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Why Do GRATs Remain In Such High Demand?

The “death” of the grantor-retained annuity trust—commonly known as a GRAT—has been greatly exaggerated.  In fact, GRATs may be reaching their zenith in popularity due to recent developments.  Nevertheless, you are well advised to keep an eye on a revenue-hungry Congress which in the past has threatened to reduce or eliminate GRAT benefits.

With a GRAT, you may be able to transfer a significant amount of your wealth to your heirs without much in the way of estate and gift tax consequences, taking full advantage of current laws. 

Here how it works:  As the “grantor,” you transfer assets into the trust while retaining the right to receive annual annuity payments for a specified number of years.  When the term of the GRAT ends, the remainder is distributed to the beneficiaries you’ve named, who are typically your children and/or grandchildren (OR TRUSTS FOR THEIR BENEFIT).

The amount of the annuity payment you receive during the term of the GRAT is calculated using a special interest rate—called the Section 7520 rate—established at the outset.  The Section 7520 rate is adjusted by the government on a monthly basis.  This is one of the key factors currently affecting the popularity of GRATs.  For June 2013, the Section 7520 rate was set at a miniscule 1.2% (see chart for first half of 2013).

Thus, for a transfer occurring in June 2013, all future growth above 1.2 percent is effectively transferred to the designated beneficiaries of the trust.  That's because all of the present value of what was transferred into the GRAT would be returned to you, in the form of annuity payments.  Ordinarily, the transfer of assets by an individuals to an irrevocable trust would be deemed to be a gift for federal gift tax purposes.  However, in theory since all of the GRAT assets could revert to you, assuming the assets don't appreciate by more than the Section 7520 rate, the gift is valued at zero for tax purposes.  This technique is known as “zeroing out” a GRAT.”

With this approach, you're hoping that the appreciation in value of the assets transferred to the GRAT will exceed the Section 7520 rate, a pretty safe bet when the rate is only 1.2 percent.  While you continue to receive the annuity payments based on a relatively low rate during the GRAT term, the beneficiaries will be entitled to receive the appreciation in excess of the Section 7520 rate. Generally, you would prefer to transfer assets to the GRAT that you would reasonably expect to appreciate substantially in value. Conversely, you might hold onto other assets projected to have a lower rate of appreciation.

Does this estate planning device sound too good to be true?  It’s not, but you should be aware that there are possible downsides to setting up a GRAT, including the following: 

1.  No one can guarantee absolutely that the assets will appreciate in value at a rate higher than the Section 7520 rate.  Even with a low 1.2% rate, it’s possible that some assets may grow at a lower rate or the GRAT even could suffer a loss.  In that case, you receive the trust assets back at their depreciated value without any tax consequence.  In essence, the GRAT “failed” to produce an estate tax savings.

2.  You might die during the GRAT term.  If that should happen, all of the assets transferred to the GRAT, plus any earnings, will revert to your taxable estate.

3.  If you use professional services, you will incur fees for establishing and administering a GRAT, usually based on a percentage of assets in the trust.

Be mindful that legislation has been proposed in Congress in recent years that would have affected GRATs adversely, particularly with regard to the zeroing-out technique.  The same or similar proposals are likely to be raised again.  If you’re contemplating the use of a GRAT, you might want to move quickly before Congress strikes. 


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