Tax Efficient Transfers Of A Family Business

How to Utilize a Grantor Retained Annuity Trust (GRAT) to Efficiently Transfer Your Family Business

Use of a Grantor Retained Annuity Trust, or GRAT, is a well-established gift and estate tax planning technique for transferring appreciating assets to beneficiaries without adverse gift tax consequences. A GRAT is often referred to as an “estate freezing” device because it allows an asset to be transferred to another party (the named beneficiary of the GRAT) at a future date, but allows the value of the gift to be calculated based on the asset’s value on the date it was contributed to the GRAT. Additionally, a GRAT allows the owner of the contributed property to receive a stream of income from the asset prior to the final transfer to the beneficiary. This makes it a sound tool for transferring a business to the next generation.

The federal gift tax system limits an individual’s ability to make tax-free gifts to cumulative lifetime gifts of $1 million. This $1 million limitation is scheduled to remain in place even if the federal estate tax is ultimately repealed. Even if the federal estate tax is not repealed, but the exclusion amount remains at its current $3.5 million, the gift tax exclusion is anticipated to remain at its $1 million limit. Therefore, finding ways to gift a business without paying gift tax can become an important consideration. For federal gift tax purposes, the transfer of assets to a GRAT is a taxable gift of the present value of the assets that will eventually pass to the beneficiary, also known as the remainder interest. The amount of the taxable gift, which generally counts against the $1 million limitation previously noted, is calculated using the current asset values and an IRS prescribed interest rate (the Section 7520 rate or discount rate) at the time of the transfer. This calculated amount is then reduced by the scheduled annuity payments so as to assign a value to the remainder that will pass to your beneficiaries. In this climate of low interest rates, it is especially beneficial to utilize a GRAT if the actual growth rate of assets exceeds the 7520 rate, as the excess will be transferred gift tax free. However, if the rate of return on the contributed property does not exceed the discount rate, the annuity payments will essentially return all of the value of the contributed property to the owner.

Under the terms of a GRAT, the trust pays the grantor (the person who established the trust) an annual amount for a specified time, known as an annuity, for a specified term of years. At the end of the term, all of the fixed annuity payments to the grantor will have been made, and the remaining assets of the GRAT will pass to the beneficiary or beneficiaries chosen by the grantor. Depending on the value of the business contributed to the GRAT, the longer the annuity payment stream; the longer the annuity payment stream, the more beneficial for reducing the gift value.

If an individual has used up the entire $1 million gift tax limitation (or simply does not wish to use a portion of the $1 million limitation), the use of a “zeroed-out” GRAT should be considered. A zeroed-out GRAT provides for an annual payment back to the grantor to be high enough so the annuity’s value approximates the value of the assets transferred into the trust, thus causing the present value of the gift to the ultimate trust beneficiaries to be at or near zero, reducing the gift tax cost to near zero. This makes the zeroed-out GRAT an excellent estate planning tool.

The use of a zeroed-out GRAT is illustrated in the following tax court case concerning two GRATs created by petitioner Audrey J. Walton.

Prior to April 7, 1993, petitioner was the sole owner of, and held in her name, 7,223,478 shares of common stock of Wal-Mart Stores, Inc., a publicly traded entity. Then, on April 7, 1993, petitioner established two substantially identical GRATs, each of which had a term of two years and was funded by a transfer of 3,611,739 shares of Wal-Mart stock. The fair market value of the Wal-Mart stock on that date was $27.6875 per share, and the consequent initial fair market value of each trust was $100,000,023.56.

According to the provisions of each GRAT, petitioner was to receive an annuity amount equal to 49.35 percent of the initial trust value for the first 12-month period of the trust term and 59.22 percent of such initial value for the second 12-month period of the trust term. In the event that petitioner’s death intervened, the annuity amounts were to be paid to her estate. The sums were payable on December 31 of each taxable year but could be paid up through the date by which the federal income tax return for the trust was required to be filed. The payments were to be made from income and, to the extent income was not sufficient, from principal. Any excess income was to be added to principal.

