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GRANTOR RETAINED ANNUITY TRUSTS

A grantor retained annuity trust (“GRAT”) is an irrevocable trust that is used to transfer significant wealth at little or no gift or estate tax cost. GRATs work especially well for pre-IPO stock and other appreciating assets. This paper explains GRATs, generally, and provides examples of the significant tax savings that can be achieved through their implementation.

GRATs Generally

A GRAT is an irrevocable trust in which the grantor retains an annuity interest during the GRAT term, with any excess remainder existing at the end of the GRAT term passing tax-free to beneficiaries. In order for the GRAT assets to produce any excess remainder, however, the GRAT assets must outperform the benchmark rate (or “7520 rate”) that is published by the IRS in the month of creation of the GRAT. The reason is that in order for the GRAT to produce a zero gift tax, the GRAT must pay back to the grantor an annuity amount totaling the initial value of the contributed assets to the GRAT, increased by phantom interest at the 7520 rate.

For May 2011, the IRS 7520 rate is 3.0% per year. For this reason, now is a great time to establish a GRAT using assets that are expected to outperform the low 3.0% rate. Such assets can include business interests, securities, and any other investment with significant earnings and/or anticipated appreciation.

It is important to note that although the 7520 rate is currently 3.0% per year, this rate changes monthly. Increases can be dramatic – in the past few months, the 7520 rate increased from an all-time low of 1.80% in December 2010 to the current 3.0% rate. Thus, if you are interested in establishing a GRAT, you should act quickly.

How GRATs Work Below is a diagram of the typical GRAT structure:

Grantor

↓ ↑

Assets ↓ ↑ Annuity payments

↓ ↑ (total value = assets value + IRS 7520 interest)

GRAT

Excess over annuity payments passes gift-tax-free at term

Beneficiaries 1

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-As shown above, after contributing property interests to the GRAT, the grantor retains the right to receive annual annuity payments for the length of the GRAT term. The amount of the annuity payments are determined so that they “zero out” the gift tax value of the remainder. To do this, the present value of all annuity payments (discounted by the IRS 7520 rate) must equal the initial value of the property interests contributed at the outset. This way, there is no gift tax at creation since the remainder value is zero; in other words, the IRS treats the beneficiaries as receiving nothing at creation of the GRAT – and, for all intents and purposes, ignores any potential market appreciation and/or income over and above the annuity payments.

If the GRAT assets outperform the IRS’ benchmark rate, any excess appreciation existing at the GRAT term passes to remainder beneficiaries, free from gift tax. Nevertheless, if the GRAT property fails to outperform the IRS benchmark rate, there is no downside since the grantor receives back everything in the form of annuity payments as if the GRAT had never been created. Thus, GRATs pose little or no risk since there is unlimited upside, without any significant downside risk (other than legal and accounting costs).

There is a catch – in addition to the assets outperforming the IRS benchmark rate, the grantor must also survive the GRAT term in order to pass on the remainder. Nevertheless, the tax consequences from death are similar to the tax consequences as if the GRAT had never been created and no other tax planning had occurred over those assets: all of the annuity payments received and any remaining GRAT assets are included in the grantor’s taxable estate.

Examples

Below is a model of a 6-year GRAT with an initial contribution of $1 million of property. The model assumes an IRS 7520 rate of 3.0%, which produces six (6) annuity payments of $184,598 each in order to produce a zero remainder value.1 Based on an average return of 5.5% per year,

this particular GRAT results in $115,420 passing to beneficiaries:

6-YEAR GRAT Year Beginning

Value Annual Return End of Year PaymentAnnuity BalanceEnding

IRS Rate 3.00% 1 $1,000,000 10% $1,100,000 ($184,598) $915,402

GRAT Contribution $1,000,000 2 $915,402 6% $970,327 ($184,598) $785,729

Term 6 3 $785,729 0% $785,729 ($184,598) $601,132

4 $601,132 3% $619,166 ($184,598) $434,568

5 $434,568 7% $464,988 ($184,598) $280,390

6 $280,390 7% $300,018 ($184,598) $115,420

Average Return 5.50% Total to Beneficiaries $115,420 1. In practice, each annuity payment may be increased by 20% each year (the maximum permitted under the Treasury Regulations) in order to “backload” the annuity payments. This allows the GRAT to retain the maximum amount of investment assets for the longest time possible. For sake of simplicity, all annuity payments in this article are calculated on a straight line basis.

