Selecting the correct payout rate and term is vital. The risk that the grantor does not survive the term of the GRAT is a serious one because if the grantor dies before the trust expires some or all of the trust assets, including appreciation, will be included in the grantor's estate.
Because the GRAT is a grantor trust, the individual who creates the GRAT pays any income tax due on the trust's investments. This is actually advantageous, because the payment of the trust's taxes by the grantor is not a gift for tax purposes. The assets of the GRAT will grow on a pretax basis, and the payment of taxes by the grantor serves as additional tax-free gifts to the trust.
For technical reasons, beneficiaries of GRATs should only be one generation younger than the grantor, meaning the GRAT is not a good multi-generational or dynastic planning vehicle. Certain types of investments, especially illiquid assets, present difficulties when placed in GRATs because the assets do not earn enough income to pay the annual annuity. It is also not uncommon to create a GRAT with a relatively small initial annuity payment that is increased up to 20% per year for the GRAT term. This is particularly helpful if the early years of an investment are expected to be less profitable.
Gift/Sale Planning
Selling an asset to a grantor trust is similar to establishing a GRAT, but with a number of extra advantages. The transaction is an initial gift to the trust, followed by a sale of assets by the grantor to the trust in return for an installment note.
In the typical structure, a grantor trust is a trust in which a grantor retains no beneficial interest and no right to distributions. As a result, the trust can be outside of the grantor's taxable estate immediately. The grantor is responsible for payment of all of the trust's income taxes. This allows the trust assets to effectively grow free of income taxes. Payment of the income taxes is a tax-free gift to the trust. There is a second income tax advantage to grantor trust status. In a grantor trust, all assets are considered owned by the grantor. For income tax purposes, it is synonymous with the grantor. Consequently, the grantor can sell assets to the trust without triggering immediate capital gains.
To use this strategy, the client forms the grantor trust and funds it with a gift of 10% of the assets ultimately to be transferred to the trust. The client then sells assets to the trust in exchange for a promissory note. A $10 million gift is now possible for married couples, which would allow a sale of upwards of $90 million of additional undiscounted assets for the promissory note.
The grantor does not recognize any gain on the sale, but for gift and estate tax purposes, the trust is separate and apart from the grantor and is not included in his or her estate. If structured as a multi-generational trust, all future appreciation escapes transfer taxes, perhaps for centuries.
The trust will repay the note using either the income generated by the asset transferred to it, or by cannibalizing the trust assets. The note will generally impose interest at the lowest permitted interest rate. In February 2011, the rate on a transfer of nine years could be as low as 2.31%. As long as the trust earns more than 2.31%, the transfer will be successful.
The sale to a grantor trust has a hurdle rate that is below the rate set in a GRAT, does not have survivorship risk and can be used for multi-generational planning. The cash flows are flexible; notes are often partially amortizing or interest-only with a balloon at the end of the term. This flexibility is not possible with a GRAT. Grantor trusts are also often structured as dynasty trusts and, depending on the jurisdiction in which they are formed, can exist in perpetuity.
Edward A. Renn is a principal in Withers Bergman LLP, where he practices in the wealth planning and family office groups.