Overview

Main Menu Name: GRAT

Calculates the value of the annuity interest retained by the grantor in a retained annuity trust (GRAT) for the grantor's life, a specified term, or the shorter of both. Through this tool, the grantor retains a fixed annuity interest in irrevocably transferred property. The remainder interest generally passes to the grantor's designated beneficiaries at the end of a specified term or at the earlier of the end of a specified term or the grantor's death. The gift tax value of the remainder interest is also computed.

In this article:

• Background
• Getting Started
• Entering Data
• Results

Background

A grantor retained annuity trust may be an effective means for a wealthy client who wants or needs to retain all or most of the income from a high-yielding and rapidly-appreciating property to transfer the property to a child or other person with minimal gift or estate tax. GRATs are particularly indicated where the client has one or more significant income-producing assets that he or she is willing to part with at some specified date in the future to save federal and state death taxes and probate costs, to obtain privacy on the transfer, and to protect the asset against the claims of creditors.

A GRAT is created by transferring one or more high-yield assets into an irrevocable trust and retaining the right to an annuity interest for a fixed term of years or for the shorter of fixed term or life. When the retention period ends, assets in the trust (including all appreciation) go to the named "remainder" beneficiary (ies). In some cases other interests, such as the right to have assets revert back to the transferor's estate in the event of the transferor's premature death, may be included.

GRATs provide a fixed annuity payment, usually expressed as a fixed percentage of the original value of the assets transferred in trust. For example, if $100,000 is placed in trust and the initial annuity payout rate is 6 percent, the trust would pay $6,000 each year, regardless of the value of the trust assets in subsequent years. If income earned on the trust assets is insufficient to cover the annuity amount, the payments will be made from principal. Therefore, the client-transferor is assured steady and consistent payments (at least until principal is exhausted).

All income and appreciation in excess of that required to pay the annuity accumulate for the benefit of the remainder beneficiary (ies). Consequently, it may be possible to transfer assets to the beneficiary(ies) when the trust terminates with values that far exceed their original values when transferred into the trust and, more importantly, that far exceed the gift tax value of the transferred assets.

The gift tax value of the transferred assets is determined at the time the trust is created and funded using the "subtraction method." The gift tax value is determined by subtracting the value of the annuity interest (and, in some cases, other retained interests, such as the right to have the assets revert back to the transferor's estate if he or she does not live the entire term of the trust) from the fair market value of the assets transferred in trust. How the annuity interest and any other retained interests are valued depends on who the remainder beneficiary (ies) is (are) and who retains the annuity and other interests relative to the transferor. There is a more restrictive and less appealing set of valuation rules when family members are beneficiaries and certain family members retain interests in the property both before and after the trust is created than when unrelated parties are involved.

When unrelated parties are involved, all interests are valued according to their actuarial present values using the valuation rules of IRC §7520. These rules mandate the use of a discount rate based on the 120% Applicable Federal Annual Midterm Rate for the month in which the trust is created and funded. The mortality factors from Table 80CNSMT, Table 90CM, or Table 2000CM are also used if the interests have a life contingency (i.e., the calculations are of type "Life" or "Shorter").

The 120% Applicable Federal Annual Midterm Rate changes monthly and is reported in the IRS's Cumulative Bulletin, in various tax services, and in various financial news publications such as The Wall Street Journal. (See Fed Interest Rates in the Money & Investing section, generally between the 18th and 23rd of the preceding month).

If family members are involved, the gift tax valuation rules of IRC §2702 may apply. Under these rules, certain types of retained interests, such as the right to have trust assets revert to the transferor's estate in the event of the transferor's premature death, may be valued at zero when computing the gift tax value of the transfer. As a general rule, every retained interest but a "qualified interest" is assigned a value of zero for gift tax valuation purposes. In the case of a GRAT, a qualified interest is the right to receive "fixed amounts" payable annually, more frequently (a fixed annuity), or a qualified remainder interest. That is, any non-contingent remainder interest if all other interests in the trust consist of qualified retained interests (qualified annuities).

