The all-time low 7520 “hurdle” rate for June has made the “GRAT” a very attractive estate planning strategy.
June 2020 is shaping up to be a very attractive month for estate planning. As we maneuver through these uncertain times in light of COVID-19, a popular estate planning strategy in the spotlight is the grantor retained annuity trust, better known as a “GRAT.”
What is a GRAT? And why should it be reviewed as strategy for your estate plan?
A GRAT is an irrevocable trust that pays an annuity amount to the grantor or settlor for a set period of years known as the “retained interest term,” after which the remainder amount passes to or for the benefit of children or others that are named as the remainder beneficiaries. The effect of a GRAT is to transfer to the trust’s remainder beneficiaries all of the appreciation or growth in excess of the so-called “7520 rate” (an IRS published interest rate).
According to Rev. Rul. 2020-12, the June 2020 7520 rate used to calculate GRAT payments is 0.6%, the lowest since the IRS started publishing these rates in 1989. This very low interest rate, combined with lower equity values in the market due to COVID-19, makes a GRAT strategy very attractive for estate planning.
Do I need to use or have an estate and gift tax exemption to create a GRAT?
No. A very popular strategy, known as a “zeroed-out” GRAT, does not require the use of any gift tax exemption to fund it. In this type of GRAT, the actuarial value of the retained annuity interest, known as the “Annuity Amount,” is equal in value to the assets used to fund the trust. The gift value completed to the remainder beneficiaries is typically only a few dimes or pennies.
However, keep in mind that a Form 709 gift tax return will still be required to be filed for the donor upon establishing the zeroed-out GRAT, due to the fact that this gift is made into the GRAT, which is an irrevocable trust and required to be reported.
How does a GRAT operate?
The best way to explain how a GRAT functions is by looking at the numbers and reviewing a proposed calculation scenario.
For example, assume the grantor wants to contribute 1000 shares of stock worth $1,000,000 to a GRAT. The grantor funds a 2-year GRAT, based on the considerations set forth below. This means that he or she will receive an annuity for two years, and whatever is left in the GRAT after those two years will pass to the grantor’s children.
Based on the 7520 rate (0.6%) in effect for June 2020, the annuity payment that will “zero out” the gift is approximately 50.45154% of the initial contribution, or, based on our example, approximately $504,515.40 annually.
The annuity can be paid in cash, but it is not necessary to sell the stock, as the appropriate amount of stock can be distributed “in kind” to the grantor or settlor to satisfy the annuity requirement. For this purpose, the stock is valued on the date that the annuity is paid at each annuity anniversary payment date.
Here are three sample scenarios to help review the Zeroed Out GRAT strategy by numbers:
Scenario 1: The stock value increases by 10% in each of the two years of the GRAT.
One year after the gift to the GRAT, the stock in the GRAT is worth $1,100,000 (10% appreciation). The Trustee then distributes $504,515.40 to the grantor, leaving $595,484.60 in value in the trust. The trust assets continue to appreciate at the rate of 10% per year, so on the second anniversary (and termination date) of the trust, the assets are worth $655,033.08.
The Trustee distributes the annuity amount of $504,515.40 to the grantor, and the remaining $150,517.68 is distributed to the grantor’s children, free of gift tax.
To recap, the grantor or settlor has received distributions with a value of $1,009,030.80, and his children as remainder beneficiaries of the GRAT will receive $159,548.46. (Note that if the stock value had increased by 20% in each of the two years, the children would receive $330,066.12.)
Scenario 2: The stock value increases by 5% in each of the two years of the GRAT.
With a 5% increase, the stock in the GRAT would be worth $1,050,000 at the end of year one. The Trustee would distribute $504,515.40 to the grantor, leaving $545,484.60 in value in the trust. The trust assets continue to appreciate at the rate of 5% per year, so on the second anniversary (and termination date) of the trust, the assets are worth $613,732.03.
The Trustee distributes the annuity amount of $504,515.40 to the grantor, and the remaining $68,243.43 is distributed to the grantor’s children, free of gift tax.
To recap, the grantor has received distributions with a value of $1,009,030.80; and his children receive $68,243.43.
Scenario 3: The stock value declines by 10% in the first year and increases by 5% in the second year of the GRAT.
With a 10% decrease, the stock in the GRAT would be worth $900,000 at the end of year one. The Trustee would distribute $504,515.40 to the grantor, leaving $395,484.60 in value in the trust. The trust assets appreciate 5% in the second year, so on the second anniversary (and termination date) of the trust, the assets are worth $415,258.83. The Trustee would distribute all of the trust assets to the grantor or settlor, and nothing would be distributed to the grantor or settlor’s children.
