For Large Estates, Consider Grantor Retained Annuity Trusts

Many parents enjoy making an annual gift of $24,000 to each of their adult children because of the personal satisfaction it brings to see them enjoy it. The children have the opportunity to be thankful year after year and are able to enjoy a lifestyle that would not be possible without the annual gift.

However, when an estate planner suggests that a client create an irrevocable life insurance trust to pay estate taxes, there is often a concern about how to pay the life insurance premium. Since premium payments burden cash flow, they can make it difficult to continue annual gifts to the kids.

A high net worth does not necessarily equate to a large amount of cash on hand. Many of our clients own land, closely held stock or other significant, appreciating assets. So how can clients continue to make annual gifts to the children while they are alive and still have the funds available to fund the ILIT? Is an ILIT still an effective technique?

The usefulness of an ILIT has long been understood. Clients like to know with great certainty that the precious stock, land or other property asset will not be forced into a sale for the purpose of paying Uncle Sam when they die. This is where having life insurance in force to pay the estate tax becomes helpful. The size of the estate, of course, determines how large a policy is needed.

Next, a determination needs to be made regarding whether the life insurance premium will cause a gift tax problem. With the lifetime exclusion for gifting purposes at $1 million for each spouse, ILITs can still be a useful tool.

However, for the largest of estates, it may not be enough. The annual premiums needed to fund the ILIT may be so large that (gift tax rules aside) it may make more sense to finance the cost of the life insurance through a reputable bank.

A grantor retained annuity trust, used with financed premiums to fund an ILIT, may help solve that problem. A GRAT allows an individual–the grantor–to transfer property to the beneficiary (the ILIT) at a reduced gift tax cost. The property for which this is most effective is an asset that is expected to appreciate, such as stock that will go public, land that is rising in value or perhaps a closely held business.

An irrevocable trust holds this property for a specified number of years. The grantor gets to retain an interest in the trust property through an annuity, whether as a fixed percentage or fixed dollar amount. The grantor’s gift to the trust is the fair market value of the property transferred, less the present value of the retained annuity payments.

At the end of the trust’s term, the remaining property passes to the remainder beneficiary (the ILIT) without additional gift tax. Assuming the grantor survives the trust term, a GRAT is an effective estate “freeze” technique.

After the GRAT is created, the appreciation of the property’s value above the assumed discount rate passes to the ILIT without gift tax, thereby freezing the value. The value included in the grantor’s estate is the value of the annuity payments.

If designed correctly, these annuity payments will help cover a portion of the annual interest payment to the bank that loaned the grantor the money to fund the ILIT. Also, the value of the interest payments made to the bank by the grantor is considered a gift for gift tax purposes. If the payment is greater than the $12,000 annual gift tax exclusion, then the excess counts toward the $1 million lifetime gift tax exclusion.

If the grantor dies during the term of the trust, then the trust assets will revert back to his estate. It would make him no worse off than if the GRAT technique had not been used.

Consider this example

A 61 year-old affluent individual creates a 10-year GRAT with an annuity payout of 13.33%.

–The individual’s property, valued at $2,297,320, is gifted to the GRAT. (The example works with property valued either at this amount or with a greater value that is reduced to $2,297,320 after the available discounts are taken.)