From the January 2009 issue of Wealth Manager Web • Subscribe!


There are times when--even for the highest-net-worth clients--wealth transfer becomes secondary to the issue of wealth preservation. Clearly, this is one of those times! The failure of Lehman Brothers, the acquisition of Merrill Lynch, and the near demise of American International Group (AIG) have all thrust wealth preservation to the forefront--not to mention that common safe havens such as money markets are now being scrutinized to determine their exposure to the financial sector fallout. This is a tumultuous period to be sure, but it's also a time when the best wealth managers can further separate themselves from the competition by introducing clients to planning strategies that can work in any environment.

It's understandable that, as clients watch their net worth gyrate, they may find it increasingly difficult to embrace the idea of giving away assets that provide them with financial security. But the depressed financial and real estate markets, along with a low applicable federal rate (AFR), make this a compelling time for high-net-worth clients to consider incorporating a grantor retained annuity trust (GRAT) into their wealth transfer plans.

Exactly what is a GRAT?

A GRAT is an irrevocable trust established by the grantor into which the grantor transfers an asset, while retaining an annuity interest in said asset for a term of years. The retained annuity interest provides the grantor with a right to receive a fixed annual payment throughout the trust term.

Since the GRAT is a grantor trust, all income and deductions pass through to the grantor. And because the grantor is responsible for all income-tax liability for the trust, the annuity payment to the grantor will not be taxed again. At the completion of the trust term, the asset remaining in the GRAT is transferred to the trust beneficiaries.

What are the benefits of using a GRAT?

A GRAT is an excellent wealth transfer tool. It can provide for a significant reduction in gift taxes paid, while also reducing the grantor's taxable estate. When the grantor transfers assets to a GRAT, there is a taxable gift. However, the grantor's retained annuity interest provides a reduction of the gift value when determining the gift tax liability.

The present value of both the annuity interest and the remainder interest is calculated upon the asset's transfer to the GRAT. The gift (represented by the remainder interest) is the result of an IRS calculation that assumes a rate of return for the trust assets equal to the current AFR for the month in which the transfer is made.

Along with providing the ability to leverage the discounted gift-tax value, a GRAT can provide significant estate tax savings. An asset transferred to the GRAT will not be included in the grantor's estate. Any subsequent appreciation of the asset during the GRAT term will also be excluded. There is one caveat: If the grantor happens to die prior to the completion of the GRAT term, the full fair-market value of the GRAT asset on the grantor's date of death will be included in the grantor's estate. Obviously, this stipulation is a primary factor in determining the GRAT term.

Implementing a GRAT

Because there are several technical aspects associated with the design and implementation of a GRAT, a hypothetical example may be useful:

Mr. Rich transfers an asset valued at $1,000,000 to a GRAT. At the time of transfer, the AFR is 3.8% (the actual current AFR). The GRAT terms state that Mr. Rich will receive a 5% annuity payment for 10 years. At the end of the 10-year term, the asset will be distributed from the trust to Mr. Rich's child.

As previously mentioned, the transfer to the GRAT is a taxable gift. For gift tax purposes, however, the value of the transfer is not the value of the asset held by the grantor just prior to the transfer. Since Mr. Rich retained a 5% annuity interest ($50,000 in annual payments), the value of the asset (for gift-tax purposes) was reduced to $590,385. Assuming that the GRAT asset appreciates at an annual rate of 8%, the remainder that passes to Mr. Rich's child will be worth $1,434,596 at the completion of the GRAT term.

The initial transfer results in a total federal gift tax liability of $250,673, which can be satisfied by using a portion of Mr. Rich's unified credit for lifetime gifts (if available). The GRAT has effectively removed $1,434,596 from Mr. Rich's estate.

Take advantage of the AFR

When calculating the value of the annuity and remainder interest upon creation of the GRAT, the IRS assumes that the GRAT assets will appreciate at the AFR, which is published each month. For October 2008, the AFR was 3.8%. Most wealth managers certainly hope that their management skills could reap returns well above the AFR.

The example above illustrated what happened when the GRAT asset appreciated at 8%. What if the asset appreciated at the AFR of 3.8%? The remainder to pass to the beneficiary would be $857,255. This is the future value of $590,385, which is the amount that was considered a taxable gift when the GRAT was funded. At 8%, however, the remainder is $1,434,596. Because the annual rate of return for the GRAT asset was 5.2% higher than the AFR, $577,341 would be transferred to the GRAT beneficiaries without any transfer costs.

Remember, the lower the AFR, the lower the value of the asset for gift tax purposes and the higher the probability of transferring more value free of transfer costs at the completion of the GRAT term.

Zeroing in

Many high-net-worth clients have very advanced wealth transfer plans. Often, these clients have exhausted their unified credit for lifetime gifts through other planning techniques such as funding an irrevocable life insurance trust (ILIT) or creating a qualified personal residence trust (QPRT). Once the credit is exhausted, can a GRAT continue to be a valuable planning tool?

High-net-worth clients may find that a zeroed-out GRAT can provide substantial wealth transfer capabilities with little or no transfer costs. In a zeroed-out GRAT, the annuity payment to the grantor is set high enough that the calculation of the remainder produces a gift to the beneficiaries of zero or a nominal amount. Using the earlier example, an annuity payment of approximately 12.2% would result in a taxable gift of $0.35. If we keep assuming that the GRAT asset appreciates at 8%, and the AFR is 3.8%, the actual amount to pass to the GRAT beneficiaries would be $390,611 without any transfer costs!

Risky business?

The risks of a GRAT not being successful due to the death of the grantor prior to the completion of the GRAT term, and/or the underperformance of the asset, could seem palatable when compared with the potential benefits. An unsuccessful GRAT could lead to wasted costs incurred creating and maintaining the GRAT, a reduction of the client's unified credit, or the unnecessary payment of gift taxes. However, the potential gift and estate tax savings make a GRAT worth considering even in light of those possible risks.

The silver lining

The real estate market has been depressed, the equities markets are as volatile as ever, and the overall economic mood is dampening. Until the situation changes, successful wealth managers must continue to locate opportunities for their clients in any climate. You could present a potentially excellent solution by using a GRAT to take advantage of low interest rates and depressed values as you strive to accomplish their wealth transfer goals.

Gavin Morrissey is the director of advanced planning at Commonwealth Financial Network in San Diego, Calif. He can be reached at Commonwealth Financial Network(R) does not provide tax or legal advice.

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