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GRATs are especially well-suited vehicles for pre-IPO stock. Consider if the stock placed in the above GRAT had instead realized a successful IPO in Year 3 that resulted in a 100% gain. All else equal, this results in $1,041,989 passing to the remainder beneficiaries, transfer-tax-free:

6-YEAR GRAT

IPO SPIKE Year Annual Return End of Year PaymentAnnuity BalanceEnding

IRS Rate 3.00% 1 10% $1,100,000 ($184,598) $915,402

GRAT Contribution $1,000,000 2 6% $970,327 ($184,598) $785,729

Term 6 3 100% $1,571,458 ($184,598) $1,386,861

4 3% $1,428,467 ($184,598) $1,243,869 5 7% $1,330,940 ($184,598) $1,146,342 6 7% $1,226,586 ($184,598) $1,041,989 Average Return 22.17% Total to Beneficiaries $1,041,989

Rolling GRATs

Depending on the assets used, it may be advisable to establish a series of 2-year “rolling GRATs,” rather than one long-term GRAT. With rolling GRATs, the grantor creates two-year GRATs, and uses the annuity payments received from each preceding year GRAT to establish a new two-year GRAT. This process continues as long as desired.

Rolling GRATs offer the unique advantage of diversifying downside risk. The reason is that any unsuccessful 2-year GRAT that fails to outperform the IRS benchmark rate does not decrease the total amount passing to beneficiaries from any successful 2-year GRATs. In other words, GRATs for unsuccessful years do not “taint the pot.” Consider the following comparison had the grantor of the 6-year GRAT used a series of three 2-year rolling GRATs:

6-YEAR GRAT Year Beginning

Value Annual Return End of Year PaymentAnnuity BalanceEnding

IRS Rate 3.00% 1 $1,000,000 10% $1,100,000 ($184,598) $915,402

GRAT Contribution $1,000,000 2 $915,402 6% $970,327 ($184,598) $785,729

Term 6 3 $785,729 0% $785,729 ($184,598) $601,132

4 $601,132 3% $619,166 ($184,598) $434,568

5 $434,568 7% $464,988 ($184,598) $280,390

6 $280,390 7% $300,018 ($184,598) $115,420

Average Return 5.50% Total to Beneficiaries $115,420

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-3 ROLLING 2-YEAR GRATs

CONSTANT IRS RATE Year Annual Return Beginning Value Year ValueEnd of PaymentAnnuity BalanceEnding

IRS Rate 3.00% GRAT 1 1 10% $1,000,000 $1,100,000 ($522,611) $557,389

Contribution $1,000,000 2 6% $577,389 $612,033 ($522,611) $89,422

($1,045,222)

GRAT 2 3 0% $1,045,222 $1,045,222 ($546,244) $498,978

4 3% $498,978 $513,947 ($513,611) $0

($1,060,191)

