Friday, March 11, 2022
The Tax Cuts and Jobs Act (TCJA) significantly increased the federal estate and gift tax exemption, and it is presently at $12.06 million for deaths occurring or gifts made in 2022. That effectively makes federal estate and gift tax a non-issue for practically all farming and ranching operations, with or without planning. But it is for some, and business succession planning remains as important as ever.
Earlier this week 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. The GRAT technique “freezes” the value of the senior family member’s highly appreciated assets at the value as of the time of the transfer to the GRAT, while providing the senior family member with an annuity payment for a term of years. Thus, the GRAT can deliver benefits without potential transfer tax disadvantages.
Transferring interests in a farming business (and other investment wealth) to successive generations by virtue of a GRAT – it’s the topic of today’s post.
A GRAT is an irrevocable trust to which assets are transferred. In return, the grantor receives the right to a fixed annuity payment for a term of years, with the (non-charitable) remainder beneficiaries receiving any remaining assets at the end of the GRAT term. The fixed payment is typically a percentage of the assets’ initial fair market value computed so as to not trigger gift tax. In other words, the amount of the taxable gift on the transfer to the GRAT is the fair market value (FMV) of the property transferred less the value of the grantor’s retained annuity interest. At the end of the grantor’s reserved term, the value of the remainder interest is included in the grantor’s estate for tax purposes. See I.R.C. §2036; I.R.C. §2039.
The term of the annuity is fixed in the instrument and is either tied to the shorter of the annuitant’s life or a specified term of years. The annuity payment can be structured to remain the same each year or (as explained more further below) it can increase up to 120 percent annually. However, once the annuity is established, additional property cannot be added to the GRAT. Treas. Reg. §25.2702-3(b)(5).
Note: The grantor receives the annuity amount annually regardless of the income that the GRAT’s assets produce. Thus, the trustee’s job is to maximize the total return on the GRAT’s assets from income or principal appreciation. If the GRAT income is insufficient to pay the annuity, the trustee must be required to invade the GRAT’s principal to do so. Thus, the assets transferred to the GRAT must produce enough cash flow to pay the annuity amount or must be able to be liquidated by the trustee to pay the annuity.
Because a GRAT is a technique that is based largely on assumptions about what the interest rate will be, ideal assets to transfer to a GRAT are those that are likely to appreciate in value (such as real estate) at a rate exceeding the rate that the IRS applies (the I.R.C. §7520 rate) to the annual annuity payment the GRAT will make. In that event, the appreciation in the GRAT assets will pass to the GRAT’s beneficiaries without triggering federal gift or estate tax to the grantor. The actuarial value of the remainder interest in the GRAT that passes to the beneficiaries when the GRAT terminates is a gift to the remainder beneficiaries that is subject to gift tax. But, if that actuarial value equals the value of the property transferred to the GRAT, there won’t be any gift tax.
If the grantor outlives the term of the annuity term, the remainder passes to the beneficiaries with no additional estate tax.
Example: Faye, at age 55, funded an irrevocable trust with $1,000,000 in March of 2022. The trust specified that Faye would receive an annual annuity of $50,000 for the next 10 years. The March 2022 I.R.C. §7520 rate is 2.0 percent. Based on the IRS specified formula, the value of Faye’s retained interest is $449,130 and the value of the remainder interest is $550,870. The value of the remainder interest would be subject to gift tax upon the GRAT’s creation. Because the funding of the GRAT involved a completed gift, when the GRAT terminates there will be no gift tax consequences. The assets remaining in the GRAT are paid to the remainder beneficiaries without Faye incurring any additional gift tax. If Faye were to die during the GRAT term with the right to receive further annuity payments, a portion of the GRAT will be included in her estate. The included portion is that fraction of the GRAT which would be required to be invested at the I.R.C. §7520 rate in effect on Faye’s death to produce income equal to the required annuity payment. If Faye is married and the right to the balance of the annuity payments passes to her spouse, the interest will qualify for the marital deduction if the spouse receives annuity payments that either pass outright to the surviving spouse or the surviving spouse’s estate, or will pass to a marital trust over which the spouse has a general power of appointment.
Perhaps the most important part of a GRAT is that the trust instrument be drafted property to satisfy I.R.C. §2702. If I.R.C. §2702 is satisfied, the grantor’s retained interest is a “qualified interest” and is subtracted from the value of the property gifted to the remainder beneficiaries. If I.R.C. §2702 is not satisfied, the grantor’s retained interest is valued at zero and the entire value transferred to the remainder beneficiaries is a taxable gift. To be a qualified interest, the grantor’s retained interest must be an interest consisting of the right to receive a fixed amount payable not less than annually that is a fixed percentage of the fair market value of the property in the GRAT determined on an annual basis. The annuity’s term must be the shorter of the life of the grantor or a specified term of years (but see the discussion surrounding the Tax Court’s decision in Walton, infra.).
