GRAT Examples

Example of GRAT valuation:

$1,000,000 trust with grantor receiving a $50,000 annuity for 10 years. If the section 7520 rate is 3.2%, the value of the grantor’s retained interest is $396,260 and the remainder is valued at $609,740.

  •  So the right to receive the $50,000 annuity for 10 years is worth $396,260 and the right to receive the remainder at the end of the 10 years is worth $603,740.
  • The value of the remainder interest ($603,740) would be subject to gift tax upon creation of the GRAT.

Example of a qualified payment in a GRAT:

Grantor transfers 100 shares of X Company to a 3 year GRAT. The terms of the trust stipulate that the trustee must pay the grantor an annuity equal to 10% of the initial value of the trust in the first year with the annuity payment increasing 20% in the second year and 20% third year. After the third year the trustee is to distribute the remaining trust to the beneficiary.

Example of how a valuation formula will reduce the risk of unexpected gift tax consequences when dealing with hard to value assets:

Grantor transfers 100 shares of X Company to a GRAT, X Company has 200 shares outstanding and a company value of $1,000,000. Under terms of the GRAT, grantor retains an annuity of 15%, increasing by 20% annually, for 5 years, with the remainder interest going to his beneficiaries. Grantor files a gift tax return showing a transfer of $300,000 to the GRAT ($1,000,000 x 50% ownership minus 40% discount), with a gift of $44,872.50 to 3 beneficiaries. If on audit the IRS only allows a 20% discount, the taxable gift would be $59,830. Thus, an increase in the amount transferred by $100,000 increases the taxable gift by approx. $15,000.


Charitable Lead Annuity Trust (CLAT)

Current economic conditions have presented intriguing options for charitably oriented individuals looking to transfer wealth tax free. A Charitable Lead Annuity Trust (CLAT) is an alternative trust structure that transfers wealth free of gift tax to an heir and a charity. In a CLAT the donor creates a charitable trust that pays an annuity to the charity and at the end of the trust the principal often transfers to the heirs. The CLAT benefits from the historically low IRS discount rate (now hovering at around 1.4%) which makes it possible to avoid gift taxes when transferring assets remaining in the trust at its termination. For a CLAT to function properly it is important that the assets in the trust have an expected appreciation value greater than the hurdle of the IRS discount rate. Fortunately, the extremely low hurdle in place now vastly widens the pool of feasible favorable asset options.

The tax law on CLATs opens a window of opportunity that is particularly appealing in today’s economy. Tax law dictates that all payment amounts be known at the creation of the CLAT; however, the payment amounts do not need to be the same. A “Shark-Fin” CLAT takes advantage of this nuance of law by making minimal payments throughout the trust’s life and in the last year makes a balloon payment large enough to cover the amount necessary for the trust to earn a 100% gift tax deduction according to the IRS discount rate. By allowing the trust to grow rapidly through the small payments in the trust’s life, the large balloon payment is made possible as long as the trust achieves the discount rate. Anything made in excess of the low discount rate is passed to the heirs free of gift tax. The Shark-Fin strategy hedges against the possibility of poor investment results in the initial years of the trust and anticipates more favorable investment results in the long term. A Shark-Fin CLAT is particularly appealing when the economy is sluggish because it compounds the benefits of both the current low IRS discount rates and the long term prospect of economic recovery.

The negatives of a Shark-Fin CLAT are mostly shouldered by the charity. A charity is most likely going to want the steady flow of sizable payments rather than one large payment at the end of the trust, especially since the charity will be receiving the same amount whether a Shark-Fin CLAT or a normal CLAT is used. Also, time-value of money makes the wealth received from a Shark-Fin CLAT less valuable to the charity than an equal amount received through a normal CLAT. Another negative is the income tax under a Shark-Fin CLAT is likely to be greater. The trust is taxed on earned income in excess of the distributions and since the distributions to the charity are small in every year except the last, the deduction amount offsetting the tax is very small.

For more information on CLATs, please contact Hoffman & Associates at 404-255-7400