1. General. Grantor retained annuity trusts (GRATs) and grantor retained unitrusts (GRUTs) are planning tools that allow a person to give away assets to family members with little or no gift tax, and without parting with all or most of the income from the property for a specified number of years. GRATs and GRUTs both involve gifts of a remainder interest in a trust that, because the donor retains an annuity interest for a term of years, has a reduced or no value for gift tax purposes. An annuity interest is essentially the right to receive regular payments, made annually or more frequently, for a fixed period of time usually expressed in years. The remainder interest is the sum of the assets remaining in the trust after the payment of annuity interest. The remainder interest may be more or less than the beginning value of the trust depending on the income experience of the trust and the annuity payments.
Thus, the donor can give away the remainder interest with a reduced or no gift tax. To create a GRAT or GRUT, the donor transfers assets to an irrevocable trust and retains an annuity interest for a specified number of years. The retained annuity interest is described either as a dollar amount or a percentage of the initial value of the trust assets (a GRAT) or as a fixed percentage of the annual value of the trust assets (a GRUT). The amount of the annuity is set according to Internal Revenue Service actuarial tables. When the retained annuity term ends, the trust may either terminate, in which case it pays all of the assets outright to the beneficiaries, or the trust may continue, in which case it will hold the assets for the beneficiaries on terms set out in the trust agreement.
1.1. Amount of Taxable Gift. The transfer of assets to a GRAT or GRUT is a taxable gift of only the value of the remainder interest.
1.2. Advantages. GRATs and GRUTs have several advantages as planning techniques for making gifts.
1.2.1. Any future appreciation and income, in excess of annuity payments, inures to the remainder beneficiary if the grantor survives the trust term.
1.2.2. The grantor retains for a period of time all or most of the income generated by the property given away.
1.2.3. GRATs and GRUTs are specifically approved by the Internal Revenue Code.
1.3. Disadvantages. GRATs and GRUTs have several disadvantages as planning techniques for making gifts.
1.3.1. They are grantor trusts. Consequently, the grantor will be taxed on all trust income even if it exceeds the amounts paid as an annuity.
The taxation of the grantor on income he or she does not actually receive is not necessarily a bad thing. By paying such tax, the grantor is effectively transferring additional family wealth to the trust's remainder beneficiaries. The payment of such tax may be an additional "gift" to the remainder beneficiaries without the imposition of an additional gift tax.
The position of the IRS on this issue is unclear. On one hand, since the grantor trust rules require the grantor to pay tax on the income of the trust, it seems illogical to deem the satisfaction of that personal obligation as a gift to someone else. On the other hand, the remainder beneficiaries receive an economic benefit from the grantor's unreimbursed payment of these income taxes, so characterization as a gift is not entirely unfounded.
As a hedge against an adverse result, it is possible to include an income tax reimbursement provision in these trusts.
1.3.2. The grantor must outlive the term of the trust in order to obtain the desired estate tax advantages. If the grantor does not outlive the annuity term, some or all of the value of the trust assets is included in his or her gross estate for federal estate tax purposes. However, if the grantor does die during the annuity term and the the property is included in the grantor's gross estate, he or she fares no worse than if no gift had been made.
1.3.3. Neither the grantor nor the remainder beneficiaries can pledge or sell the assets of the trust and neither one can include the assets themselves on a financial statement for purposes of securing loans.
1.3.4. The gift portion of a GRAT or GRUT is a remainder interest. Since a remainder is a future interest, no part of any taxable gift to the beneficiaries of GRAT or GRUT qualifies for the gift tax annual exclusion. The grantor's unified credit must be relied on to shelter a transfer to a GRAT or GRUT from current gift tax.
1.3.5. GRATs and GRUTs are moderately complicated, requiring a formal trust agreement, a trustee, a tax identification number, and annual trust income tax returns. The grantor might serve as a trustee during the term of the annuity since the trust is already a grantor trust and its property is already included in the grantor's gross estate if the grantor dies during the annuity period. If the property will be held in trust after the annuity period, however, the general estate and income tax rules will often dictate the use of a different trustee.
2. Qualified Interests. The Internal Revenue Code provides that in order to determine the value of a gift to a person's family members, the value of the entire asset given away is reduced by the value of a "qualified" interest retained by the person. If the retained interest is not "qualified", then the value of the gift is the entire value of the asset given away not reduced by any retained interest. A "qualified" interest is one that is in the form of a fixed annuity payable at least annually, a fixed percentage of the value of the trust assets payable at least annually (i.e., a unitrust interest), or a noncontingent remainder following an annuity or unitrust interest. The retained interest in a GRAT or GRUT is a qualified interest. GRATs and GRUTs, however, must comply with certain requirements.
3. Requirements Common to Both GRATs and GRUTs. There are four requirements that apply to both GRATs and GRUTs.
3.1. A Trust must be either a GRAT or a GRUT. For a retained interest in a trust to be a qualified interest, the trust must be and operate as either a qualified GRAT or a qualified GRUT.
