GRATs Part 2: The Zero-Out GRAT

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GRATs Part 2: The Zero-Out GRAT

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A Primer on Grantor Retained Annuity Trusts - Part Two- The Zero-Out GRAT

The GRAT is particularly attractive for individuals who have used their applicable exclusion amount but still want to transfer wealth to others. A "zero-out GRAT" can be used so that there is no gift tax consequences to the creation of the trust. By structuring the GRAT so the value of the annuity equals the value of the property transferred, the taxpayer can avoid using applicable exclusion or paying gift tax. If the transferred assets increase in value at a rate greater than the Section 7520 rate during the term of the GRAT, some appreciation is transferred out of the taxpayer's estate tax free. Given the low interest rate environment that has existed in recent years, it does not take much appreciation for a GRAT to be successful, and significant appreciation can result in a large tax-free transfer.

Section 2702 provides that an interest in a trust retained by the grantor will be valued at zero for purposes of determining the value of the gift to the trust, unless the retained interest is a qualified annuity interest, a qualified unitrust interest or a qualified remainder interest. The regulations under Section 2702 provide that the term of the annuity or unitrust interest "must be for the life of the term holder, for a specified term of years, or for the shorter (but not the longer) of those periods." Treas. Reg. § 25.2702-3(d)(3).

Despite the apparent statement in its own regulations granting three options for the term of a GRAT, the IRS took the position when it initially issued its final Section 2702 regulations that an annuity payable for a term of years (with annuity payments continuing to the grantor's estate if he or she died during the term) always had to be valued as an annuity for a term of years or the prior death of the grantor. The position was not stated in the text of the final regulations; rather it was illustrated in one of the regulation's examples. See prior Treas. Reg. § 25.2702-3(e). Example 5. The requirement that one always must take into account the possibility of the grantor's death before the end of the term in valuing the annuity had the effect of reducing the value of the annuity, and increasing the value of the remainder interest and, therefore, the value of the gift for a transfer to a GRAT. Because of this and other requirements for valuing annuities, the IRS made it impossible to create an annuity in a GRAT with a value equal to the value of the property transferred.

In Walton v. Commissioner, 115 T.C. 589 (2000), the taxpayer challenged the position in the IRS regulations. The Tax Court agreed that Example 5 in the regulations is inconsistent with the purposes of the statute and declared the Example invalid.

The case involved the widow of Sam Walton. In 1993, she transferred 7 million shares of Wal-Mart stock to two GRATs in which she retained an annuity of 59.22% for two years.  If she died during the term, the annuity payments would continue to her estate. The GRATs failed to produce the desired benefits. The price of Wal-Mart stock remained essentially flat for two years, and all the stock was paid back to Mrs. Walton to satisfy the annuities.

Mrs. Walton brought the suit to avoid a large gift tax liability for the failed transfer. Her annuity interests valued for the full two-year term resulted in a gift to the GRATs of about $6,195.& If her annuity interest was valued as a right to receive payments for two years or her prior death, as the IRS asserted, the gift would be $3,821,522.

The Tax Court first recognized that the IRS's regulations are entitled to considerable deference, but, as interpretative regulations, they still could be ruled invalid if they do not implement the congressional mandate in some reasonable manner. Based on the purpose of the statute and its legislative history, the court concluded that there was no rationale for requiring that the annuity be valued as a two-year or prior death annuity. In particular, the court noted that Congress referred to the charitable remainder trust rules as a basis for the Section 2702 provisions, and the regulations clearly allowed a two-year term to be valued without prior death contingencies in a charitable remainder annuity trust.

The IRS subsequently amended its regulations to specifically recognize the valuation of term interests as term interests.

The ruling in Walton gave taxpayers the unique opportunity to implement a technique that has no tax cost if it fails. By structuring the GRAT so the value of the annuity equals the value of the property transferred, the taxpayer can avoid using applicable exclusion or paying gift tax.

The significant benefits of GRATs, particularly short-term zero-out GRATs, have caught the attention of Congress. Several pieces of legislation introduced in 2010 have included a proposal to impose a minimum ten-year term on GRATs. The Obama administration continues to support this change. But no such change has been included in any recent legislation.

A zero-out GRAT often works best when the annuity term is short (such as two years) and the GRAT is funded with one stock. A single stock that performs well during a two-year period easily can grow at an annual rate of 20% or more over that time frame.

EXAMPLE. When the Section 7520 rate is 4.2%, an individual creates a two-year GRAT and funds it with $500,000 of stock that has a current price of $25 per share.  He retains the right to receive an annuity of 53.18% each year for the two years. The value of the annuity is $500,000, and the gift when the individual creates the trust is zero. If the stock increases to $30 per share after one year, and $36 per share at the end of two years (a 20% increase each year), there will be $135,020 left in the GRAT at the end of the two years to pass to children tax-free:

Initial Value of Stock:

$500,000

End Year 1 Value

600,000

Annuity to Grantor:

(265,900)

Beginning Year 2 Value

$334,100

End Year 2 Value:

$400,920

Annuity to Grantor:

(265,900)

Property Remaining for Children:

$135,020

If the individual created this GRAT when the Section 7520 rate was 1.2% (the rate in June 2012), the annuity payments would be only $256,050 and the GRAT would have $161,375 remaining at the end of the term.

The property transferred to a two-year GRAT needs to sustain a high growth rate for only a short period of time for the GRAT to be successful. If the property does not appreciate as anticipated, it all is returned to the grantor in the annuity payments. The grantor then can create a new GRAT.

If a short term GRAT is used, it is better to isolate separate stocks in separate trusts so that the losers do not pull down the winners.