Note: The value of the qualified annuity is determined via I.R.C. §7520.
It is critical to have an accurate appraisal of the assets/interests to be contributed to the GRAT. If the appraisal is not accurate, the annuity may be determined to not be a qualified interest. See Atkinson v. Comr., 309 F.3d 1290 (11th Cir. 2002), aff’g., 115 T.C. 26 (2000); C.C.A. 202152018 (Oct. 4, 2021). This is a particular issue when a potential sale or merger is involved when valuing assets to be contributed to the GRAT.
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. Treas. Reg. §25.2702-3(b)(1). There is a 105-day window within which the GRAT can satisfy the annual annuity payment requirement. This is the case if the annuity payment is based on the GRAT’s anniversary date. Treas. Reg. §25.2702-3(b)(4). 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.
Note: The annuity payment may, alternatively, be based on the taxable year of the GRAT. If so, the annuity must be paid in the subsequent year by the date on which the trustee must file the GRAT’s income tax return (without extension). Treas. Reg. §25.2702-3(b)(4). As noted, the annuity cannot be prepaid. Treas. Reg. §25.2702-3(d)(4).
The GRAT must be drafted to require the trustee to actually pay the annuity amount, it is not sufficient for the grantor to merely have a withdrawal right. Treas. Reg. §25.2702-(3)(b)(1)(i).
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. Treas. Reg. §25.2702-3(b)(1)(ii). 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.
Note: The fixed amount need not be the same for each year, but one year’s amount may not vary by more than 120 percent from the amount paid in the immediately prior year. Treas. Reg. §25.2702-3(b)(1)(ii).
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
Grantor trust status. 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).
Note: It is possible that a GRAT could be a grantor trust for some but not all purposes. Generally, a GRAT should be a grantor trust for all purposes. Language can be drafted into the GRAT document ensuring classification as a grantor trust for all purposes.
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.
Gift tax treatment. 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.
It is possible to “zero-out” the gift value so there is no taxable gift. This occurs when the value of the grantor’s retained interest equals the value of the property transferred to the trust. 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 remaining 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 be an independent trustee.
Underperforming GRAT. 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.
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 under I.R.C. §2036. 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.
Perhaps the risk of the grantor dying during the GRAT term has been minimized. In Walton v. Comr., 115 T.C. 589 (2000), the Tax Court concluded that the value of an annuity payable over a term to the grantor and to the grantor’s estate if the grantor dies during the GRAT term is not reduced by the value of the contingent interest in the grantor’s estate. The reason the Tax Court gave was because a fixed annuity payable to the grantor or the grantor’s estate does not constitute a “qualified interest” under I.R.C. §2702. Thus, a GRAT may be created with a fixed term that will not end upon the grantor’s death, and the annuity that is paid to the grantor during life and to the estate at death during the GRAT’s term will be included in the value of the retained annuity interest – and, thus, give a value to the remainder interest. The IRS may not agree with the result in Walton (particularly outside of the Eighth Circuit). But, the Tax Court’s opinion is a full Tax Court opinion that is applicable nationwide.
GRAT Advantages and Disadvantages
Advantages. For large transfers, a GRAT reduces the gift tax cost of transferring assets as compared to a direct gift. Also, the GRAT receives grantor trust status which allows the grantor to 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)). Also, the GRAT term can safely be as short as two years.
Disadvantages. Upon formation, some of the grantor’s applicable exclusion might be utilized. But this likelihood has been reduced in recent years given the substantial increase in the federal estate and gift tax exemption amount. Also, the grantor must survive the GRAT term to avoid having any part of the GRAT assets being included in the grantor’s gross estate (but see the discussion about the Walton case above). Another potential disadvantage of a GRAT is that notes or other forms of indebtedness cannot be used to satisfy the required annuity payments. Treas. Reg. §25.2702-3(d)(2). In addition, the grantor continues to pay income taxes on all of the GRAT’s income that is earned during the GRAT term.
When to Consider Using a GRAT
So, when should a GRAT be utilized as a part of an estate/business succession plan? If the grantor has assets that are likely to appreciate more than the I.R.C. §7520 rate, it is a good way to transfer value to the grantor’s children. Also, in situations where the unified credit exemption has already been used, a zeroed-out GRAT may still be used because it does not trigger a taxable gift to the remainder beneficiaries.
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 wealth a a desire to pass the business to the next generation. Also, keep in mind that the present level of the federal estate and gift tax exclusion amount of $12.06 million is scheduled to “sunset” after 2025. After that, under present law, the exclusion will drop to $5 million (in 2011 dollars) with an inflation adjustment.