The right to receive a "fixed amount" means the annuity must be a specified fixed dollar amount or a fixed percentage of the initial value of the trust payable each year rather than merely the income produced by the assets in the trust. Although fixed payments throughout the term of the trust are the norm, final regulations define the term "fixed amount" more liberally. They would permit the annuity payments to increase or decrease in a systematic manner each year without adverse gift tax consequences. However, the annuity amount may not increase by more than 20 percent over the prior year. For example, if the initial annuity payment is $1,000, the trust could provide that annuity payments in subsequent years increase by as much as 20 percent, to $1,200 in the second year, $1,440 the third year, and so on. If the transferor retains the right to the greater of a fixed amount or the trust income in each year for a term of years, the annuity will still be a qualified annuity. However, the right to the trust income, if any, in excess of the fixed amount is valued at zero for gift tax purposes. Thus, the retained interest is valued for gift tax purposes as if it did not include any rights to excess income.

We suggest you "insure" or "bulletproof" the tax savings. The risk of inclusion of trust assets should be covered by the purchase of life insurance owned by the appropriate beneficiary on your life in the amount of the anticipated federal estate taxes that would be saved if you survive the term of the trust.

Since the GRAT permits payment of both income and trust principal to satisfy the annuity payments you have retained, the GRAT should be treated as a grantor trust for income tax purposes. This means you (the transferor-annuitant) are taxed on income and realized gains on trust assets even if these amounts are greater than the trust's annuity payments. This further enhances this tool's effectiveness as a family wealth-shifting and estate-tax-saving device. In essence you are effectively allowed to make gift tax-free gifts of the income taxes that are really attributable to assets backing the remainder beneficiary's interest in the trust.

By making assumptions about income to be earned by the trust in the future, and future capital growth, it is also possible to project the future value of the principal remainder that will be payable to the beneficiaries at the end of the term of the trust. If limited partnership interests, minority stock interests, or other fractional or non-controlling interests have been contributed to the GRAT and appropriate discounts claimed for lack of voting power or lack of marketability, it may also be useful to illustrate the future economic growth of the pre-discounted value of the principal, and to compare the present value of the remainder for gift tax purposes (including appropriate discounts) with the projected future value of the principal remainder (without discounts).

Getting Started

A grantor retained annuity trust may be an effective means for a wealthy client who wants or needs to retain all or most of the income from a high-yielding and rapidly-appreciating property to transfer the property to a child or other person with minimal gift or estate tax. GRATs are particularly indicated where the client has one or more significant income-producing assets that he or she is willing to part with at some specified date in the future to save federal and state death taxes and probate costs, to obtain privacy on the transfer, and to protect the asset against the claims of creditors

Entering Data

• Trust Type:  Select a type of trust (Term/Life/Shorter). If you select Life, the Economic Schedule runs from year one until the Life Expectancy or until the remainder is zero (whichever happens first). If you select Term or Shorter, the Economic Schedule runs from year one until the end of the Term or until the remainder is zero (whichever happens first).
• Transfer Date: Enter the month and year.

Note: For May or June of 2009, you have the choice of using mortality Table 90CM or 2000CM (see https://www.irs.gov/irb/2009-20_IRB). After June 2009, the program will automatically use Table 2000CM. For dates before May 2009 and after June 1999, the program will use Table 90CM. For May or June of 1999, you have the choice of using Table 80CNSMT or Table 90CM. For dates before May 1999 and after April 1989, the program will automatically use Table 80CNSMT. For dates before May 1989, the program uses Table LN from Treas. Reg. section 20.2031-7A(d)(6).

