Creating a grantor retained annuity trust (commonly referred to as a “GRAT”) is a relatively simple way to transfer property to your children at virtually no gift tax cost. In order for a GRAT to be successful, your retained annuity from the GRAT must increase in value greater than a hurdle rate. The hurdle rate is linked to the market yield on U.S. government-issued debt, which is largely determined by the Federal Reserve’s monetary policy. The hurdle rate for June 2020 has dropped to 0.6%, which is a new all-time low. Thus a super low interest rate combined with the recent decrease in the stock market has created a significant opportunity to transfer wealth with minimal gift tax cost by creating a GRAT.

Basic Operation of a GRAT

In a typical GRAT, you contribute assets to a trust which provides that you are to receive an annuity payment annually for a fixed number of years (the “annuity period”). The annuity amount is typically a stated percentage of the initial fair market value of the trust. It can be stated as a fixed percentage or as a percentage that can increase as much as 20% per year over the trust’s term.

At all times during the term of the trust, you will receive the predetermined annuity amount, regardless of how much income the trust assets actually generate or whether the value of its assets rises or falls. To the extent that the income is insufficient to cover the annuity payments, trust principal will be paid to you to make up any shortfall.

At the end of the annuity period, any property remaining in the trust passes to the ultimate beneficiaries of the trust, typically your children or other family members, in further trust or outright, depending upon your preference. Alternatively, you can delay the transfer of assets to your children by naming a trust for your spouse and your descendants as the beneficiary until the spouse’s death, at which time your children (or other family members) become the beneficiaries.

Gift Tax Is Minimized

The transfer of property to a GRAT constitutes a gift for gift tax purposes, but the value of that gift is only the value of the trust assets on the date of the transfer reduced by the present value of the annuity you have retained. The calculation of the present value of your retained annuity is based, in part, upon the interest rates promulgated by the IRS for the month the transfer is made, or the I.R.C. Section 7520 rate, commonly referred to as the “hurdle” rate. The hurdle rate is linked to the market yield on U.S. government-issued debt, which is largely determined by the Federal Reserve’s monetary policy. The hurdle rate for June 2020 has dropped to 0.6%, which is a new all-time low.

In order for a GRAT to be successful, the combined appreciation and income of the assets used to fund the GRAT must exceed the hurdle rate. At the end of the annuity period, the value of the appreciation and income exceeding the hurdle rate will pass to the beneficiaries (or to trusts for their benefit), free of transfer tax. As a result, when the 7520 rate is low, it is “easier” to have a successful GRAT. Since interest rates are currently near historic lows, the potential tax savings are maximized. Additionally, it may be easier to identify appropriate assets to contribute to a GRAT in a down market, where asset values are depressed and significant future growth is expected.

The most popular use of this device in sophisticated estate plans has been the short-term, “zeroed-out” GRAT, in which the term is typically limited to two or three years and the annuity amount is maximized in order to produce as small a taxable gift as possible. For zeroed-out GRATs, the gift, for gift-tax purposes, is usually negligible. In this way, it is possible to use anticipated short-term growth in the trust assets for estate planning purposes without risking longer-term uncertainty, and the risk of depreciation is neutralized by virtually eliminating the gift tax cost.

Suppose you create a GRAT with $5,000,000 to pay yourself an annuity of $2,522,552 per year for two years. Applying June’s hurdle rate, the value of your retained interest is approximately $4,999,950, making the taxable gift about $50. This amount would be reported on a gift tax return, but no tax would be due unless you have no remaining gift tax exemption, which, as a practical matter, is extremely unusual. If the principal of the trust appreciates (including capital growth and income) over the two-year period, so that, after receiving your annuity payments, there are assets remaining in the GRAT – whether one dollar or millions of dollars – your children will receive that amount at no gift tax cost (other than the nominal tax paid, if any, on the initial gift of about $50). On the other hand, if the value of the trust falls or fails to beat the hurdle rate, you will simply get back everything you put in, and you will have lost nothing. Distributions may be made in-kind so there is no need to sell any property in order to receive your annuity payments or transfer assets to individuals or trusts upon completion of the annuity period.

