A Primer on Grantor Retained Annuity Trusts - Part Three - GRATS for Closely Held Stock and Partnerships

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A Primer on Grantor Retained Annuity Trusts - Part Three - GRATS for Closely Held Stock and Partnerships

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The attributes of a GRAT fit well with closely held stock. The owner can use a GRAT to try to shift additional stock out of his or her estate, at no tax cost. The stock does not have to grow at a tremendous rate for the GRAT to have some benefit. As long as the stock grows at a rate greater than the assumed IRS rate used in determining the gift, there will be some benefit.

The GRAT can be a particularly advantageous way to transfer stock in an S corporation. An irrevocable grantor trust is a permissible shareholder of stock in an S corporation. See, e.g., Ltr. Rul 9415012 (January 13, 1994). Because the S corporation is a flow-through entity for income tax purposes, the trustee of a GRAT is able to satisfy annuity payments with pre-tax dollars from the corporation.

EXAMPLE: Carlos transfers $2,000,000 of S Corporation stock to a GRAT and retains an annuity of $184,000 (9.2%) per year for 12 years. The $2,000,000 value is determined after applying appropriate valuation discounts to the stock. The value of Carlos' retained annuity interest is $1,994,542, so Carlos makes a taxable gift of only $5,458 when he creates the GRAT. The S Corporation distributes cash of about $200,000 per year (i.e., 10% of the initial $2,000,000 value) to provide funds for income taxes and some additional amounts for discretionary use by the shareholders. Thus, the GRAT can pay Carlos the annuity out of part of the $200,000 that the GRAT receives each year, and Carlos uses a portion of the annuity distribution to pay his income taxes related to S corporation income. If the value of the stock increases by about 5% per year, and the cash distributions increase over the term, the GRAT will have $5,563,750 in stock and investments after 12 years.

If voting stock in a closely held corporation (one in which the grantor and related parties own 20 percent or more of the voting stock) is transferred to the GRAT, the grantor should not retain the right to vote that stock beyond the date that is three years before the end of the annuity term. The right to vote the stock will cause the stock to be included in the grantor's estate under Section 2036(b), and the relinquishment of that right within three years of death will cause inclusion under Section 2035(d). If the grantor retains the right to vote the stock until the end of the annuity term, he must survive an additional three years to ensure that the property will be excluded from his estate. This problem can be avoided by using non-voting stock.

GRATs and Partnerships

A client theoretically can create a high return asset for a GRAT by creating a family limited partnership and then funding the GRAT with discounted limited partnership interests.

EXAMPLE: Before creating a 15-year GRAT, Dan creates a limited partnership with other family members and funds it with various assets, including real estate and securities. The partnership assets return about 6% per year. Dan transfers limited partnership interests with a net asset value of $2,000,000 to the GRAT. Thus, the GRAT will achieve a return of about $120,000 per year. To take into account the lack of control and lack of marketability of the limited partnership interests, Dan values those interests at a 35% discount, or at $1,300,000, for purposes of the transfer. The effective yield on the discounted value of the limited partnership interests is 9.23% ($120,000 ÷ $1,300,000).

There are in fact risks to this approach, especially if the limited partnership must liquidate capital to make the required distributions. If a limited partnership regularly makes significant distributions, including distributions of capital, and it appears that this was the plan at the time the partnership was formed, then the IRS has strong grounds for challenging the size of the valuation discounts.