• §7520 Rate:  The program automatically enters the correct §7520 discount rate if you have kept the AFR Rates Manager up-to-date. If the AFR Rates Manager is not up-to-date, the program shows a 30% value for the selected transfer date. The program automatically rounds the rate to the nearest 2/10 of 1% as required under §7520.
• Grantor' Age:  This data input field is only used when Life or Shorter is chosen as the Calculation Type. Use a value from 0 to 109 to indicate the age of the person whose life is being used to measure the term of the trust. Enter the age using the birth date which is nearest to the transfer date.
• Income Earned by Trust:  Enter the income earned by the trust. Enter a positive value. It is only used for the Economic Schedule, and it is applied to the Pre-discounted Fair Market Value, not the Discounted Fair Market Value. This need not be entered if you are not interested in that analysis.
• Term of Trust:  Enter the term of the trust.
• Annual Growth of Principal:  Enter the annual growth of the principal. Use a positive or negative value. It is only used for the Economic Schedule, and it is applied to the Pre-discounted Fair Market Value, not the Discounted Fair Market Value. This need not be entered if you are not interested in that analysis.
• Pre-discounted Fair Market Value:  Enter the value of contributed principal prior to any appropriate discount, such as for minority interests or lack of marketability. This value will not affect the gift tax calculations, but it will be used for the economic projections. When you enter a value for this input, the program automatically enters the same value for the Discounted Fair Market Value.
• Discounted Fair Market Value:  Enter the gift tax value of contributed principal after appropriate discounts, such as minority interests or lack of marketability. The program uses this value to calculate the annuity payout, the present value of the annuity payments, and the present value of the remainder for gift tax purposes. By default, this value is the same as the Pre-discounted Fair Market Value. You can change this value, however, if you later change the Pre-discounted Fair Market Value, the program will also change the Discounted Fair Market Value.
• Percentage Payout:  Enter the initial annuity payout rate with up to five places after the decimal. This input is expressed as a percentage of the initial capital value of the trust.
• Exhaustion Method:  Select the IRS Method or the Illustrated Method.
• Payment Period:  Select the number of payments per year (annual, semi-annual, quarterly, monthly, or weekly).
• Payment Timing:  Select Begin or End to indicate when the payment should be made for the selected payment period. A Begin case is assumed to be the same as an End case with an additional payment made at the beginning of the period.
• Number of Payments:  The program calculates the number of payments based on the term and the payment period. If you would like to have a trust that makes additional payments (beyond the normal term), use this input field to indicate the total number of payments to be made. For example, if you have a trust making quarterly payments for 10 years, this data field would default to 40. If you wished to make payments for 10 years and 1 quarter, you would change the value to 41.
• With Reversion?:  (This selection only appears when Shorter is used) Select the check box if reversion is to be included. Check this box to show that the assets should revert to the grantor's estate in case of the grantor's death during the term of the trust.
• Distribute Princ. In Kind:  Check this box if the annuity payments will be made by transferring property in kind back to the grantor (without the realization of any gain or loss.) If checked, the economic schedule will show the reduction in principal that occurs when the discount that was applied on the transfer to the GRAT is also applied to the principal (but not income) being distributed.
• Varying Annuity Payments?:  Select the check box if you want to vary annuity payments. When you indicate there are varying annuity payments which do not grow by a constant rate, the program always uses the Illustrated Method for Rev. Rul. 77-454. If you select this check box, the Edit button will appear.

Edit:  This button appears when you select to have varying annuity payments. You can choose to grow annuity payments by a constant rate or enter your own yearly payout rates for Shorter or Term cases. The program allows the entry of a value more than 20% greater than the preceding value, but displays a warning on the screen.

• Is Transfer To or For the Benefit of a Member of the Transferor's Family? Is Interest in Trust Retained by the Transferor or an Applicable Family Member?:  The special Section 2702 rules are applied when both of these checkboxes are selected.
• Optimize:  Set this input to "Yes" to calculate the optimum payout rate. This feature is useful in creating a new trust if you have not designed one before. If you Optimize for Life Optimize for Shorter Term or Life, you will be given a choice of two different kinds of optimization.

GRAT Optimization for Term: Set the Optimization input to "Yes" if you want to set up a trust for term, that will find the Percentage Payout that provides the lowest taxable gift ($0 - $1). If you have already drafted a trust, this feature will not be beneficial.

If you choose to optimize, the program near-zeroes the Taxable Gift (based on term interest.)

GRAT Optimization for Life and Shorter of Term or Life: When the set the input for Optimization to "Yes" for a Life or Shorter (of term or live) calculation, an input that appears that you lets you select the optimization option:

Setting the option input to the Optimize For Taxable Gift of Residual Interest in Trust will calculate a payout with the smallest possible positive value for the remainder, using the annuity factor for the life and stated term (if any) and without regard to the possibility of exhaustion. In most cases, this will result in a payout that will exhaust the trust before the end of the stated term of the trust (for a Shorter trust) or during the possible lifetime of the grantor (in the case of a Life trust) .

Setting the option input to the Optimize For Taxable Gift Limited By Reg. 20.7520-3(b)(2)(i) will calculate the largest payout that will not exhaust the trust before the end of the stated term of the trust (for a Shorter trust) or during the possible lifetime of the grantor (in the case of a Life trust).