In a two-year zeroed-out GRAT, your children or other named beneficiaries will receive the remaining principal in the trust at the end of two years at no gift tax cost to you or them.

No Extra Cost If You do not Survive the Annuity Period

If you die prior to the end of the annuity period, the annuity will continue to be paid to your estate and the value of the assets in the GRAT at your death will be included in your gross estate for estate tax purposes. Your estate will receive credit for any gift tax already paid, however. Thus, although you will have lost the tax advantage the GRAT was designed to achieve, your estate will be in the same position as if you had not created it.

Gift of Stock in a Closely-Held Business

From the perspective of the IRS, the hurdle rate represents a reasonable assumption of the generally expected yield at market based on general economic factors. From your perspective, however, it may be feasible to select “hot” assets that are expected to generate greater returns. You may be able to achieve substantial benefits by transferring a closely-held business interest or real estate, which you anticipate will increase in value, to your GRAT. In fact, this may be the ideal estate planning device for such a transfer to your children, because you may be in a unique position to predict the future growth of your own business or real estate assets.

Of particular appeal is the fact that the GRAT also removes the risk of undervaluing a closely-held business interest or real estate asset for gift tax purposes. With an outright gift, there is no way to guard against a substantial gift tax deficiency if the value of the property is later challenged by the Internal Revenue Service and increased on audit. But, if instead the gift is the remainder interest in a “zeroed-out” GRAT, and if the annuity amount is expressed as a percentage of the initial value of the trust principal (rather than a dollar figure), any increase in the value of the business (or real estate) determined on an audit of the gift tax return would result almost entirely in an increase in the value of the retained interest and, in turn, in only a nominal gift tax increase.

In the previous example, if the IRS successfully asserts that the value of your company’s stock transferred to the trust is $6,000,000 instead of $5,000,000, because your annuity is defined as a percentage of the value of the stock, your annuity is now worth $5,999,940 and the value of the resulting gift to your children, is about $60 instead of $50.

Income Tax Considerations

Since the GRAT is a “grantor trust” for income tax purposes, all of its income and deductions are included on your personal return, as if there had been no transfer at all, until the property passes to the ultimate beneficiaries of the GRAT. Therefore, the GRAT is generally income tax-neutral, meaning that your income taxes should be the same whether or not you create the GRAT. If you choose to keep the property in trust for your children (or your spouse and children) after the annuity period, the continuing trust or trusts also can be structured as grantor trusts so that you can continue to pay the income tax attributable to the trusts’ income each year until you choose otherwise. Ordinarily, payment of another person’s income taxes would have potentially negative tax consequences. However, because a grantor trust is treated as your alter ego for income tax purposes, your payment of the trust’s income tax essentially is an additional tax-free gift to your children and can further decrease the value of your estate. Paying the income tax liability from an external source (i.e., from individually owned assets that would have otherwise been includible in your estate) also allows the trust assets to continue to grow and compound on an internally “income tax-free” basis outside of your estate. This is an extremely effective estate planning tool.

Fixing 2019 and 2020 GRATs that may be Underwater due to Recent Market Decline

A GRAT may include provisions to allow you, as the Grantor, to engage in a “substitution transaction” during the annuity period without triggering any tax. In other words, you can retain the right to swap assets held within the trust for other assets of equal value. This creates an opportunity to take advantage of market volatility or other factors that cause the value of the contributed assets to decline. Assume, for example, that, following the creation of the GRAT, the value of the asset decreases by 20% and it appears unlikely that the value will rebound to the extent necessary to beat the hurdle rate. During the annuity period, you could make the decision to “pull the plug” on the GRAT by substituting cash for the lower value assets. Then, immediately following the swap, you could contribute the same assets to a different GRAT and start the process again. A patient Grantor could simply implement multiple GRATs over time, using the same assets, until their values eventually rise. This is often an attractive option in an environment where asset values have declined and interest rates remain low. This strategy should also be considered for startup companies, which may experience substantial initial costs, but are expected to appreciate dramatically at some point in the future.