Upon completion of the two-year trust term, the remaining balance was to be distributed to the designated remainder beneficiary. Petitioner’s daughter Ann Walton Kroenke was the beneficiary so named under one trust instrument; petitioner’s daughter Nancy Walton Laurie was named in the other.

The following are payments made to the petitioner from each of the GRATs.

The assets of each GRAT were exhausted upon the final payment of stock in June of 1995, as all income and principal had been distributed to petitioner pursuant to the scheduled annuity payments. Since the aggregate amount of annuity payments called for by each trust instrument was $108,570,025.58 (49.35 percent x $100,000,023.56 + 59.22 percent x $100,000,023.56), each GRAT resulted in a $14,465,475.01 shortfall in annuity payments to the grantor and left no property to be delivered to the remainder beneficiary.

Petitioner timely filed a United States Gift (and Generation-Skipping Transfer) Tax Return, Form 709, for the taxable year 1993. Therein, petitioner valued at zero the gifts to her daughters of remainder interests in the GRATs. Petitioner represented that the value of her retained interests in the GRATs equaled 100 percent of the value of the Wal-Mart stock on the date of the transfer, thus eliminating any taxable gift to the remaindermen. Respondent subsequently issued a notice of deficiency determining that petitioner had understated the value of the gifts resulting from her establishment of the two GRATs. Petitioner now concedes on brief that the gift occasioned by each GRAT should be valued at $6,195.10, while respondent asserts that the taxable value of each gift by petitioner is $3,821,522.12. Walton v. Commissioner of Internal Revenue, 115 T.C. 589 (2000).

In the Walton case, the tax court agreed with Walton’s position, holding that, “…we construe each of the subject GRATs as creating a single, noncontingent annuity interest payable for a specified term of years to the undifferentiated unit of petitioner or her estate. We further conclude that Congress meant to allow individuals to retain qualified annuity interests for a specified term of years, and that the proper method for doing so is to make the balance of any payments due after the grantor’s death payable to the grantor’s estate.”

The IRS eventually acquiesced to this case holding, giving the client more flexibility in zeroing out a GRAT through the continuation of payments to her estate after death. It is imperative that the GRAT provisions be drafted correctly so as not to create any other unintended estate tax issues.

For income tax purposes, a GRAT is structured as a “grantor trust.” The grantor trust rules provide that items of income and deduction attributable to the trust, including capital gain, are taxed to the grantor. The annuity payments have no effect on the business owner’s taxable income. Further, any income tax payments by the owner on account of trust income under present law are not considered additional gifts to the trust. As a result, income taxes generally do not reduce the value of the assets transferred to the children and enhance the estate planning results of the GRAT.

From an estate tax perspective, the use of a zeroed-out GRAT is a no-lose proposition. If the total return on the assets of the zeroed-out GRAT exceeds the prediction inherent in the discount rates set by the Internal Revenue Service, all of the excess will pass tax free to the beneficiary. If the total return does not exceed the prediction, all of the assets contributed to the zeroed-out GRAT by the grantor will be returned to the grantor in the form of annuity payments, and the grantor is no worse off than if the GRAT had never been created.

In order to completely remove the GRAT’s remainder interest on the estate, the owner must survive the term of the GRAT. If the grantor survives the specified term of years, the assets remaining in the GRAT will not be included in the grantor’s gross estate for federal estate tax purposes. Conversely, if the grantor passes away before the specified term of years ends, the GRAT will be included in the grantor’s gross estate, leaving the grantor no worse off than if the GRAT had never been established.

This is a simplified discussion of a complicated topic. Planning for a possible marital deduction in the case of a zeroed-out GRAT can be particularly complex, and there are other ways to structure GRATs in an effort to deal with specific situations. Also, there are certain risk factors, including potential changes in the tax law, valuation risks and the possibility that the grantor might pass away during the term of the trust, that must be reviewed and analyzed in each individual case.