In each case, exhaustion is calculated using the 7520 rate and the methodologies used by the IRS in applying Reg. 20.7520-3(b)(2)(i).

"Optimize for Taxable Gift Limited by Reg. 20.7520-3(b)(2)(i)" is generally recommended, because it avoids the application of the exhaustion test under the regulations and so avoids the possibility that the trust will be required to make payments to the grantor that were ignored in valuing the remainder for gift tax purposes.

Note: These optimization calculations are only used when planning a GRAT and are not applicable to an existing GRAT with a payout rate stated in the trust document.

Results

Click on the various tabs in the bottom portion of the screen to view the Reversion, and to view the Economic Schedule. In addition, the calculation provides detailed analyses of the selected type of GRAT showing required annuity factors, adjustment factors, and the "subtraction method" of computing the taxable gift value of the residual interest in trust.

A GRAT is created by transferring one or more high-yield assets into an irrevocable trust and retaining the right to an annuity interest for a fixed term of years or for the shorter of fixed term or life. When the retention period ends, assets in the trust (including all appreciation) go to the named "remainder" beneficiary (ies). In some cases other interests, such as the right to have assets revert back to the transferor's estate in the event of the transferor's premature death, may be included.

GRATs provide a fixed annuity payment, usually expressed as a fixed percentage of the original value of the assets transferred in trust. For example, if $100,000 is placed in trust and the initial annuity payout rate is 6 percent, the trust would pay $6,000 each year, regardless of the value of the trust assets in subsequent years. If income earned on the trust assets is insufficient to cover the annuity amount, the payments will be made from principal. Therefore, the client-transferor is assured steady and consistent payments (at least until principal is exhausted).

All income and appreciation in excess of that required to pay the annuity accumulate for the benefit of the remainder beneficiary (ies). Consequently, it may be possible to transfer assets to the beneficiary (ies) when the trust terminates with values that far exceed their original values when transferred into the trust and, more importantly, that far exceed the gift tax value of the transferred assets.

The gift tax value of the transferred assets is determined at the time the trust is created and funded using the "subtraction method." The gift tax value is determined by subtracting the value of the annuity interest (and, in some cases, other retained interests, such as the right to have the assets revert back to the transferor's estate if he or she does not live the entire term of the trust) from the fair market value of the assets transferred in trust. How the annuity interest and any other retained interests are valued depends on who the remainder beneficiary (ies) is (are) and who retains the annuity and other interests relative to the transferor. There is a more restrictive and less appealing set of valuation rules when family members are beneficiaries and certain family members retain interests in the property both before and after the trust is created than when unrelated parties are involved.

When unrelated parties are involved, all interests are valued according to their actuarial present values using the valuation rules of IRC §7520. These rules mandate the use of a discount rate based on the 120% Applicable Federal Annual Midterm Rate for the month in which the trust is created and funded. The mortality factors from Table 80CNSMT, Table 90CM, or Table 2000CM are also used if the interests have a life contingency (i.e., the calculations are of type "Life" or "Shorter").

Optimized help by Trust type:

Trust: For May or June of 2009, you have the choice of using mortality Table 90CM or 2000CM (see https://www.irs.gov/irb/2009-20_IRB). After June 2009, the program will automatically use Table 2000CM. For dates before May 2009 and after June 1999, the program will use Table 90CM. For May or June of 1999, you have the choice of using Table 80CNSMT or Table 90CM. For dates before May 1999 and after April 1989, the program will automatically use Table 80CNSMT. For dates before May 1989, the program uses Table LN from Treas. Reg. section 20.2031-7A(d)(6).

If family members are involved, the gift tax valuation rules of IRC §2702 may apply. Under these rules, certain types of retained interests, such as the right to have trust assets revert to the transferor's estate in the event of the transferor's premature death, may be valued at zero when computing the gift tax value of the transfer. As a general rule, every retained interest but a "qualified interest" is assigned a value of zero for gift tax valuation purposes. In the case of a GRAT, a qualified interest is the right to receive "fixed amounts" payable annually or more frequently (a fixed annuity), or a qualified remainder interest. That is, any non-contingent remainder interest if all other interests in the trust consist of qualified retained interests (qualified annuities).

