Can you provide an example of a GRAT?
A Grantor Retained Annuity Trust, or “GRAT”, is an “estate freeze approach” that allows a Donor to give away the appreciation of an asset gift tax free. The Donor transfers high income-producing assets or assets with substantial growth potential (or cash to be invested in such assets) to a trust from which the Donor will receive a fixed amount annually (an “annuity”) for a designated period of years (“GRAT Term”). At the end of the GRAT Term, if the Donor is living, the beneficiaries named in the trust instrument (individuals or a continuing trust) will receive the assets remaining in the GRAT after payment of the final annuity free of gift and estate tax. Depending on the GRAT’s cash flow and/or the appreciation of the GRAT’s assets (the “total investment return”), substantial estate and gift tax savings may be achieved.
The advantage in terms of taxes achieved through this method arises from the way the taxable value of the gift made to the GRAT is determined. Instead of considering the value of the assets transferred to the GRAT, the taxable gift value is based on the present value of the beneficiaries’ entitlement to receive the assets that remain in the GRAT after the GRAT Term ends, following payment of the necessary annuity payments to the Grantor. The duration of the GRAT and the amount of the annuity payments are predetermined to minimize the taxable gift to either zero or a nominal amount. This kind of GRAT is commonly referred to as a “zeroed-out” GRAT.
If the total investment return of a GRAT surpasses the expected return determined by the IRS for the month when the GRAT is funded (referred to as the “7520 rate”), any excess investment return will pass to the Grantor’s beneficiaries at the end of the GRAT without being subject to gift and estate taxes. In case the total investment return is lower than the 7520 rate, no assets will remain to be transferred to the Grantor’s beneficiaries upon the expiration of the GRAT. However, as long as the taxable gift upon funding the GRAT is zero, the only cost incurred will be that of establishing and administering the GRAT.
A person named Jane transfers $1,000,000 worth of stock to a 2-year GRAT. Jane believes that the stock is undervalued and expects it to increase by 25% per year for the next two years. Assuming an interest rate provided by the IRS of 4.4%, Jane must receive an annuity of $533,248 for the two years of the GRAT to reduce the taxable gift to a nominal amount. If the stock appreciates in value at the 25% annual rate that Jane expects, $362,693 of stock will pass tax-free to her children at the end of the two year term.
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