Similarly, you may choose to make the continuing trusts under your GRAT grantor trusts and include substitution provisions. This can produce a unique opportunity to eliminate capital gains tax, leverage timing to your advantage and create multiple GRATs using the same assets after the annuity period has ended. Returning to the first example discussed above, assume further that the initial $5,000,000 contribution to the GRAT experienced capital growth over the annuity period at an annual rate of 10% and that you have retained a substitution power over continuing trusts for your children. Making these assumptions, the GRAT will succeed and about $750,000 worth of value will pass to the continuing trusts.

You can now make the decision to substitute the $750,000 worth of assets for cash. By doing this, you are bringing the assets back into your estate, where the $750,000 worth of assets (in addition to any other gain in excess of your basis) will receive a new basis equal to fair market value on your death. This has the effect of eliminating capital gains tax that would otherwise be payable on a sale or exchange of the assets. You have now returned to where you started, except you have successfully transferred $750,000 out of your estate at virtually no tax cost, and you will have eliminated your capital gains tax liability on the assets that you retain in your estate. This technique can be especially effective if, prior to the substitution, you expect the value of the assets to fall dramatically.

By swapping a depreciating asset back into your estate in exchange for a stable asset, such as cash, you can “freeze” the value of assets excluded from your estate, expose your estate to the downside risk and eliminate any capital gains liability. If you subsequently believe the stock will rebound, you can simply contribute the stock to a new GRAT. In effect, a GRAT can be an excellent tool for both estate tax and income tax arbitrage.

Similarly, many clients opt to “reGRAT” the assets they receive in satisfaction of their annuity payments. This technique, often referred to as a “rolling GRAT” approach, allows the Grantor to exclude appreciation from his estate on a continual and incremental basis without the need commit to a lengthy annuity period. This creates a significant amount of flexibility to reassess your plan as interest rates and asset values change over time.

Summary

When properly structured, a GRAT can truly have a “heads you win, tails you break even” result. By adjusting the terms of your trust, you can nearly eliminate the gift tax associated with the transfer of property to your children.

Upon termination of the GRAT, all the appreciation on the assets in excess of the hurdle rate will pass to your children free of gift tax. But if the appreciation is not as expected, or if you do not survive the term of the trust, there are no adverse tax consequences.

GRATs are extremely versatile and can be designed with significant estate tax and income tax savings in mind. With thought and careful planning, they can be used to take advantage of fluctuations in value in a broad array of circumstances.

Finally, in designing the manner in which the ultimate beneficiaries of the GRAT are to receive the trust assets at the end of the GRAT period, you may choose among many options available to achieve the result most consistent with your family and financial objectives.

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Photo of Mitchell Gaswirth Mitchell Gaswirth

Mitchell M. Gaswirth is a partner in the Tax Department. His practice focuses primarily on income, gift and estate tax and related business planning. Mitchell counsels individuals, entrepreneurs and business entities in connection with the various income and other tax issues which arise…

Mitchell M. Gaswirth is a partner in the Tax Department. His practice focuses primarily on income, gift and estate tax and related business planning. Mitchell counsels individuals, entrepreneurs and business entities in connection with the various income and other tax issues which arise in sophisticated business transactions.

Mitchell’s practice also encompasses a wide array of merger and acquisition, business formation and financing, debt restructuring, and real property acquisition, disposition and exchange transactions. His knowledge encompasses the complex and often arcane application of California’s property tax regime (“Proposition 13”) in a variety of business transactions directly or indirectly involving California real property.

Photo of Albert Gortz Albert Gortz

Albert W. Gortz is a partner in the Private Client Services Department and has been with the firm since 1970 and in the Florida office since he opened it in 1977.

Al has built an extensive practice counseling individuals and families of high…

Albert W. Gortz is a partner in the Private Client Services Department and has been with the firm since 1970 and in the Florida office since he opened it in 1977.

Al has built an extensive practice counseling individuals and families of high net worth regarding estate, personal, charitable and financial planning. This includes guidance in areas of gift, estate and generation-skipping tax planning. He has in-depth experience in the administration of complicated estates and trusts. Al also has extensive experience in representing charitable organizations and has worked with public charities in setting up planned giving programs.