The right to receive a "fixed amount" means the annuity must be a specified fixed dollar amount or a fixed percentage of the value of the trust payable each year rather than merely the income produced by the assets in the trust. Although fixed payments throughout the term of the trust are the norm, final regulations define the term "fixed amount" more liberally. They would permit the annuity payments to increase or decrease in a systematic manner each year without adverse gift tax consequences. However, the annuity amount may not increase by more than 20 percent over the prior year. For example, if the initial annuity payment is $1,000, the trust could provide that annuity payments in subsequent years increase by as much as 20 percent, to $1,200 in the second year, $1,440 the third year, and so on. If the transferor retains the right to the greater of a fixed amount or the trust income in each year for a term of years, the annuity will still be a qualified annuity. However, the right to the trust income, if any, in excess of the fixed amount is valued at zero for gift tax purposes. Thus, the retained interest is valued for gift tax purposes as if it did not include any rights to excess income.

Term Calculations and the Regulations

By T.D. 9181, 70 F.R. 9224 (2/25/2005), the IRS amended Treas. Reg. Sec. 25.2702-3(e), Example 5, to conform to the decision of the U.S. Tax Court in Walton v. Commissioner, 115 T.C. 589 (2000), acq. in result, Notice 2003-72, 2003-2 C.B. 964, meaning that shorter of term or life calculations are no longer required, and a term calculation is based solely on the term of years without regard to any ages or life expectancies.

For GRATs with payments at the beginning of each period (and not the end of the period, which is more common), we use a Shorter of Term or Life calculation that has one less payment than usual.. This is done to equalize the number of payments for the Shorter case with the Term case. Term cases with a payment at the beginning are valued actuarially by the IRS by simply adjusting the Frequency Adjustment Factor. For example, a two-year semiannual term valuation involves four payments at points 0, ½, 1 and 1½. However, Shorter of Term or Life cases (and for that matter, all cases with life contingencies) with a payment at the beginning of period are valued by the IRS by adding a payment to the normal end of the period valuation. For example, a two year semiannual shorter of term or life calculation involves five payments at points 0, ½, 1, 1½ and 2. Our revised Shorter of Term or Life calculations eliminate the last payment (the one at point 2 in our example) by using a pro-rata valuation for a one-year case and a two-year case to eliminate the last payment. This valuation approach is based on informal consultations with the National Office of the IRS.

For all three GRAT calculation types, the program includes a Rev. Rul. 77-454 test (also known as the "exhaustion" test). The program also shows Taxable Gift if the value of Rev. Rul. 77-454 is ignored (some commentators suggest Rev. Rul. 77-454 is incorrect although it is now part of the §7520 Regs.). It then shows the Taxable Gift limited by Rev. Rul. 77-454. Often the values are the same. However, if the Rate of Annuity is higher than the Sec. 7520 rate, the Taxable Gift under Rev. Rul. 77-454 will often be higher. In some cases where the Annual Payment Growth value is negative, the Rev. Rul. 77-454 Taxable Gift value may actually be lower.

Rev. Rul. 77-454 Test

When Rev. Rul. 77-454 may apply for a Shorter of Term or Life calculation, the program includes a year-by-year Rev. Rul. 77-454 schedule. As for the mechanics of the 77-454 test, there are gray areas once you get beyond the simple case of an annual payment at the end of the period. The program uses an approach long followed for the similar Rev. Rul 77-374 test that is applied for Charitable Remainder Annuity Trust life cases. See George H. Moor Est., 43 TCM 1982-299, for the proposition that annual payments are adjusted by a payout frequency factor.

For the Shorter Calculation with Gift 2 selected for the Near Zero-Out option, the program finds the Rev. Rul. 77-454 value which does not increase the Taxable Gift beyond what it would be under Gift 1 (i.e., the Taxable Gift before consideration of Rev. Rul. 77-454).

Economic Schedule

For illustration purposes, the GRAT calculation also includes an Economic Schedule. Its growth and income values are calculated on an average annual basis, based on the Pre-discounted Fair Market Value entered for the contributed principal. It should be noted that the Pre-discounted Fair Market Value, Annual Growth of Principal, and Income Earned by Trust inputs are only used for the Economic Schedule and are not used for any other part of the GRAT calculations.

