A grantor retained annuity trust (GRAT) is a gifting vehicle that offers a way to shift future appreciation of property to others at a minimal gift tax cost. Under this strategy, you would create a trust under which you would retain the right to receive annual annuity payments for a fixed period, such as four years. After the annuity payment period expires, your interest in the trust would terminate, and your children would become the trust beneficiaries. Note that the Obama Administration has proposed changing the rules for GRATs so that a minimum term of 10 years must be used and zeroing-out the gift tax may not be possible in taking advantage of the rules and benefits described below. Please keep this possible legislative change in mind when planning your estate.

The success of the GRAT strategy generally will depend on whether the assets transferred to the GRAT have a total annual return during the annuity period in excess of the IRS assumed rate of return.

For example, assume that when the IRS rate is 5.0%), a client (assume he or she is 40 years old) transferred assets valued at $1,000,000 to a 4-year GRAT that provides for four annual annuity payments to the client, each payment to equal approximately 28.2% of the value of the property initially contributed to the GRAT ($282,000). At the end of the four-year period, the client’s children will become the beneficiaries of the ongoing trust (or outright). The tax results are as follows:

1. Under the Walton case, there should be little or no taxable gift associated with the transfer of assets to the GRAT. The size of the gift may be greater than zero, although still very modest (here, practically $0), and essentially is zeroed out.

2. Assume that the GRAT actually had an annual investment return of 20%. In the example, there would be approximately $559,800 of value left in the GRAT at the end of the GRAT term for the benefit of the children after the required annuity payments are made to you (or your estate in the event of death).

3. If there is adverse investment performance and the GRAT has a rate of return of, say, 2% you will receive back all of the trust assets via the annuity payments, and nothing will be left for the benefit of the children. Comparing the favorable result in the preceding paragraph against this downside scenario highlights a key tax benefit of the GRAT – when it works, the results are excellent, and when it doesn’t, the loss is fairly minimal. Based on this characteristic, a GRAT would be an excellent vehicle to hold a highly speculative investment that has the potential for significant appreciation, without any real downside risk.

There are some other material tax points regarding the GRAT:

1. If you die before the end of the annuity period, all trust assets will be includible in your estate, and the tax advantages of the GRAT strategy will be lost. Depending upon the facts, this may favor use of a shorter annuity period. In addition, the fact that is generally is easier to “beat” the IRS rate of return over a short period than a long period favors use of a short annuity term (for example, a 20% annualized appreciation on stock over a two-year period happens frequently, while a 20% annualized rate of return over a 10-year period does not). Therefore, it could be more beneficial to create successive 2-year GRATs (known as “rolling GRATs”) than to have a single 4-year GRAT. Recognizing this, the IRS has become sensitive to the use of very short-term GRATs, and a two-year annuity term may be considered an aggressive strategy, even tough it was approved by the U.S. Tax Court in the Walton case. A four or five year term would be less aggressive.

2. It may be better to have multiple GRATs, each holding a different investment, than a single GRAT with a diversified portfolio. This will prevent losing investments from negating the tax benefits of winning investments. Also, if a single security is used, it may be wise to ladder several GRATs of varying duration. There is no limit on the number of GRATs a person can create.

3. A GRAT should be taxed as a “grantor trust” for income tax purposes, and this has several benefits. First, since it is a grantor trust, you will report the income from the GRAT during the annuity period on your income tax return and pay the taxes from your own funds; accordingly, the GRAT strategy generally will produce gifts to the ultimate beneficiaries if the pre-tax return on its assets exceeds the assumed IRS rate. Second, as a grantor trust, the GRAT can pay you the annuity using appreciated property (e.g., shares of stock) without the distribution being treated as a taxable sale of the property. Thus, if you fund the GRAT with illiquid stock, the GRAT can make annual annuity payments to the client using the stock.

4. Funding a GRAT with hard-to-value property poses valuation challenges and additional costs. For example, if you fund the GRAT with illiquid assets, such as privately held company shares, and plan to have the annual annuity payments made to you by the GRAT by distributing back to you shares of stock having value equal to or greater than the required annuity payment, you will need to value the assets on the date they are contributed to the GRAT and again on each annuity payment date. Some taxpayers have attempted to avoid the need for annual valuations by having the GRAT issue a promissory note in payment of the annuity, with the expectation that the note will be paid when the GRAT sells the hard-to-value asset. The IRS, however, has vigorously opposed this technique.

5. A GRAT is not a good vehicle for generation-skipping (i.e., to grandchildren), although it can be coupled with a dynasty trust to achieve this result.

6. A GRAT can own shares of an S corporation.