Estate Freezing Techniques Available Through Grantor Retained Annuity Trusts

The United States imposes estate and gift taxes on certain transfers of U.S. situs property by “nonresident citizens of the United States.” In other words, individual foreign investors may be subject to the U.S. estate and gift tax on their investments in the United States. The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or donative transfer. An individual foreign investor’s U.S. taxable estate or donative transfer is subject to the same estate tax rates and gift tax rates applicable to U.S. citizens or residents, but with a substantially lower unified credit. The current unified credit for individual foreign investors or nonresident aliens is equivalent to a $60,000 exemption, unless an applicable treaty allows a greater credit. U.S. citizens and resident individuals are provided with a far more generous unified credit from the estate and gift tax. U.S. citizens and resident individuals are permitted a unified credit of $13.61 million.

For individuals that may be subject to the estate and gift tax, there are a number of planning opportunities available to mitigate the harsh consequences of the estate and gift tax. One method that may potentially be utilized to plan for the estate and gift tax are private annuities. This article discusses how grantor retained annuity trusts may be utilized to avoid the estate and gift tax.

Overview of How a Grantor Retained Annuity Trust Works

A grantor retained annuity trust (“GRAT”) is an estate freezing technique which is specifically authorized by Internal Revenue Code Sections 2702(a)(2)(B) and 2702(b) and can be a dramatic tax-saver in the right circumstances. A contributor to a GRAT is typically called a “grantor.” The grantor of a GRAT transfers property to the trust and retains an annuity payable for a term of years or for the shorter of the grantor’s life or a term of years. The period for which the grantor retains the annuity may be referred to as the “term.” This term should be shorter than the grantor’s life expectancy. At the end of the term, the trust property will remain in trust for, or pass directly to, the remainder beneficiaries provided in the trust instrument. Below, please see Illustration 1 which demonstrates how a GRAT operates.

Illustration 1.

Lisa establishes a GRAT with a term of ten years. She contributes a bond with a coupon of 12 percent. The bond’s face amount is $1,000,000. She reserves an annuity of 7 percent. Teresa (or her estate, if she dies within the term) will receive $70,000 over the 10-year term. At the end of the term, the trust assets will pass to her beneficiaries.

On the initial transfer of the bond to the GRAT, Lisa makes a taxable gift of the value of the remainder interest after the term. The amount of the gift is ordinarily determined under actuarial tables published by the Department of Treasury, and depends on the length of the term (ten years), the amount of the retained annuity (7 percent), and the 7520 rate at the time of the transfer. If Lisa dies during the 10-year term, part or all of the trust property may be includable in her gross estate for estate tax purposes. Lisa makes a taxable gift of the remainder interest. The gift will ordinarily be valued pursuant to the actuarial tables. The opportunity in the table valuation is that Lisa can transfer to the remainder beneficiaries, free of gift tax, an amount equal to: 1) any excess of the value they actually receive at the end of the term less 2) the amount they would have received at the end of the term if the trust property had earned the 7500 rate which applied at the time of transfer.

Thus, a GRAT is an opportunity to make a tax-free gift of an amount greater than the amount the actuarial tables claim is being transferred. In other words, a GRAT offers a chance to transfer all of the appreciation in the transferred property in excess of a fixed amount at no or minimal gift tax.

Structure of Trust

The statute allows the trust to be structured as either a GRAT or a grantor retained unitrust (“GRUT”). In a GRUT, the grantor’s unitrust interest would not be a fixed amount, as in the case of an annuity under a GRAT. Rather, it would be a percentage of the value of the trust each year, so that the amount of the grantor’s annual payment would float with the value of the trust. As a practical matter, an individual establishes an estate-freezing trust so to transfer as much as possible to the remainder beneficiaries for a given amount of gift tax. Assets that are expected to earn a great deal of income or appreciate substantially are typically chosen to fund the trust, in the hope that as much as possible of that income and appreciation can pass to the remainder beneficiary. Accordingly, in such a situation it would be counterproductive to do a GRUT, which would increase the grantor’s interest with each increase in the value of the trust assets.

In order to properly structure a GRAT, there must be a payment to an annuity. The annuity must be structured as a “qualified annuity interest,” which is an irrevocable right to receive a fixed amount. See Treas. Reg. Section 25.2702-3(b)(1)(i). The annuity must be payable to (or for the benefit of) the holder of the annuity interest at least once a year for each year of the term. The annuity payment may be made after the close of the taxable year, provided that it is made by the due date of the trust’s federal income tax return for the taxable year (without regard to extensions). A “fixed amount” means a stated dollar amount or a fixed fraction or percentage of the initial fair market value of the property transferred to the trust. In either case, the amount payable in any year cannot exceed 120 percent of the amount payable in the preceding year. See Treas. Reg. Section 25.2702-3(b)(1)(i). The income tax regulations permit the annuity to increase by up to 20 percent per year. See Treas. Reg. Section 25.2702-3(b)(1)(ii). And, a graduated annuity may be advantageous from a tax perspective, since the trust will have more time in the early years to accumulate funds to pay the later years’ annuities and leave a return for the remainder beneficiaries.