When discounted fair market values are entered for the transfer to the GRAT and "Distribute Princ. in Kind?" is checked, the economic schedule shows the reduction in principal that occurs when the same discount is re-imposed on the principal (but not income) distributions.

If you select Life as the Trust Type, the Economic Schedule runs from year one until the Life Expectancy or until the remainder is zero (whichever happens first). If you select Term or Shorter, the Economic Schedule runs from year one until the end of the Term or until the remainder is zero (whichever happens first).

§2702 Rules

The more restrictive valuation rules apply if the transfer is to or for the benefit of a "member of the transferor's family" and an interest in the trust is "retained" by the transferor or an "applicable family member." A member of the transferor's family includes the transferor's spouse, ancestor, lineal descendent, an ancestor or lineal descendent of the spouse of the transferor, a brother or sister, and the spouse of any of these. A retained interest means a property interest held by the same individual both before and after the transfer in trust. An applicable family member is defined as the transferor's spouse, an ancestor of the transferor or an ancestor of the transferor's spouse, and the spouse of any such ancestor.

In summary, if the §2702 rules apply, the annuity must be for a fixed amount or a fixed percentage of the initial value of the trust for a specified term. The annuity will be considered for a qualified "fixed amount" if the scheduled payment in any year does not exceed 120 percent of the prior year's payment. The specified term may be the life of the annuitant, a fixed term or the shorter of a fixed term or the life of the annuitant. Regardless of the specified term, the annuity is valued for gift tax purposes as if it were for the shorter of a fixed term or the life of the annuitant.

Any other retained interest (other than the retention of a qualified remainder interest), including any rights to income or to a reversion of trust assets in the event of premature death, are valued at zero for gift tax purposes. Therefore, the gift tax value of the transfer is determined by subtracting the actuarial valued of the qualified life-contingent annuity from the fair market value of the trust assets at the time the trust is created and funded.

If the transferor-annuitant survives the term of the GRAT, the assets transferred in trust are not included in the transferor's gross estate and escape estate taxation. However, if the transferor dies during the term of the trust, some or all of the trust's assets will be included in the transferor's gross estate. Although there is no statutory or regulatory authority on the issue, some experts think the maximum amount the IRS could include is the lesser of the entire trust corpus or the amount of corpus required to provide the promised annuity for the term (without invading principal). This calculation can be performed by the software's Inclusion calculation.

This amount is computed by dividing the required annuity payment, for example, $20,000, by the §7520 rate as of the date of the transferor-annuitant's death, say 7.6%, to derive the required capital, in this instance, $263,158. A logical but more aggressive and uncertain argument can be made that the amount included should not exceed the present value of a term-certain annuity of the scheduled payments over the remaining term of the trust discounted at the §7520 rate. For example, if 3 years remained in the term of the trust, the present value of a $20,000 term-certain annuity discounted at 7.6% would be only $51,916. The risk of inclusion of trust assets should be covered by the purchase of life insurance owned by the appropriate beneficiary on the transferor's life.

Since the GRAT permits payment of both income and trust principal to satisfy the transferor-annuitant's annuity payments, the GRAT should be treated as a grantor trust for income tax purposes. This means the transferor-annuitant is taxed on income and realized gains on trust assets even if these amounts are greater than the trust's annuity payments. This further enhances this tool's effectiveness as a family wealth-shifting and estate-tax-saving device. The transferor-annuitant is effectively allowed to make gift-tax free gifts of the income taxes that are actually attributable to assets backing the remainder beneficiary's interest in the trust.

Note: the program is a tool that is meant to aid professionals in performing actuarial calculations. It is, of course, your responsibility as a professional to determine their usefulness or applicability to any given case. We are always happy to discuss how we arrive at our calculations, but we cannot offer any estate planning advice. Although we strive to duplicate the same calculation results as the IRS, there can be no guarantee that the program will exactly duplicate IRS values. This is particularly true in the GRAT area since the IRS has published examples involving only the most simple fact patterns. Nonetheless, we believe the software contains the most comprehensive and accurate coverage of GRAT calculations of any program available.

It should be remembered that the GRAT area is still evolving. There are gray areas involving many aspects of the calculations, especially when adjustments are required under Rev. Rul. 77-454. Updates may be released from time-to-time to incorporate calculation changes to reflect new Regulations, Rulings and/or court cases. Such updates are sent automatically to those who subscribe to maintenance coverage.