GRATS: A Key Part of Business Transaction Planning

June 22, 2006

Published in the AICPA's Wealth Management Insider

As many CPAs and other financial professionals know, a grantor retained annuity trust ("GRAT") is a wealth-shifting technique that should be considered as part of every business owner's pre-transaction planning.  A GRAT is a technique that permits your clients to transfer the future appreciation in their stock, real estate or partnership interests in excess of the IRS assumed rate of return to their beneficiaries (typically, their children) at a significantly reduced transfer tax cost.  If used prior to a business liquidity event, your clients can realize very significant tax benefits.

How it works

A GRAT works as follows:  your client sets up an irrevocable trust that meets the requirements of the Treasury Regulations.  The trust lasts for a term of years, during which your client retains the right to receive an annual annuity.  At the end of the trust term, which must expire during your client's lifetime for the technique to work, the trust assets will pass to your client's children.  Your client's gift at the time the trust is established is measured by the present value of the remainder interest in the trust, and not the current value of the property transferred to the trust.  So, the gift for gift tax purposes is the difference between the amount contributed to the trust and the present value of the annuity payments that your client will receive.  To calculate the value of the annuity payments, the IRS makes an assumption about the rate at which the trust assets will appreciate.  Success depends on beating the interest rate hurdle tied to Treasury bonds, as defined by the Internal Revenue Code.

With expert planning, advisors can assist a client in selecting the combination of annuity payments and trust term that will result in the present value of all future payments exactly equaling the amount contributed to the trust.  By IRS calculations, the GRAT will then have zero assets by the time the trust expires and no gift tax at all is ever levied.  The term of a GRAT can be as short as two years, and a series of two or three year "rolling" GRATs can be used to try and capture periods of appreciation in the assets.  As in all grantor trusts, the grantor remains responsible for any income and capital-gains taxes incurred inside the trust.

GRAT as part of a business owner's pre-transaction planning

If the GRAT is funded with shares from a closely held business, there is the possibility that substantial additional wealth can be passed to your client's children.  When a minority interest in a closely held business is placed in the GRAT, the interests may be assigned a value that is less than their potential future worth because of their inherent lack of marketability at that time.  If your client later decides to sell the business and receives a price higher than that previously assigned value, the beneficiaries (typically the children) reap the benefit of the sale free of transfer tax.  And even if your client decides not to sell the business, or the sale price is lower than anticipated and the GRAT fails to pass any assets to the children, the only costs incurred are the legal fees it took to set it up.  The client will have received back everything he or she put into the GRAT via the annuity payments.

Example:  To illustrate, assume your client, a business owner, puts a 25% interest in his business into a GRAT with a two year term.  Although the owner believes the business may be worth as much as $100 million, because the shares lack liquidity and marketability, this contribution of 25% is valued at $17.5 million.  If the business is sold for $100 million, the 25% interest which is held by the GRAT is now worth $25 million so there is an additional $7.5 million available over the original valuation of $17.5 million.  The grantor will receive approximately $17.5 million back as annuity payments over the 2 year period and the children will receive the $7.5 million free of tax.  And, the grantor would pay the entire tax bill from the sale which is an added benefit to the children but not considered a gift for gift tax purposes. 

The tax efficiency of the strategy can be improved even more by first recapitalizing the client's company, or retitling assets in a limited partnership and then transferring non-voting stock or the limited partnership units to the GRAT. The use of non-voting stock or limited partner units may permit you to achieve a discount for lack of control and marketability on the value of the contributed assets between 25% and 45%.

As part of your client's advisory team, you can assist in ensuring that business owners have the right vehicle in place pre-transaction.