Photo of Andrew M. Katzenstein Andrew M. Katzenstein

Andrew M. Katzenstein is a partner in the Private Client Services Department where he assists high net worth individuals, companies and charitable organizations with all aspects of tax and estate planning. He focuses his practice on tax planning matters, which include estate, gift…

Andrew M. Katzenstein is a partner in the Private Client Services Department where he assists high net worth individuals, companies and charitable organizations with all aspects of tax and estate planning. He focuses his practice on tax planning matters, which include estate, gift and generation-skipping tax planning, as well as income tax of trust planning, probate and trust administration matters, resolving disputes between fiduciaries and beneficiaries, and charitable planning.

Chambers USA consistently ranks Andy among the leading tax attorneys in the country, and highly regards his estate planning expertise in advising wealthy individuals and charitable organizations on a range of matters, including tax planning, trust administration and philanthropic giving. A client is quoted as saying, “He’s extraordinarily knowledgeable and creative. He’s one of the smartest estate planners in the US and I learn a lot from him. He’s a pleasure to work with – he gets very deeply engaged with his clients and he gets to the point very quickly in a friendly and professional way. He makes clients comfortable that they’re with the best planner around. He delivers quickly and efficiently and he has outstanding technical skills – 11/10.”

Andy is a much sought-after speaker on estate planning and probate issues and has appeared on CBS’ 48 Hours Mystery, NPR, and served as host of KFNX’s weekly radio talk show “Principal of the Matter,” which addressed a variety of trust and estate planning topics. He has published numerous articles in Estate Planning Magazine, the Journal of Taxation, Taxes Magazine and Major Tax Planning, and was one of the principal contributors to the probate treatise “Marshall and Garb on Probate.”

A frequent lecturer on a variety of estate planning and tax related topics, appearing annually before the Los Angeles County, Beverly Hills and California State Bar Associations, Andy also has participated in the prestigious USC Tax Institute, the USC Probate and Trust Law Conference, has lectured in Europe, Canada and across the United States and is a featured speaker at the CalCPA Education Foundation Annual Conference on seminars in estate planning. Andy has taught estate and gift tax law at USC Law School since 2009 and previously taught estate tax at UCLA Law School for 18 years. He has also taught estate planning and advanced estate planning in the Graduate Tax Program at the University of San Diego and at Golden Gate University. Andy currently teaches Estate and Gift Tax in the LLM program at the UC Irvine School of Law.

Photo of Hank Leibowitz Hank Leibowitz

Hank Leibowitz, a partner in the Private Client Services Department, has a practice encompassing all aspects of estate and tax planning, estate and trust administration and fiduciary litigation. Hank is a member of the Firm’s cross-disciplinary, cross-jurisdictional Coronavirus Response Team. He addresses client…

Hank Leibowitz, a partner in the Private Client Services Department, has a practice encompassing all aspects of estate and tax planning, estate and trust administration and fiduciary litigation. Hank is a member of the Firm’s cross-disciplinary, cross-jurisdictional Coronavirus Response Team. He addresses client concerns with respect to gift tax and estate tax issues. Additionally during the pandemic Hank has had to deal with logistical issues concerning the execution of documents requiring witnesses and notaries as well as navigating the probate court system during this difficult time.

Hank primarily represents individuals in a wide variety of estate and financial planning issues including estate, gift and generation-skipping tax planning. He has obtained favorable private letter rulings from the IRS in connection with the preparation of estate plans for his clients. In recent years, Hank has become very involved with planning relating to distributions from qualified plans and IRA’s, including Roth rollovers, income and estate tax issues and devising methods that allow continued tax deferral within said plans. He also has extensive experience with all types of life insurance planning, including split-dollar arrangements.

Photo of David Pratt David Pratt

David Pratt is Chair of the Private Client Services Department and head of the Boca Raton office. His practice is dedicated exclusively to the areas of trusts and estates, estate, gift and generation-skipping transfer, fiduciary and individual income taxation and fiduciary litigation. He…

David Pratt is Chair of the Private Client Services Department and head of the Boca Raton office. His practice is dedicated exclusively to the areas of trusts and estates, estate, gift and generation-skipping transfer, fiduciary and individual income taxation and fiduciary litigation. He has extensive experience in estate planning and post-mortem tax planning. He has been routinely “Chambers” ranked.

