GRATs and GRUTs: Shifting Assets Within the Family
Let us imagine that among your assets you have $3 million in securities that you
plan to leave to your children. These securities are likely to shoot up in value
during the next decade. In another ten years they could be worth $10 million, which
could mean $3 million or more in federal estate taxes, depending upon the size of
your estate and the tax rates in effect at your death.
Better to give the assets to the kids now, because all further growth in value avoids
estate and gift taxes. Two problems present themselves. First, there’s a very real
gift tax cost for a $3 million gift—at least several hundred thousand dollars, and
more if you’ve already used up a portion of your estate and gift tax credit. Second,
you may not be ready to part with the assets; you may want the income, or at least
some of it.
The solution: Consider a Grantor Retained Annuity Trust (GRAT) or Grantor Retained
How the trusts work
In a nutshell, you transfer the $3 million to an irrevocable trust to last for a
specific time period, say ten years. You receive an annual income from the trust,
and after ten years the assets pass to your beneficiaries.
There are two ways to define your retained income interest. In most cases the income
is set at a fixed dollar amount, or a fixed percentage of the initial value of the
trust. This is an annuity, putting the “A” in GRAT. Alternatively, the income interest
may be a fixed percentage of the value of the trust, recomputed each year. This
is called a “unitrust” income interest, and it puts the “U” in GRUT.
A unitrust income interest can grow over time as the value of the trust grows. However,
this fights against the primary objective of the trust: transferring the largest
amount to beneficiaries at the lowest possible tax cost. That is why GRATs usually
are preferred to GRUTs.
Because the trust is irrevocable, the moment that it is created, a taxable gift
has been made to the beneficiaries. However, the taxable value of the gift is reduced
to reflect the value of the income interest retained by the grantor. The longer
the trust lasts, and the higher the retained income interest, the lower will be
the taxable value of the gift.
GRATs and GRUTs are not for everybody, nor are they suitable for every type of asset.
A few of the negatives to keep in mind:
• The grantor loses control over trust assets, including control over buy and sell
• Because these trusts are grantor trusts for income tax purposes, all the trust
income will be taxable to the grantor, whether or not it is distributed. For this
reason, such trusts are normally invested for capital appreciation rather than income,
to reduce current taxation.
• Should the donor die before the expiration of the term of the trust, the full
value of the assets will be included in his or her taxable estate. Therefore, this
type of plan is more likely to succeed for younger donors with a longer life expectancy.
• GRATs and GRUTs are not good tools for dealing with the generation-skipping transfer
tax. Gifts to grandchildren probably should be taken care of separately.
Looking longer term
When the grantor’s income interest ends, the trust assets may be distributed to
the designated family members. Alternatively, the assets may be held in further
trust for their benefit. Careful trust drafting is needed to ensure that the successor
trust will not be included in the grantor’s estate.
The GRAT and the GRUT are good tax-saving tools. They can be used to help shape
an overall estate plan, putting part of the plan into effect during life, and keeping
down the total transfer taxes imposed on the family.