of the grantor’s retained annuity interest. In essence, the transferred assets are treated as a gift of the present value of the remainder interest in the property. That allows asset appreciation to be shifted (net of the assumed interest rate that is used to compute present value) from the grantor’s generation to the next generation.
If the GRAT underperforms (i.e., the GRAT assets fail to appreciate at a higher rate than the interest rate of the annuity payment), the GRAT can sell its assets back to the grantor with no income tax consequences (assuming the GRAT is a wholly-owned grantor trust. Rev. Rul. 85-13, 1985-1 C.B. 184. Then, the repurchased property can be placed in a new GRAT with a lower annuity payment. The original GRAT would then pay out its remaining cash and collapse.
It is possible to “zero-out” the gift value so there is no taxable gift. An interest rate formula determined by I.R.C. §7520 is used to calculate the value of the remainder interest. If the income and appreciation of the trust assets exceed the I.R.C. §7520 rate, assets remain at the end of the GRAT term that will pass to the GRAT beneficiaries. The basic idea is to transfer wealth to the subsequent generation with little or no gift tax consequences.
The grantor’s payment of taxes is not treated as a gift to the trust remainder beneficiaries. Rev. Rul. 2004-64, 2004-27 I.R.B. 7. Also, if the trustee reimburses (or has the power to reimburse) the grantor for the grantor’s payment of income tax, the reimbursement (or the discretion to reimburse) does not cause inclusion of the trust assets in the grantor’s estate. But, it’s important that the trustee is an independent trustee.
Death of Grantor During GRAT Term
If the grantor dies before the end of the GRAT term, a portion (or all) of the GRAT is included in the grantor’s gross estate. The amount included in the grantor’s estate is the lesser of the fair market value of the GRAT’s assets as of the grantor’s date of death or the amount of principal needed to pay the GRAT annuity into perpetuity (which is determined by dividing the GRAT annuity by the I.R.C. §7520 rate in effect during the month of the grantor’s death). Rev. Rul. 82-105, 1982-1 C.B. 133.
Example: Bubba died in June 2018 with $700,000 of assets held in a 10-year GRAT. At the time the GRAT was created in June of 2010 with a contribution of $1.5 million, the annuity was calculated to be $183,098.70 per year (based on an interest rate of 3.8 percent and a zeroed-out gift). The amount included in Bubba’s gross estate would be the lesser of $700,000 (the FMV of the GRAT assets at the time of death) or $5,385,255.88 (the value of the GRAT annuity paid into perpetuity ($183,098.70/.034)). Thus, the amount included in Bubba’s estate would be $700,000.
To minimize the risk of assets being included in the grantor’s estate, shorter GRAT terms are generally selected for older individuals. There is no restriction in the law as to how long a GRAT term must be. For example, Kerr v. Comr., 113 T.C. 449 (1999), aff’d., 292 F.3d 490 (5th Cir. 2002) involved a GRAT with a term of 366 days, and there is no indication in the court’s opinion that the term was challenged. In Priv. Ltr. Rul. 9239015 (Jun. 25, 1992), the IRS blessed a GRAT with a two-year term. See also Walton v. Comr., 115 T.C. 589 (2000).
GRAT Advantages and Disadvantages
To summarize the above discussion the following is a brief listing of advantages and disadvantages of a GRAT.
Advantages: 1) there is a reduced gift tax cost as compared to a direct gift; 2) the GRAT receives grantor trust status; 3) the grantor can borrow funds from the GRAT and the GRAT can borrow money from third parties (however, the grantor must report as income the amount borrowed - Tech. Adv. Memo. 200010010 (Nov. 23, 1999)); and 4) the GRAT term can safely be as short as two years.
Disadvantages: 1) upon formation, some of the grantor’s applicable exclusion might be utilized; 2) the grantor must survive the GRAT term to avoid having any part of the GRAT assets being included in the grantor’s gross estate; 3) notes or other forms of indebtedness cannot be used to satisfy the required annuity payments; and 4) grantor continues to pay income taxes on all of the GRAT’s income that is earned during the GRAT term.
The GRAT is another way to pass interests in the farming or ranching operation to the next generation. While it’s not a technique for everyone, it can be helpful for those with substantial estates. Also, keep in mind that the present level of the federal estate and gift tax exclusion amount of $11.18 million is scheduled to “sunset” after 2025. After that, under present law, the exclusion will drop to $5 million with an inflation adjustment. Also, if the political landscape changes to a significant enough degree the exemption could fall sooner and to a greater degree.