3.2. No Payments May be Made to Other Persons. Until the expiration of the qualified interest, the trust must prohibit distributions from the trust fund to any persons other than the annuitant.
3.3. Term of Annuity or Unitrust. The governing instrument must fix the term of the retained annuity or unitrust interest.
3.4. Commutation. A GRAT or GRUT trust instrument must prohibit any commutation of the interest of the annuitant. Commutation occurs when the trust terminates before the end of the term and the trust fund is distributed between the grantor and the beneficiaries on an actuarial basis.
4. Additional Requirements for GRATs. Four separate rules applicable only to a GRAT.
4.1. Payment of Annuity Amount. The qualified annuity interest in a GRAT must be an irrevocable right to receive a fixed amount payable annually or more often. However, an amount is deemed fixed even if it is changed annually to the extent that the amount payable in any year does not exceed 120 percent of the amount payable in the preceding year.
4.2. Incorrect Valuation of Trust Property. A GRAT that describes the annuity amount as a percentage of the initial value of the trust assets must require that, if the trust assets were incorrectly valued, a compensating payment will be made either to or by the annuitant on account of the incorrect valuation.
4.3. Computation of Annuity Amount in Short Years. A GRAT must include a provision adjusting the annuity amount in the case of short taxable years and in the case of the trust's last taxable year.
4.4. Additional Contributions Prohibited. A GRAT must prohibit the trustee from accepting any additional contributions to the trust.
5. Additional Requirements for GRUTs. There are three additional requirements for GRUTs.
5.1. Payment of Unitrust Amount. The qualified unitrust interest in a GRUT must be an irrevocable right to receive a fixed percentage of the annually determined value of the trust fund, payable annually or more often. A unitrust amount may be increased throughout the term of the retained interest to the extent that the fraction or percentage payable in any year does not exceed 120 percent of the fraction or percentage payable in the preceding year.
5.2. Incorrect Valuations of Trust Property. A GRUT must require that if the trustee incorrectly values the trust assets in any year, a compensating payment will be made either to or by the annuitant on account of the incorrect valuation.
5.3. Computation of Unitrust Amount in Short Years. A qualified GRUT must include a provision requiring that the unitrust amount will be adjusted in the case of short taxable years and in the case of the trust's last taxable year.
6. Designing the GRAT or GRUT.
6.1. General Considerations. The value of a gift of a remainder interest in a GRAT or GRUT is the value of the trust assets, less the actuarial value of the retained interest. The critical computation is the present value of the reserved annuity. The annuity or unitrust amount is valued under actuarial tables provided by the Internal Revenue Service. Interest rates vary monthly.
6.2. GRATs vs. GRUTs. In addition to selecting the term and size of the annuity payments, it is important to decide whether to use a GRAT or a GRUT. In the case where there is insufficient income to make the annuity payments, a GRAT produces a smaller gift than does a GRUT. With a GRAT, it is assumed that if the annuity rate exceeds the trust income, trust principal will be distributed each year without any reduction in the size of the subsequent annuity payments. However, if a GRUT payment exceeds the trust's income, and principal is distributed, the size of the next annual payment is reduced because it is a percentage of the value of the trust fund remaining on the first day of each taxable year.
6.3. Premature Death. One significant risk undertaken in establishing a GRAT or GRUT is the possibility that the grantor will die during the annuity or unitrust term. In such case, all or much of the trust fund will be included in the grantor's gross estate. A shorter term for a GRAT or GRUT may be more desirable than a longer term, as the grantor has a greater chance of outliving the trust term.
7. Designing the Remainder Interest. The remainder interest in a GRAT or GRUT can be distributed outright or held in continued trust, depending on the grantor's tax and nontax desires. If the grantor dies during the annuity or unitrust term, all or a significant portion of the trust assets will be included in the grantor's gross estate.
8. Generation-Skipping GRATs and GRUTs. A GRAT or GRUT permits the donor to make a gift at a reduced gift tax cost, but this leverage is not available to reduce the amount of the transfer subject to generation-skipping tax.
9. Mortgaged Property in a GRAT or GRUT. Both a GRAT and a GRUT may hold mortgaged property, but such debts cause significant income and gift tax problems. Although, because the trust is a grantor trust, there is no deemed disposition of the encumbered property on the creation of the trust, there is, however, a deemed disposition when the reserved annuity or unitrust interest terminates and the trust ceases to be a grantor trust. Then, if the trust's basis in the real property is less than the outstanding debt, the grantor will recognize a gain. Payments of principal and interest on the mortgage by the grantor pose additional tax issues.
10. Cash-Poor Trusts. One of the problems for any GRAT or GRUT is meeting the obligation to make regular payments. There is no problem if the asset transferred to the trust generates a periodic cash distribution sufficient to pay the annuity or unitrust amount. However, if the asset fails to generate sufficient cash to meet this obligation, the trustee must meet it from other sources. One way is to distribute principal to the grantor. Another way is to borrow money. The IRS has ruled that borrowing money from the grantor will cause a GRAT or GRUT not to be qualified. Borrowing from other sources on market terms may be acceptable.