David’s clients consist predominantly of high net worth individuals and families. He regularly counsels his clients regarding how to transfer wealth from generation to generation with the least amount of tax and the maximum amount of asset preservation at each generation, including protection for a divorcing child or grandchild and from potential creditors. While many of David’s clients are retired, he also represents a significant amount of business owners. He has recommended and implemented many plans which have transferred ownership of business interests to the next generation with minimal transfer tax cost and without disruption of the family business. Such plans very often include recommendations resulting from the family dynamics involved with a family business.

Photo of Jay Waxenberg Jay Waxenberg

Jay Waxenberg is a partner in our Private Client Services Department and a former Chair. He advises on all aspects of multi-generational wealth planning and has particular expertise in complex estate planning, related tax work and the administration of estates and trusts. As…

Jay Waxenberg is a partner in our Private Client Services Department and a former Chair. He advises on all aspects of multi-generational wealth planning and has particular expertise in complex estate planning, related tax work and the administration of estates and trusts. As a member of our Fiduciary Litigation Group, Jay is regularly involved in will contests and other estate- and trust-related litigations. He is a member of the Firm’s Executive Committee.

Jay has extensive experience working with high-net worth individuals and their estates and has assisted clients, often for many years, in the structuring of their estate plans so as to minimize gift, estate and generation-skipping taxes in the transmission of their wealth through several generations. Lauded by his clients as “an all-star private client lawyer” who is “very focused on client service,” he is involved in the full range of his clients’ economic and personal concerns, including closely held businesses, commercial and residential real estate holdings, artistic collections and philanthropy. Jay has helped his clients structure new business ventures, restructure existing ventures with an emphasis on shifting appreciation potential to younger generations, and has guided the sale and liquidation of businesses. He regularly handles family matters, such as the preparation of prenuptial and postnuptial agreements, counsels on charitable giving and structures plans to enable client’s businesses to remain intact at their death, and to ensure the desired continuity of ownership and control.

Jay lectures regularly on estate planning topics and has written numerous articles that have appeared in various legal publications. He is a Fellow of the American College of Trust and Estate Counsel. Jay is a former Chair of the Estate and Gift Tax Committee of the Association of the Bar of the City of New York. He serves on the professional advisory committees of a number of museums and hospitals in New York.

Photo of Nathaniel Birdsall Nathaniel Birdsall

Nathaniel W. Birdsall is a senior counsel in the Private Client Services Department. His practice focuses on estate planning for high-net-worth individuals and families, including testamentary planning, lifetime gifts and sales, and estate administration. He advises clients with respect to charitable gifting, insurance…

Nathaniel W. Birdsall is a senior counsel in the Private Client Services Department. His practice focuses on estate planning for high-net-worth individuals and families, including testamentary planning, lifetime gifts and sales, and estate administration. He advises clients with respect to charitable gifting, insurance planning and inter-generational transfers of closely-held business interests, marketable securities, real estate and tangible property.

Nat prepares wills, trusts, and other documents necessary to effectuate an estate plan, such as purchase or gift agreements. He is experienced in reviewing and preparing gift, estate and generation-skipping transfer tax returns, as well as with IRS gift and estate tax audits. Nat also advises on the “decanting” of irrevocable trusts and with issues relating to state income taxation of resident trusts.

Photo of Vanessa Maczko Vanessa Maczko

Vanessa is a senior counsel in the Private Client Services Department.

Vanessa advises moderate to high net-worth international and domestic individuals and families on multi-generational transfers of assets, such as closely-held business interests, marketable securities, art collections, real estate, tangible personal property and…

Vanessa is a senior counsel in the Private Client Services Department.

Vanessa advises moderate to high net-worth international and domestic individuals and families on multi-generational transfers of assets, such as closely-held business interests, marketable securities, art collections, real estate, tangible personal property and insurance policies. Her practice focuses on estate, gift and generation-skipping transfer tax planning.