Gift Tax Consequences of Establishing a GRAT

The grantor’s gift of the remainder interest in the trust is ordinarily valued according to the Treasury’s actuarial tables. The gift’s value is partly a function of the 7520 rate on the date of the gift. A low 7520 rate at the date of gift will result in a smaller gift than a high 7520 rate would.

Estate Tax Consequences

If the grantor dies within the term, some, all, or none of the trust assets may be included in his or her gross estate. There is authority for all three positions. The Seventh Circuit, reversing the United States Tax Court, has held that no part of a trust was includable in the estate of a grantor who retained an annuity for life. See Estate of Maria Becklenberg v. Commissioner, 273 F.2d 297, 301 (7th Cir. 1959), rev’g 31 TC 402. The Seventh Circuit’s theory was that the retention of an annuity is not the equivalent of the retention of an income interest under Section 2036 of the Internal Revenue Code. The GRAT may give rights to the remaining annuity to the grantor’s estate if he dies within the term. Even if none of the trust is included in the grantor’s estate under Section 2036 of the Internal Revenue Code, the present value of any payments the estate is actually entitled to receive from the GRAT would be included in the grantor’s gross estate under Internal Revenue Code Section 2033.

Support for this position may be found in authority concerning charitable remainder trusts. The Internal Revenue Service (“IRS”) has an official position, stated in Revenue Ruling 82-105, 1982-1 CB 133, on the amount includible in the grantor’s estate when the deceased grantor of a charitable remainder annuity trust retained an annuity for life. The amount includible in his gross estate under Internal Revenue Code Section 2036(a)(1) is that portion of the trust property that would generate the income necessary to produce the annuity for the lifetime of a person of the grantor’s age immediately before his death, using the discount rate in effect at the grantor’s death. The formula to determine that position of the property is:

Annuity rate amount includible
(as a percentage X value of trust – in the gross estate
Of date of death trust value at date of death under Section 2036

Under this formula, the amount includible in the estate is determined by the 7520 rate existing at the grantor’s death, rather than at the date the contribution to the trust was made. As a result, less than full inclusion will occur when the payout rate at the date of the grantor’s death (as a percentage of the value of the trust on the date) is less than the 7520 rate then in effect. Below, please see Illustration 1 which demonstrates how this formula is applied.

Illustration 2.

In Year One, Dad transfers $1,000,000 to a charitable remainder trust which pays him eight percent of the initial fair market value of the trust, or $80,000, for life. At the time, the 7520 rate is nine percent. Six years later, Dad dies. At that time the property in the trust is worth $1,600,000, and the annuity ($80,000) is therefore five percent of the estate tax value of the trust. The 7520 rate at the time is eight percent. Only five-eights of the trust, or $1,000,000, will be includable in Dad’s estate (5 percent divided by 8 percent).

The same rule was also applied by the IRS in a private letter ruling dealing with the establishment of a settlement trust providing a life annuity to the grantor. See Priv. Ltr. Rul. 9638036 (June 24, 1996). Revenue Ruling 82-105 addresses the amount includible if the grantor retains an annuity for life. A GRAT will typically not have a life annuity, but a term of years. The United States Tax Court has held that the portion of trust property required to yield retained annuity payments for the remainder of the transferor’s life expectancy immediately before his death was includable in the grantor’s estate, even though the right to the annuity was limited to a term of years. See Estate of Pardee v. Commissioner, 49 TC 140, 150 (1967). Below, please see Illustration 3 which demonstrates this rule.

Illustration 3.

A establishes a GRAT, retaining an annuity of $10,000 for 20 years. Nineteen years have passed when A dies. The 7520 rate is 6 percent on A’s death. Under Pardee, the amount includible in A’s estate would be the lesser of $10,000 divided by 6 percent (i.e., $166,667) or the value of the trust property, and not the remaining amount that A’s estate actually has the right to receive, namely, $10,000 after one year has elapsed.

The IRS’s position is apparently that the entire amount of a GRAT is includable in the estate of the grantor who dies within the term under Internal Revenue Code Section 2039. See Priv. Ltr. Rul. 9451056 (Sept. 26, 1994); Priv. Ltr. Rul. 9345035 (Aug. 13, 1993). Section 2039 includes the value of any annuity or other payment receivable by any beneficiary by reason of surviving the decedent, if, under the agreement or other payment was payable to the decedent.

Conclusion

Beyond simply paying out annuities, GRATs are often used for estate and gift tax minimization. For estate planning purposes, a GRAT is a type of gifting trust that allows individuals to transfer high-yield assets or rapidly appreciating assets to a beneficiary with minimal estate and gift tax consequences. The trust also pays out an annuity to the grantor each year which can be part of a retirement strategy. GRATS should be a consideration in any complex estate tax plan.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.