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The Grantor Retained Annuity Trust (GRAT)

Sept. 13, 2022

The December 2017 tax bill temporarily doubled the "basic exclusion amount" for federal estate and gift taxes, from $5 million to $10 million. These figures are indexed for inflation from 2010, so that in 2022, the exclusion amount is $12.06 million, which means that with proper planning a married couple could transfer as much as $24.12 million to their children and grandchildren without incurring estate or gift tax. However, the 2017 measure will "sunset" at the end of 2025, and unless Congress takes further action, the exclusion amount will revert to somewhere between $6 million and $7 million in 2026.

The Treasury has issued regulations saying that if you use some or all of the "bonus" credit before 2026 in lifetime gifts, those amounts will not be "clawed back" into the calculation of your estate tax liability if you die after the exclusion amount has reverted. So people whose net worth is well above six or seven million are under some pressure to make lifetime gifts to consume the "bonus" credit before it disappears.

It is possible to reduce the taxable value of a gift by postponing the date it takes effect. A dollar in hand ten years from now is worth considerably less than a dollar in hand today. It used to be this was as simple as setting up an irrevocable trust, reserving the "income" interest to yourself for a term of years, and giving the remainder to your children or grandchildren. The present value of the remainder gift was "discounted" by the present value of your reserved income interest. This was called a "grantor retained income trust," or "GRIT."

But the GRIT was vulnerable to abuse, and in 1990 Congress enacted section 2702 of the tax Code, requiring that the reserved interest be in the form of a fixed annuity or a fixed "unitrust" percentage payout, at least where the remaindermen are in your immediate family. A unitrust does not provide "leverage" for discounting the remainder value, so we are primarily looking at the "grantor retained annuity trust," or GRAT. The present value of the remainder of a ten-year GRAT paying ten percent is close to zero, so at first the leverage looks very good.

But there are a few caveats. One, the ten percent annuity is being added back to your taxable estate as you receive it, so all we are really shifting tax free to the next generation is any growth in the underlying asset. Two, because the remaindermen are receiving the proceeds of a lifetime gift, and not "acquiring the property from a decedent," there will be no basis adjustment at your death, so we need to balance the gift tax savings against the eventual additional capital gains tax they will incur on selling the trust assets. And three, if you happen to die during the term of years, the entire value of the trust is brought back into your taxable estate, and you have achieved nothing, though the remaindermen do get a basis adjustment.

This last concern has led to the development of a strategy involving short term "rolling" GRATs. The idea is to set up a series of two- or three- year GRATs, year after year, each with rather high payouts which you then feed back into the next GRAT. The mortality risk for any one of these GRATs is considerably lower than with a single, longer-term trust.

There is of course a cost to setting up and administering a strategy like this, but for very high net worth clients the tax savings can more than justify the expense.

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