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Opportunity in April, 2008 for Tax-Free Transfer of Wealth

The Internal Revenue Service ("IRS") recently announced that the interest rate used for calculating the fair market values of annuities is 3.4% for the month of April 2008.1 This rate is near the historic low of 3.0% and presents significant estate planning opportunities that should be acted upon before the interest rates begin to climb. One such opportunity is a type of trust called a "Grantor Retained Annuity Trust."

Grantor Retained Annuity Trust ("GRAT"). A GRAT works as follows:

(1) the donor contributes assets to the trust at the time of its creation,
(2) the trust periodically pays the donor a flat amount that is usually described as an annuity for a term of years, and
(3) whatever is left at the end of the term either remains in trust for or is paid out to the donor’s children.2

For federal gift tax purposes, the value of the children’s remainder interest in a GRAT is equal to the value of the assets the donor contributes to the trust less the value of the donor’s annuity. Typically, a GRAT is designed so that the annuity will be sufficiently large so that its fair market value is equal to the fair market value of the assets the donor contributes to the trust. This results in the donor being treated as if he made no gift for federal gift tax purposes and enables the donor to pass whatever is left in the trust at the end of the annuity term free of federal gift tax. Such a trust is commonly referred to as a "Zeroed Out GRAT" because the donor is treated as if he made no gift for federal gift tax purposes.

The fair market value of an annuity is determined by interest rates in effect at the time a donor creates a GRAT. Once the GRAT is created, the value of the annuity for federal gift tax purposes is locked in place. A low annuity value makes it easier for the GRAT to generate sufficient income to pay the donor’s annuity and have assets left over at the end of the term. Consequently, it is advantageous to create a GRAT when interest rates are low if the donor wishes to pass wealth to his or her children.
Example 1. A sixty-five year old donor creates a Zeroed Out GRAT on May 1, 1997 that pays him an annuity for fifteen years. At that time, the relevant federal interest rate was 8.2% and he contributed $1 million to the trust. In that interest rate environment, a GRAT with a fifteen year term must pay 11.82606% of the initial value of the trust to the donor every year for the next fifteen years for the donor to be considered as if he made no taxable gift. This means that such a trust must pay the donor $118,260 per year during the next fifteen years or until it exhausts its assets.
Amount Contributed to GRAT: $1,000,000.00
Interest Rate for May 1997: 8.2%
Annual Annuity Needed to Zero Out Gift: $118,260.60
Taxable Gift: $0.00
This means that the GRAT must generate at least an $118,260.60 of income every year on its $1 million of assets for the donor’s children to take $1 million free of federal and state estate & gift taxes when the annuity expires on April 30, 2012. Achieving such a rate is quite difficult. However, the tax benefit of success is high because a Maryland resident’s family would avoid paying approximately $540,000 of federal and state estate taxes if the GRAT has $1 million in it when the annuity expires.
Example 2. A sixty-five year old donor creates a Zeroed Out GRAT on April 30, 2008 that pays him an annuity for fifteen years. At this time, the relevant federal interest rate is 3.4% and the donor contributes $1 million to the trust. In this interest rate environment, a GRAT with a fifteen year term must pay 8.62083% of the initial value of the trust to the donor every year for fifteen years for the donor to be considered as if he made no taxable gift. This means that such a trust must pay the donor $86,208.30 per year during the next fifteen years or until it exhausts its assets.
Amount Contributed to GRAT: $1,000,000.00
Interest Rate for April 2008: 3.4%
Annual Annuity Needed to Zero Out Gift: $86,208.30
Taxable Gift: $0.00
This means that the GRAT must generate at least $86,208.30 of income every year on its $1 million of assets for the donor’s children to take $1 million free of federal and state estate & gift taxes when the annuity expires on April 30, 2023. Again, the tax benefit of success is high because a Maryland resident’s family would avoid paying approximately $540,000 of federal and state estate taxes if the GRAT has $1 million in it when the annuity expires.

The difference between a GRAT needing to generate an 8.6% annual rate of return versus generating an 11.8% rate of return is likely to be the difference between the GRAT funding its annuity obligation out of its return on investments and having to dip into capital. Further, a GRAT can be combined with other estate planning tools that will make it more likely that the trust’s annuity will be sufficiently small not to exhaust its assets.


Who Should Use a GRAT? A GRAT is an estate planning tool that may be attractive to someone who is in sufficiently good health to make it likely he or she will survive the annuity term, and has more than $2 million of personal wealth. Owners of a closely-held business or a large portfolio of securities are particularly good candidates for using a GRAT.

A GRAT is an estate planning tool that may be attractive to someone who is in sufficiently good health to make it likely he or she will survive the annuity term, and has more than $2 million of personal wealth. Owners of a closely-held business or a large portfolio of securities are particularly good candidates for using a GRAT.

There are several other estate planning tools that are also particularly attractive in a low interest rate environment. Of course, the current interest rate environment may be short-lived, and, therefore, people interested in these options, including a GRAT, may want to act sooner than later.
1 Revenue Ruling 2008-20.
2 There is an estate planning tool available to a donor who wishes to benefit nieces and nephews or an unrelated younger person called a Grantor Retained Interest Trust ("GRIT") that is similar to a GRAT but has even better estate & gift tax consequences.

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Date

04.08.08

Type

Publications

Authors

Johnson, Laura L.
Spatz, Y. Jeffrey

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