GRAT 3 5 7% $1,060,191 $1,134,404 ($554,067) $580,337

6 7% $580,337 $620,961 ($554,067) $66,893

Total to Beneficiaries from All

Three GRATs $156,315

As shown above, the three rolling 2-year GRATs pass $156,315 to beneficiaries, while the 6-year GRAT with the same asset performance passes only $115,420. The reason is that, with the 6-year GRAT, the amount passing to beneficiaries in Year 6 is a function of the asset performance for all years, including the “drag” from Years 3 & 4 (in these years, the assets returned 0% and 3%, respectively, and therefore did not outperform the 3.0% benchmark rate). With the rolling GRATs, however, the successful Year 1/2 and Year 5/6 GRATs pass their appreciation of $89,422 and $66,893 to the beneficiaries, respectively, without being affected by the unsuccessful Year 3/4 GRAT. Instead, the underperforming Year 3/4 GRAT merely returns its capital to the grantor (even though it does not have enough to cover the Year 4 payment of $546,244) and the grantor uses the capital received to establish the Year 5/6 GRAT. This is the diversifying benefit of rolling GRATs. Rolling GRATs should not be used if it is believed that the IRS benchmark rate will substantially increase. Consider the effects of using rolling GRATs in an environment of rising IRS benchmark rates:

3 ROLLING 2-YEAR GRATs

INCREASING IRS RATE Year Annual Return Beginning Value Year ValueEnd of PaymentAnnuity BalanceEnding

IRS Rate - 1st GRAT 3.00% GRAT 1 1 10% $1,000,000 $1,100,000 ($522,611) $557,389

IRS Rate - 2nd GRAT 4.00% 2 6% $577,389 $612,033 ($522,611) $89,422

IRS Rate - 3rd GRAT 7.00% ($1,045,222)

GRAT Contribution $1,000,000

GRAT 2 3 3% $1,045,222 $1,076,578 ($554,172) $522,406

4 3% $522,406 $538,078 ($538,078) $0

($1,092,251)

GRAT 3 5 7% $1,092,251 $1,168,708 ($604,115) $564,593

6 7% $564,593 $604,115 ($604,115) $0

Total to Beneficiaries from All

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In this example, the grantor would have been much better off locking in the low 3.0% rate (shifting $115,420), rather than using rolling GRATs to diversify the performance fluctuations (shifting only $89,422). Thus, in selecting the GRAT term and deciding whether to use rolling GRATs, it is important to analyze the interaction between the expected rate of return on the GRAT property, as well as any anticipated increases in the IRS benchmark rate.

Summary of Tax Consequences The following is a summary of the tax consequences of a GRAT:

Gift Tax: There is generally no taxable gift on the creation or termination of a zeroed-out GRAT.2

By providing for the grantor’s retained annuity interest amount to be equal to the value of the contributed assets (as adjusted by the IRS 7520 rate), the taxable gift can effectively be zeroed out. Future appreciation on the contributed assets is not included in determining the value of the taxable gift.

Estate Tax: If the grantor dies during the GRAT term, then the remaining GRAT assets (including appreciation) get pulled back into the grantor’s taxable estate. If the grantor survives the GRAT term, then only the value of the annuity payments remain part of the grantor’s taxable estate. Generation Skipping Transfer Tax: For purposes of generation skipping transfers, GRATs are not a viable option because of a special rule called the Estate Tax Inclusion Period (“ETIP”). The ETIP rules provide that a grantor cannot allocate generation skipping transfer tax (“GST”) exemption unless and until the grantor survives the term of the GRAT. Therefore, a grantor cannot have certainty as to the amount of GST exemption required to make an exempt gift until the GRAT term is over, making GRATs correspondingly less attractive for GST planning.

Income Tax: For income tax purposes, the grantor is treated as the owner of all of the assets in the GRAT during the GRAT term. Accordingly, income earned on any GRAT asset during the GRAT term is taxable to the grantor. Any transfers between the grantor and the GRAT (such as when assets are contributed to the GRAT or annuity payments are made to the grantor) during the GRAT term are not treated as taxable events for income tax purposes.

2. In practice, it is sometimes desirable to create a nominal gift in order to neccessitate the filing of an IRS Form 709 Gift Tax Return in order to start

the 3-year statute of limitations.

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-If you have any questions or would like to discuss any of the above in more detail, please feel free to contact one of our estate planning attorneys listed below:

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Recently adopted Internal Revenue Service regulations generally provide that, for the purpose of avoiding federal tax penalties,

a taxpayer may rely only on formal written advice meeting specific requirements. Any tax advice in this message does not meet

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References

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