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.

On the other hand, if the GRAT instrument allows (but does not require) the trustee to reimburse the grantor for income taxes, and there is no implicit or explicit agreement between the grantor and the trustee that the GRAT assets will always be available to reimburse the grantor, the reimbursement provision should not, by itself, have any estate tax consequences. This suggests that a tax reimbursement provision should always be fully discretionary and should not require the trustees to reimburse the grantor for income taxes.

However, even a discretionary income tax reimbursement provision could create estate tax problems if under state law such a provision would allow the grantor’s creditors to reach the assets held in the GRAT. If the grantor’s creditors can reach the assets, then the IRS says that they should be included in the grantor’s taxable estate.

But what is the estate tax treatment absent any kind of reimbursement provision? It turns out that it is virtually identical, meaning that there is little practical reason not to include an income tax reimbursement provision in a GRAT.

Here is why: The regulations under Internal Revenue Code section 2036 require the grantor to include in his estate property sufficient to produce the remaining GRAT annuity payments from only trust income, assuming there is an income rate equal to the then-7520 rate. This requirement makes it almost certain that all the remaining GRAT property will be taxed in the grantor’s estate if he dies during the GRAT term, regardless of whether the GRAT instrument includes an income tax reimbursement provision.

Consider the following example: A client creates a two-year GRAT in October 2013 (when the statutory rate is 2.4%), funds the GRAT with $1 million and dies during the initial term. Under the section 2036 regulations, in order for any part of the GRAT assets to escape estate tax on the grantor’s death, the GRAT would have to be worth over $21 million. Needless to say, very few GRATs will ever be this successful.

All of this means that, in most cases, including an income tax reimbursement provision in a GRAT does not create any additional estate tax exposure.

When To Include A Reimbursement Provision
Advisors should evaluate whether to include an income tax reimbursement provision in a GRAT based on several factors. If, for example, a client has sufficient other assets to pay any income tax liability that could be generated by the assets held inside a GRAT, a reimbursement provision may be unnecessary.

But if a client prefers the flexibility of including an income tax reimbursement provision, then be sure to make that reimbursement provision fully discretionary. This way, if the GRAT is wildly successful and the section 2036 regulations would not otherwise require the grantor to include the entire GRAT property in his estate, the estate will have an argument that the discretionary reimbursement provision should not have the effect of including the balance.

Finally, advisors should keep in mind that using assets held inside the GRAT to pay the donor’s income tax liability undermines the effectiveness of the GRAT technique. Assets held in a successful GRAT could pass to the next generation without any gift tax cost.
If instead some of the GRAT assets were used to pay income taxes, there would be less appreciation to benefit the remainder beneficiaries of the GRAT.

The bottom line is that, while a client may choose not to include an income tax reimbursement provision because he has sufficient assets outside the GRAT to pay any such tax liability, the risk of potential estate tax inclusion should not drive the decision.