From the January 2004 issue of Investment Advisor • Subscribe!

When Zero Has Value

The cloud hanging over zeroed-out GRATs as a wealth-transfer tool has lifted, thanks to a ruling by the IRS

When it comes to transferring wealth, one of the biggest challenges is to minimize the amount of estate and gift taxes incurred by clients and their beneficiaries. In the past, one popular strategy was to use a "zeroed-out" grantor retained annuity trust (GRAT).

In 2000, the IRS challenged the validity of these trusts, putting their use in a state of limbo. However, many financial and tax advisors felt that the IRS's stance was unreasonable and took the position for a number of years that "zeroed-out" GRATs are permissible and often the most optimal way to structure a GRAT. As it turns out, these advisors were correct. On October 15, 2003, the IRS announced that it will follow a 2000 decision of the Tax Court, Walton v. Commissioner, which approved of the concept of a "zeroed-out" GRAT.

What was the IRS's justification for fighting "zeroed-out" GRATs? It all goes back to Example 5 under Treas. Reg. Sec. 25.2702-3(e). This example discussed a GRAT where the annuity was payable to the donor and, in the event of the donor's death during the term of the GRAT, to the donor's estate.

The example went on to imply that the annuity should be valued based on a term that was adjusted downward for the actuarial probability that the donor would die during this term. Thus, the value of the retained interest would be less, causing the value of the gift to be greater. The IRS called this an unavoidable mortality premium on any GRAT gift.

The saga continued when the widow of Sam Walton (of Wal-Mart fame) contributed Wal-Mart stock worth approximately $100,000,000 to each of two GRATs for the benefit of her daughters. The GRATs were structured so that if Mrs. Walton were to die during the trust term, the annuity payments would continue to be paid out to the estate. Based on her tax advisor's calculations, the value of her retained interest was 100% of the fair market value of the stock on the date of transfer and, therefore, there shouldn't be any gift tax. As you might expect, the IRS did not agree. Based on Example 5 referenced above, it concluded that each GRAT in fact triggered a gift in excess of $3,800,000. Mrs. Walton then appealed the decision that was subsequently reviewed by the Tax Court.

An Invalid Interpretation

Ultimately, the court determined that Example 5 under IRC Reg. Sec.25.2702-3(e) was an invalid interpretation of Sec. 2702. The court concluded that the donor's retained interest must be valued as an annuity for a specified term of years, thus making it possible to "zero out" a GRAT. The IRS chose not to appeal this decision, but it also decided not to officially announce its position on the issue.

Fortunately, the clouds have finally lifted. As previously mentioned, on October 15 of this year the IRS announced that it will follow a 2000 decision of the Tax Court that approved the concept of a "zeroed-out" GRAT. With the current low interest-rate environment and the fact that everyone is now in agreement, GRATs should be considered for your client's wealth transfer needs.

GRATs 101

A GRAT, authorized by IRC ?? 1/2 2702, is a split-interest trust in which the grantor retains the right to receive lead fixed annuity payments for a set number of years. The remainder interest then goes to a non-charitable beneficiary(s). When the assets are initially contributed to the trust, the client is deemed to be making a completed gift to the beneficiaries, thus subject to gift tax. The taxable gift is calculated by taking the full value of the property contributed to the trust, minus the present value of the qualified retained annuity interest.

To calculate the present value of the annuity payments, the IRS makes an assumption about the rate at which trust assets will appreciate. This rate, known as the "Section 7520 Rate" is derived from the mid-term applicable federal rate (AFR) and fluctuates monthly. GRATs implemented in a particular month will lock in that month's 7520 rate regardless of the length of the GRAT term. As of November 2003, the 7520 rate was 4.0%. The average 7520 rate during the last 10 years was approximately 7.1%. While the actual rate of return of the assets over the term of the trust does not affect the gift tax calculation, it is imperative in determining the effectiveness or the success of this technique. Why? Because to the extent that the assets in a GRAT grow in excess of the 7520 rate, the excess is transferred to the remainder beneficiaries at the end of the trust term, with no gift tax implications. Consequently, it may be possible to transfer assets when the trust terminates with amounts that far exceed their original values when transferred into the trust. More important, the transfer can far exceed the gift tax value of the transferred assets.

Zeroed-Out GRATs

A zeroed-out GRAT seeks to minimize or completely eliminate the gift tax. To accomplish this, the annuity payments are set at a rate that is high enough to cause the GRAT to "zero out" or not have any value at the end of the specified term. As a result, no taxable gift is deemed to be made when the trust is created. Then, as with a GRAT, as long as the trust's assets appreciate at a rate higher than the 7520 rate, the excess passes to the beneficiaries free of gift tax.

To see how a "zeroed-out" GRAT works, consider this example. A father establishes a GRAT and names his daughter as the ultimate beneficiary. The father transfers $5 million in stock to the GRAT and specifies an annuity that will cause the trust to "zero out" in five years.

Assuming the 7520 rate is 3.6%, if the stock appreciates at 8% over the five-year life of the trust, the daughter receives $831,780 at the end of the term. The father incurs no gift tax on the transfer of over $800,000 and receives back the $5 million, plus a 3.6% return. If the stock appreciates more than 8%, the daughter would receive an even larger gift, tax free.

To understand the power of a low 7520 rate, let's use the same example, but assume that the 7520 rate is 7.2%. If the stock appreciates the same 8%, only $154,188 gets transferred to the daughter, rather than $600,000 in the previous example. Given today's relatively low 7520 rate, it may now make sense to consider "zeroed-out" GRATs for your clients.

One of the more visible ways you can add value for your high-net-worth clients is by recommending innovative ways for them to transfer wealth and save taxes at the same time. With the IRS now allowing "zeroed-out" GRATs, you have another arrow in your quiver when seeking to meet the financial needs of your key clients. Employing a GRAT strategy can also lead to multi-generational planning opportunities, as they present a way for you to interact with the client's beneficiaries.

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