The first two issues of Owner to Owner provided a broad overview of the benefits and mechanics of gifting interests in privately-held businesses to loved ones and charities. This article will examine two popular and effective techniques for transferring the future appreciation on assets to beneficiaries, or trusts for their benefit, at little or no gift tax cost: grantor retained annuity trusts (GRATs) and sales to grantor trusts. These planning techniques are ideal for the owner of a business that is expected to increase in value dramatically over the next few years.
A GRAT is an irrevocable trust designed to transfer a portion of the future appreciation on the trust assets to family members or other beneficiaries. A successful GRAT is one of the most tax-efficient vehicles for transferring assets to the next generation. Interests in a privately-held business that are expected to increase in value significantly during the term of the trust are ideal assets for funding a GRAT.
How a GRAT Works
A grantor (in this case, the business owner) transfers a portion of his interests in the business to a GRAT in return for a stream of annuity payments during the term of the GRAT. GRAT terms can be as short as two years and as long as 99, but generally shorter terms of two to five years are advisable in order to capture an increase in the asset value without significant risk that the assets will decrease during the term of the GRAT. Another reason to use a shorter GRAT term is that the grantor must survive the term. If the grantor dies during the term, all or a portion of the GRAT assets will be included in the grantor’s estate.
During the term of the GRAT, the grantor receives back the full value of his initial contribution plus statutory interest in the form of annuity payments. The stream of annuity payments is calculated using the applicable rate published by the IRS at the time the GRAT is funded. GRATs are particularly attractive when interest rates are low, as they have been for years. The August 2015 rate applicable to GRATs is 2.2%. If a business owner funded a two-year GRAT in August with interests in his business that appreciate at a rate greater than 2.2% over the next two years, all of the excess appreciation would be transferred to the business owner’s beneficiaries, or trusts for their benefit, free of gift tax.
GRATs are usually structured so that the grantor does not make a taxable gift. Under current law, if the value of the annuity payments is equal to the property transferred to the trust, plus applicable interest, no gift tax will be due when the GRAT is created because the value of the gift is effectively reduced to zero. This is a called a “zeroed-out” GRAT.
During the term of the GRAT, the trust is a “grantor trust” for federal income tax purposes. This means that the business owner grantor continues to be treated as the owner of the trust property and pays any income and capital gains taxes associated with the property. While this may sound like a negative result for the grantor, it is actually very beneficial. The assets in the trust grow “tax-free” during the trust term, thereby increasing the likelihood that there will be assets remaining at the end of the GRAT term to be transferred to beneficiaries.
Below is an illustration of a four-year GRAT established in August 2015.