For lifetime planning, Vanessa drafts and analyzes inter vivos trust agreements, such as insurance trusts, grantor trusts and dynasty trusts. She advises clients on the funding of trusts, whether through direct or formula gifting or leveraged sales, as well as on the administration and taxation of trusts. Vanessa prepares and reviews gift tax returns in connection with the transfer of assets and represents clients in gift tax audits with the Internal Revenue Service. In addition, she advises clients on the structuring of new investments as well as the restructuring of existing businesses with a focus on transitioning wealth and control to the next generation in a tax efficient manner that maintains business continuity.

Vanessa also assists with the preparation of testamentary documents and estate administration, including the probating of wills, the marshalling of assets, the filing of state and federal estate tax returns, the sale of estate assets and the distribution of assets among estate beneficiaries. Vanessa also has experience administering intestate estates and representing estate fiduciaries in estate tax audits.

Vanessa advises clients on charitable giving by forming and administering private foundations, setting up donor advised funds, papering pledges and drafting charitable lead and charitable remainder trusts.

Photo of Lindsay Rehns Lindsay Rehns

Lindsay A. Rehns is a senior counsel in the Private Client Services Department. Her diverse private client services practice includes estate, gift and generation-skipping transfer tax planning, probate, estate and trust administration matters and preparing and negotiating prenuptial and postnuptial agreements. Lindsay assists…

Lindsay A. Rehns is a senior counsel in the Private Client Services Department. Her diverse private client services practice includes estate, gift and generation-skipping transfer tax planning, probate, estate and trust administration matters and preparing and negotiating prenuptial and postnuptial agreements. Lindsay assists high net worth individuals and families with developing suitable estate plans to maximize and protect the transfer of wealth to future generations. She is able to carefully navigate the often sensitive family dynamics involved in representing individuals and can make complex issues more comprehensible to her clients so they can make informed decisions about their assets.

Lindsay also supports Proskauer’s fiduciary litigators on estate, trust and tax related matters both relating to trial and settlement negotiations. She has extensive experience handling IRS estate and gift tax audits and prepares and reviews gift and estate tax returns.

Lindsay is experienced in implementing advanced estate planning techniques, including:

  • Estate, gift and generation-skipping transfer tax planning
    • Drafting wills, trusts and other estate planning documents
    • Charitable gift planning, including forming foundations and charitable trusts and obtaining IRS tax-exempt status
    • Life insurance planning
    • Asset protection planning
    • Coordinating transfers and estate plans among generations
  • Estate and trust administration
    • Preparing and filing estate and gift tax returns
    • Representing fiduciaries and beneficiaries in the probate and administration process
    •  Post-mortem tax planning
    • Probate court proceedings
    • Handling all aspects of estate administration, from marshaling assets to asset distribution

Lindsay has worked both in Proskauer’s Florida and New York offices and frequently travels between offices to best service clients. She is qualified to practice in Florida, New York and Georgia.

Daniel Hatten

Daniel W. Hatten is an associate in the Private Client Services Department and a member of the firm’s Fiduciary Litigation group.

Dan advises clients on a range of estate and wealth planning transactions, including the preparation of estate planning documents, lifetime gifting, multigenerational…

Daniel W. Hatten is an associate in the Private Client Services Department and a member of the firm’s Fiduciary Litigation group.

Dan advises clients on a range of estate and wealth planning transactions, including the preparation of estate planning documents, lifetime gifting, multigenerational planning, estate administration and fiduciary litigations.  He also advises clients on issues relating to their retirement plans, charitable giving, change of domicile and life insurance, including split-dollar life insurance.  Dan works with clients in a range of industries, including insiders of public companies, entrepreneurs, art dealers and art collectors, and helps clients navigate issues specific to their assets and situations.

Dan has also been involved in many fiduciary litigation matters and disputes with the IRS.  He has helped clients to obtain favorable private letter rulings from the IRS and navigate estate tax audits initiated by the IRS.  Dan has been involved in all aspects of fiduciary litigation proceedings, including briefings in Surrogate’s Court proceedings, appeals and settlement negotiations of interfamily disputes.