Passing on the Rapidly-Growing Business

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A GRAT (Grantor Retained Annuity Trust) is a gift of a remainder interest in a trust, which, because the donor retains an annuity interest for a term of years, has a reduced value for gift tax purposes. Thus, the donor can give away the remainder interest with a reduced gift tax.

Business owners often own businesses that are appreciating in value. Good estate planning will try to reduce the effect of estate taxation on the business, because as time passes this growth will create a tremendous amount of estate tax before it can be passed to children, grandchildren, or other beneficiaries. Many times, however, the business is generating considerable amounts of income that the owner cannot or does not want to give up right now. And, it may be that the gift tax cost of giving the business away may be prohibitively expensive.

GRATs offer an excellent solution to these problems. To create a GRAT the donor transfers assets to an irrevocable trust and retains an annuity interest for a specified number of years. The annuity interest is described as a fixed dollar amount or a fixed percentage of the trust’s assets on the date the trust is created. The amount of the annuity is set according to IRS actuarial tables.

When the term ends, the trust quits paying the donor an annuity and either pays all of the assets outright to the beneficiaries, or continues to hold them in trust for their benefit.

The transfer of assets to a GRAT is a taxable gift only of the value of the remainder interest. Depending on the annuity rate assumed, the remainder interest may have little or no gift tax value.

Since the value of the assets – and the gift to the beneficiaries – is based upon today’s value and not a projected future value, the assets pass to the GRAT beneficiaries with no other tax consequence. All of the appreciation of the property from the date of the gift forward is shifted to the beneficiaries, totally eliminating the federal estate tax on those assets in the estate of the trustmaker.

The greatest risk involved in this strategy is that if the trustmaker dies during a GRAT term, all or part of the value of the assets are pulled back into the trustmaker’s estate. However, nothing is lost if this occurs; it is just as if the GRAT was never implemented.

GRATs have two key advantages as a technique for making large tax-free gifts. First, they involve an immediate gift of the entire asset, in this case a growing business, so any future appreciation inures to the benefit of the remainder beneficiaries.

Second, the grantor retains most or all of the income generated by the property given away. If the property generates a return exceeding the annuity percentage, the additional income will be accumulated for the remainder beneficiary without added gift taxes.

The GRAT is not without disadvantages however. Business owners who are likely to need the income from the business for a prolonged period of time should consider alternative methods of planning. The income interest from a GRAT will end eventually, and when it does, the trustmaker either has to have enough income to replace that income which is lost or simply have no need for additional income.

Individuals who are elderly or not in good health should also avoid this strategy. There must be a very high probability that the maker will outlive the term of the GRAT. If there is a risk that the assets given to a GRAT will not generate enough income to support payments to the maker, then this strategy may not be viable. If there is not enough income generated, then the trustee of the GRAT may have to sell assets in the trust or return some of them to the maker in order to satisfy the income requirement.

Another potential disadvantage is that the trust is a grantor trust. The federal tax law says that a trustmaker is taxed as the owner of any portion of a trust income that is or may be paid to or accumulated for the benefit of the trustmaker.

Since the GRAT annuity permits all income and all principal to be paid to the trustmaker, the trustmaker will be deemed the owner of the entire trust for income tax purposes, during the term of the annuity. Thus, the trustmaker will be taxed on all trust income and gains, even if they exceed the amount paid as an annuity. However, this may not always be a disadvantage if the trustmaker uses those tax payments to further reduce the size of the estate for estate tax purposes.

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