December 2002

The combination of historically low interest rates and generally depressed securities values have made the “Zeroed-out GRAT” more attractive than ever, and this bulletin is intended to inform our clients about the structure and advantages of this technique.

The Grantor Retained Annuity Trust, or GRAT, is a trust which requires: (i) the payment to the Grantor (the person who creates the trust) of either a fixed dollar amount or a fixed percentage of the original value of the trust each year (the “Annuity Payments”) for a fixed number of years (the “Term”), and (ii) after the end of the Term, the trust is either distributed to or held in trust for other beneficiaries, usually the Grantor’s children.

The value of the beneficiary’s rights in the trust after the Term ends is subject to gift tax (or application of all or a portion of the Grantor’s $1,000,000 lifetime gift tax exemption) and is equal to the initial value of the property transferred to the trust less the present value of the Annuity Payments retained by the Grantor, as determined by the Grantor’s age and an interest rate prescribed by the Internal Revenue Service (“IRS”) which, for December, 2002, is 4%.

A Zeroed-out GRAT is designed with a very high Annuity Payment continuing for a short period, which must be at least two years, so that the discounted present value of the series of Annuity Payments is equal to the full value of the property transferred to the GRAT, thereby reducing the value of the gift portion of the GRAT to zero. For example, if a GRAT were funded with securities with a value of $1,000,000 and the Grantor retained the right to Annuity Payments of $530,195 for two years, the trust would be “zeroed out” and there would be no taxable gift. If the trust assets appreciated at 15% per year, $182,581 would pass to the successor beneficiaries after two years, without gift tax.

The IRS Regulations provide that the risk of the Grantor’s death during the two-year period must be taken into account, but this Regulation was held to be invalid in a unanimous Tax Court decision which the IRS did not appeal. Even if the IRS were to prevail in a later case, the amount of the gift in our illustration for a 65 year-old Grantor would be only $18,344. Note that, for gift tax purposes, the value of the gift portion of the GRAT is determined when the GRAT is created and is not redetermined at the end of the term of the GRAT (unless the beneficiary is a grandchild, which would defeat the purpose of the GRAT).

The reason for using the shortest possible term is to reduce the risk of the Grantor’s death during the term as much as possible, because the Grantor’s death before the end of the Term will result in the trust being included in his estate for estate tax purposes, entirely or in part. For example, there is an 87% chance that an 80 year-old Grantor will survive for two years, but the probability of survival for five years is reduced to 67%.

Since the GRAT will generally have securities as its only assets and capital gains tax would be incurred on the sale of a portion of such securities to make the Annuity Payment in cash, the Annuity Payment typically is made by returning a portion of the trust’s securities to the Grantor at their market value on the date of payment. (There are no tax consequences from this in-kind payment, as discussed below.) The use of marketable securities facilitates the calculation of the Annuity Payments for a GRAT since their values are known. Nevertheless, stock of a family business or other closely-held stock or entity interests could be used to fund the GRAT, but it would be necessary to obtain professional appraisals of the stock value, at both the initial funding of the trust and each Annuity Payment. There is a risk of the IRS not agreeing with the taxpayer’s appraisals, but the risk becomes minimal by stating the Annuity Payment as a percentage of the initial value of the trust rather than as a dollar amount.

If the Grantor has large holdings of individual securities, it will be desirable to establish a separate GRAT for each security to avoid the risk of diluting the gain from stocks which perform well by losses from other stocks. For example, if the GRAT holds two securities, one of which appreciates by 15% and the other of which declines by 15%, the net effect will be no appreciation or depreciation in the GRAT assets. On the other hand, if each security were held in a separate GRAT, the Grantor would receive back all of the depreciated security but the portion of the appreciated security in excess of the Annuity Payments would pass to the Grantor’s children, gift tax-free.

This illustrates the popularity of the Zeroed-out GRAT: the nearly unlimited potential, with appreciating property, of passing wealth to one’s children without incurring a gift tax liability.

For income tax purposes, the trust is a “grantor trust” so long as the Grantor is receiving Annuity Payments. The Internal Revenue Code provides that the Grantor of a grantor trust will be deemed to be the owner of the trust for income tax purposes, so that all income and deductions of the trust are included on the Grantor’s income tax returns as if he or she still owned the GRAT’s assets. Moreover, no gain is recognized on transactions between the Grantor and the “grantor trust,” which is the reason that making the Annuity Payment with appreciated securities does not incur capital gains tax.

There are no adverse ramifications if the assets in the GRAT do not appreciate and, therefore, the trust is exhausted by making the Annuity Payments to the Grantor. Further, in either this event or upon the return of a portion of the securities as an Annuity Payment, and assuming current law remains the same, a Grantor could create another Zeroed-out GRAT with the same securities anticipating appreciation in the trust assets in the next GRAT Term.

This bulletin is for general information only and should not be construed as legal advice. If you wish to consider the applicability of a GRAT to your specific circumstances, please contact either of the authors or your regular ECJ attorney. +

+ If you have any questions regarding this bulletin, please contact Marvin H. Lewis, Esq., at 310.281.6302 or mlewis@ecjlaw.com, or Reeve E. Chudd, Esq., at 310.281.6308 or rchudd@ecjlaw.com. If you would like to receive our newsletters by e-mail, please send your e-mail information to Cynthia Kaiser, Marketing Director, at 310.281.6328 or ckaiser@ecjlaw.com. Be sure to let us know if you would also like to continue to receive a hard copy of this or any other ECJ publication. If you would like the Tax Bulletin sent to you, please contact Cynthia S. Kaiser at 310.281.6328 or ckaiser@ecjlaw.com.

Tax Bulletin

Zeroed-out GRATs