Among other potential strategies, while the markets remain
volatile, if timed right, a short-term grantor retained annuity
trust (GRAT) could be an option to pass significant wealth to the
next generation. Investments used to fund the GRAT that have
dropped in value due to temporary volatility could be transferred
to a GRAT and, assuming the investment returns to its earlier
value, the difference between the low value at the time of transfer
and the more reasonable long-term value will pass to the next
generation without any gift tax. The remainder of this alert will
briefly describe a GRAT and explain how a GRAT can be used to pass
significant wealth to the next generation. You should discuss the
potential use of a GRAT with your investment advisor and estate
planning attorney to make sure it is appropriate for you.
A short-term GRAT can be used to transfer income/appreciation in
your investments to your children at a low gift tax cost. A
short-term GRAT has the following characteristics:
- The trust would have a stated term of two to four years.
- While the trust is in existence, the trust would have an obligation to pay you a specified annual amount (the "retained annuity").
- When the trust terminates, any property remaining in the trust would be distributed to your children free of any gift or estate tax.
- If you die before the trust terminates, the trust would not result in any benefit to your estate, because the remaining property in the trust would be included in your estate for estate tax purposes.
The purpose of this type of trust is to allow your children to
receive, on a virtually tax-free basis, the investment returns on
property in excess of a stated Internal Revenue Service interest
rate. Since January 2023, that interest rate has fluctuated between
4 and 6 percent. Thus, if the funds in the trust generate a total
return in excess of the IRS rate, your children would receive that
excess return. On the other hand, if the property does not generate
a return of at least the stated IRS rate over the course of the
trust, then all of the trust assets would ultimately be repaid to
you. Your children would receive nothing from the trust, but they
would not have suffered any loss either.
If you made a gift of the property to your children and the
property declined in value, then you would have paid gift tax on
the property at a value higher than is ultimately received by your
children. The same is true if you were to loan money to your
children and they either had losses or did not achieve a return
equal to the minimum IRS rate (approximately 4-6 percent for
short-term loans), because they would still owe you the principal
amount of the debt. In this regard, the GRAT is essentially a
risk-free technique.
For example, if you transfer $1 million of assets to a two-year
GRAT and your children invest those funds and receive an annual
return of 6 percent, at the end of two years, your children would
receive a tax-free gift of approximately $50,000-80,000. You would
transfer $1 million of securities to the trust and the trust would
promise to pay you approximately $510,000-530,000 at the end of the
first year (depending on the IRS interest rate), and an additional
$510,000-530,000 at the end of the second year. These annual
payments constitute your "retained annuity." By paying
you this amount, there is a very small taxable gift at the time the
trust is established. If the trust promised to pay you a smaller
amount, then there would be a significant gift at the time the
trust is established. If the trust earns 6 percent in the first
year, the net value of the trust at the end of the first year would
be $1,060,000. At that time, the trust would pay you $520,000 in
cash or other property. The trust would then invest the remaining
$540,000 for another 12-month period and earn a 6 percent return
equal to $32,400. At the end of the second year, the trust would
have $572,400, and it would owe you the second annuity payment of
$520,000. Thus, at the end of the second year, the trust would have
a net amount of about $53,000, which is paid to your
children.
The reason to keep the term of the trust short is to avoid
offsetting gains in early years against losses in later years. For
example, if a trust had a six-year term and experienced 12 percent
gains in the first two years, then had a loss in years three and
four, then had significant gains again in years five and six, the
bad years would offset the good years, reducing the amount
ultimately payable to your children. However, if you established a
two-year trust and then established a new two-year trust each time
a distribution was made, you would better capture the gains in the
good years, and, as noted above, if the trust experiences a loss
(or does not earn at least the minimum Internal Revenue Code stated
interest) your children would not have to make up the loss. The
trust would merely transfer all of its assets back to you in full
settlement. Having a short-term trust also minimizes the risk that
you would die during the term of the trust, eliminating any benefit
which might have previously accrued under that trust. On the other
hand, if interest rates rise, then each new two-year trust would be
required to make larger annuity payments, reducing the net returns
to your children.
Because of the nature of a GRAT, it is generally advisable for
either you or your spouse to establish a trust, or you could each
establish a separate trust, but you should not establish one trust
together with community property. Thus, it may be necessary for you
to partition community property so that you can establish the trust
with separate property. This is not a problem with cash, but it
might have adverse consequences if you use property which has a
low-income tax basis. If you were to partition community property
with a low-income tax basis, you would then each hold that property
as separate property. And if one of you dies, the other
spouse's one-half of the property would not receive a new
income tax basis on death (thereby forfeiting one of the advantages
of community property).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
