9023 / How can a three-year grantor retained income trust (GRIT) be used in family business succession planning?

A grantor retained income trust (GRIT) is an irrevocable trust created by the grantor allowing the grantor to retain an income interest for a term of years. At the end of the term, the property held in trust is distributed to, or remains in trust for, the named beneficiaries. If the grantor survives beyond the retained income term, then the property transferred in trust—the remainder interest in the trust property—is not included in the grantor’s estate. Although the transfer of a remainder interest is a taxable gift—a gift tax is due when the transfer is made—a GRIT can reduce a grantor’s overall transfer tax liability because the gift tax is based on the value of the remainder when transferred. Thus, any appreciation in the remainder property (from the date of the gift to the date of the grantor’s death) is effectively transferred estate tax-free. However, if the grantor dies before the retained income period expires, the trust property is included in the grantor’s estate and will be subject to estate tax.

A three-year GRIT is simply a GRIT whose specified term is three years—a time period that stems from the general rule that gifts that are made within three years of a donor’s death will be brought back into the donor’s estate.¹ In this context, a gift of stock is transferred to a GRIT that provides that all income from the trust will be paid to the parent generation for a period of three years. Because this income right is not a fixed amount or fixed percentage of the fair market value of the stock transferred, it is not a “qualified interest,”² so that the value of the income interest—or the “retained interest”—will be zero.³ This means that, for gift tax purposes, the value of the interest that remains at the end of the term will be the entire value of the stock transferred.⁴ Effectively, this strategy is most valuable when the parent generation has determined that it is willing to pay the gift taxes on the stock transfer currently in order to avoid the inclusion of the appreciated stock in their estate.

At the end of the three-year period, the stock will pass to the next generation. The risk of this strategy is that, if the parent generation dies within the three-year period, the value of the stock (including any appreciation that occurs within the three-year period) and all gift taxes paid will be included in the parent’s estate (although the estate will receive a credit for the gift taxes already paid). If the parent outlives the three-year period, this risk is eliminated and any appreciation in the stock is transferred estate tax-free.

The ability to use this technique has been limited with the advent of IRC Section 2702. This section provides that the retained interest is valued at zero, unless the retained interest is a “qualified retained interest.” The rules of Section 2702 apply with respect to transfers to family members.⁵ Therefore, the ability to implement a GRIT is limited to those parties that are not family members within the statutory definition. This technique may have applicability to same sex couples who do not get married and other unrelated parties within the definition.