With interest rates dipping to near-historic lows, grantor-retained annuity trusts (or GRATs) remain a very effective estate planning tool. While many sophisticated advisors continue to use this technique to help their high-net-worth clients transfer assets to the next generation at a low (or even zero) tax cost, there is a hidden risk inherent in some GRATs that many planners may not be sufficiently focused on. If a GRAT is successful, there is a material risk that a grantor-client will be hit with an outsized capital gains tax liability.

Although a GRAT can be funded with virtually any type of asset, the technique works especially well when the GRAT is funded with assets that are expected to appreciate dramatically in a short period of time. One example is stock in a private company that may be sold during the GRAT term.

Consider this typical scenario: A company founder contributes his relatively low-value private stock to a GRAT. During the GRAT term, the company is sold and the founder’s stock is converted to cash at a much higher sale price than the per-share valuation when the stock was originally contributed to the GRAT.

This set of facts produces a very good planning result, since under the terms of the GRAT, the original low valuation (and not the subsequent high sale price) determines the stream of annuity payments back to the grantor. This means that almost all of the appreciation over the initial valuation—more specifically, everything in excess of a low statutory interest rate (2.4% in October)—will remain in the GRAT at the end of the term and pass to the grantor’s chosen beneficiaries or a trust for their benefit, gift-tax free.

But what about the large capital gains tax liability due on the sale of the founder’s stock? Who pays that bill?

The Income Tax Implications Of A “Too Successful” GRAT
A GRAT is a grantor trust for income tax purposes, which means that all of the trust’s income is treated as if it were received directly by the grantor. When GRAT assets are sold, therefore, it is the grantor individually, and not the GRAT, that must pay the income tax liability.

For many company founders, a large proportion of their wealth is tied up in their company’s stock. If a founder contributes that stock to a GRAT and the shares are sold during the GRAT term, it may be difficult for the grantor to come up with funds outside the GRAT to pay the capital gains tax liability triggered by the sale.

Remember, too, that the grantor will only be entitled to a stream of annuity payments from the GRAT calculated based on the initial (low) valuation of the GRAT assets. If a GRAT is wildly successful, the tax bill due on the sale of the assets may exceed the sum of the annuity payments due back to the grantor. This leaves the grantor with a highly successful estate planning strategy and wealthy beneficiaries, but his own pockets will be empty.

Income Tax Reimbursement Provision
This problem can be avoided by including a provision in clients’ GRAT instruments that allows the trustee to reimburse the grantor for income taxes generated by the assets held in the GRAT. Some planners are reluctant to include such a provision because they fear it will cause the GRAT assets to be included in the grantor’s estate if he dies during the GRAT term. But this is almost certainly the case regardless of a reimbursement provision, and it should not dissuade planners from including a properly structured tax reimbursement provision in their GRATs.

Estate Tax Issues
It’s important to remember that a GRAT only works if the grantor survives the initial trust term. If the grantor dies during the term, the IRS requires the grantor to include at least part (and usually all) of the GRAT assets in his estate. The question, then, becomes what portion of the GRAT’s assets will be subject to estate tax.

The IRS says that if the GRAT instrument requires the trustee to reimburse the grantor for income taxes, the entirety of the GRAT assets will be taxed in the grantor’s estate.