Transfer business interests via a GRAT

During the past few years, Congress has failed to agree on legislation that would derail a powerful estate planning technique for small business owners.

Strategy: Set up a Grantor Retained Annuity Trust (GRAT) to “zero out.” This enables you to transfer substantial wealth to beneficiaries without any dire estate and gift tax consequences.

But this technique is likely to be a target of lawmakers again, so you should act soon.

Here’s the whole story: With a GRAT, you (the grantor) generally transfer a business interest to an irrevocable trust while receiving annuity payments for a fixed term. At the end of the term, the remaining assets are distributed to the beneficiaries, usually your children. Therefore, the assets are removed from your taxable estate.

When you create the GRAT, you’re treated as having made a taxable gift equal to the present value of the assets, minus the value of the retained annuity. The present value is based on the monthly Section 7520 interest rate. The lower the interest rate when you set up the GRAT, the lower the value of your remainder interest.

Book of Company Policies D

The rates have remained rock-bottom low the past few years, encouraging transfers to GRATs. For instance, the rate was only 2.22% for October 2014 (see chart). As recently as May 2010, it was 3.4% and back in August 2007 it was 6.2%.

If you die before the end of the trust term, the assets will be included in your taxable estate.

Going to zero power

It’s important to minimize the value of the remainder interest under a GRAT. Reason: The value of the remainder interest doesn’t qualify for the annual gift tax exclusion ($14,000 for 2014). However, annuity payments for a GRAT can be structured so that there are no assets left in the GRAT at the end of the trust term.

This is accomplished based on the assumed Section 7520 rate. By “zeroing out” the GRAT, the grantor owes no gift tax on the funding.

Example: You establish a nine-year GRAT in a month when the Section 7520 rate is 3.4%. Then you name your child as the remainder beneficiary. Because you don’t want to incur any gift tax, you need to retain an annuity of $654,201. At the assumed interest rate of 3.4%, the annuity will completely deplete the GRAT at the end of nine years.

However, assume that you fund the trust with $5 million of undervalued assets that actually grow by 8% a year instead of 3.4%. After nine years, you will have accumulated $1,825,000, which can pass to your child completely free of gift tax.

Recent legislative proposals would have curtailed tax benefits by requiring the GRAT to last for a minimum of 10 years or prohibiting the value of the remainder from being reduced to zero.

Tip: If you’re contemplating a GRAT designed to zero out, now is the time to take action.