Because the assets did not appreciate at a rate greater than the Section 7520 hurdle rate of return of 0.6%, the GRAT has not accomplished anything. However, the costs of this “failure” are minimal. All stock is returned to the grantor or settlor, and other than the trust administration costs, this grantor or settlor is in the same position, from both a financial and a federal estate review standpoint, as he would have been had he not funded the GRAT.
(It is important to note that the above scenarios do not include that the annuity payments to the grantor or settlor may also be set to vary by 120% of the annuity amount payable in the preceding year, in accordance with Treas. Reg. § 25.2702-3(b)(1)(ii).)
How is a GRAT treated for tax purposes: gift, estate, and income?
- Gift Tax – For gift tax purposes, the only taxable gift is the actuarial value (using the published IRS 7520 interest rate) of the remainder interest that is projected to pass to the children when the GRAT terminates. In the case of a zeroed out GRAT, the annuity is set at such that the projected value of the remainder interest is typically calculated at less than one dollar. If the GRAT outperforms the 7520 hurdle rate (0.6% for June), the remainder amount that passes to the children at the termination of the trust passes free of gift tax.
- Estate Tax – For estate tax purposes, given that the grantor outlives the term of the trust, the GRAT assets will not be included in the grantor’s estate when he or she dies. As noted above, if the GRAT does not outperform the Section 7520 hurdle rate or grantor dies during the term of the trust, the GRAT will pass back into the estate of the grantor for estate tax purposes.
- Income Tax – For income tax purposes, the GRAT is a grantor trust, meaning that the grantor pays the income taxes on the trust’s income during the term of the GRAT. If the beneficiaries receive any part of their distribution at termination in stock, the beneficiaries will take the grantor’s “carryover” basis in the stock they receive.
How many years should a GRAT term be?
It is generally accepted in accordance with IRS publications that two years is the minimum term and that there is no maximum term. However, for a zeroed-out GRAT, the grantor must be alive at the end of the term in accordance with Section 2036 of IRC; the length of the GRAT term should therefore be set as such that the grantor has a strong likelihood of outliving it.
If the grantor dies during the term of the GRAT, the remainder amount and the Annuity Amount distribute back into the grantor’s estate, and the GRAT is unsuccessful.
How does one choose the term of the GRAT?
The grantor and their estate planning attorney should consider several factors, including the age and health status of the grantor, as well as the grantor’s views regarding the future appreciation of the asset used to fund the GRAT.
Although we have illustrated this technique with 2-year GRATs, a longer term could be quite advantageous, as the 0.6% June 2020 rate would be locked for the entire term of the GRAT. If, for example, a 10-year term were selected, the GRAT’s annual annuity payment would be 10.33292% of the initial contribution’s value of $1,000,000: approximately $103,329.20.
What is the best time to fund a GRAT?
The best time to fund a GRAT is when interest rates are low and asset prices are depressed or otherwise have great appreciation potential. With respect to interest rates, we are living in a great environment for GRAT strategies. The 0.6% interest rate, in effect for the entire month of June, is at an all-time low since the IRS began publishing this rate, as referenced above. The IRS publishes the Section 7520 rate for the next month about two weeks prior to the start of said month.
The other key factor is reviewing the asset values to be used to fund the GRAT. COVID-19 has triggered a shift down in the market, providing a potential opportunity for lower asset values in the portfolio of the grantor as a result. As can be seen in the third example, if asset values do not increase, the GRAT is not effective to transfer wealth to the remainder beneficiary and simply pours the principal back into the grantor’s estate.
If you think values are at or near the bottom, this is a good time to fund the GRAT.
What if I funded a GRAT before the crash when stock prices were high?
If an existing GRAT is underperforming, and it is likely that nothing will clear the Section 7520 rate hurdle to pass to the remainder beneficiaries on termination, it might be a good idea to “freeze” the GRAT by swapping the GRAT’s current assets for assets with lower volatility, such as cash or bonds, and then use the withdrawn assets to fund a new GRAT that would take advantage of the current depressed asset values and low interest rates, if still present. The original GRAT would then return the substituted assets to the donor when it terminates, as highlighted in Scenario 3 above.
Pittsburgh Estate Planning Attorneys
For more information on the impacts of COVID-19 on estate planning strategy or with questions regarding your own estate plan, Charles Hadad, Partner and Estates & Trusts Chair, is available by phone at 724.776.8000 or by email at email@example.com.