Grantor Retained Annuity Trust (GRAT).
In the typical GRAT, the grantor contributes income-producing assets (i.e., Subchapter S stock or an interest in an FLP or FLLC) to a trust and receives a fixed payment (the annuity) from the trust each year. Whatever remains in the trust when the GRAT term ends passes to the remainder beneficiaries tax free. For the year the GRAT is created, the grantor has made a taxable gift equal to the difference between the amount contributed (after considering valuation discounts) and the present value of the annuity payments that the grantor will receive. This present value calculation is computed using the IRC Section 7520 rate for the month the GRAT is established. The Section 7520 rate is 120 percent of the annual mid-term applicable federal rate (AFR). Savvy planners will select the combination of annuity payment and trust term that will result in the present value of all future annuity payments equaling the amount initially contributed to the trust. Thus, no (or little) gift tax will be levied. If the GRAT’s actual rate of return exceeds the Section 7520 rate, the excess appreciation will pass to the GRAT remaindermen free of transfer taxes. Additional transfer tax savings occur because the grantor is not separately taxed on the annuity payments, but instead is responsible for paying all of the GRAT’s income taxes. This is because the GRAT will be a “grantor” trust. Rev. Rul. 2004-64. This tax payment is effectively a tax-free gift to the GRAT’s remainder beneficiaries to the extent the GRAT’s income exceeds the annuity payments.
If the grantor dies during the GRAT term, a portion of the GRAT’s assets are included in the grantor’s estate. The portion so included in the amount necessary to produce the retained interest in perpetuity (as if the annuity amount were the annual income of the GRAT’s assets) using the IRC Section 7520 rate in effect on the date of death (or the alternate valuation date). Generally, if a GRAT’s assets have substantially appreciated, there will be a significant tax-free transfer of wealth even if the grantor dies during the term.
Intentionally Defective Irrevocable Trust (IDIT).
An intentionally defective irrevocable trust is an irrevocable trust that the grantor purposely creates to be “defective” for income tax purposes, but “effective” for transfer tax purposes. If properly designed, the IRS treats the grantor as the owner of the trust’s assets only for income tax purposes (a so-called “grantor” trust). After the IDIT is established and a small gift (i.e., seed money) is made to the trust, the grantor sells income-producing assets (i.e., Subchapter S stock or interests in a family LLC) to the trust in exchange for the trust’s installment note. The sales price will consider valuation discounts.
In the typical sale to an IDIT no down payment is made, the IDIT pays the grantor annually interest only at the AFR for the month of the sale, and there is a balloon payment at the end of nine or more years. Because the sale is between the grantor and his/her grantor trust, the IRS does not recognize any gain or loss on the sale. Under Rev. Rul. 85-13, transactions between a grantor and his/her grantor trust are disregarded for income tax purposes. If the assets in the IDIT appreciate greater than the AFR, such excess value is removed from the grantor’s estate. Additional transfer tax savings occur because the grantor is not separately taxed on the interest payments, but instead is responsible for paying all of the IDIT’s income taxes. This tax payment is effectively a tax-free gift to the beneficiaries of the IDIT to the extent the IDIT’s income exceeds the interest payments. Rev. Rul. 2004-64.
A private annuity is a contractual arrangement that is very much like an installment sale, except that the payments must continue until the seller’s death. In the typical private annuity, a parent (seller) sells income producing assets (i.e., Subchapter S stock or interests in a family LLC) to a child (buyer). The sales price will consider valuation discounts. The buyer takes legal title to the property and promises to make payments (the annuity) to the seller for the rest of the seller’s lifetime. The amount of the annuity is determined by IRS actuarial tables established under IRC Section 7520. Until April 18, 2007, the annuitant (seller) was able to report the built-in gain on the property sold piecemeal as part of each annuity payment. Under current law, the entire amount of the seller’s gain or loss (if any) must be recognized at the time of sale. Thus, part of each payment will now be a tax-free return of basis and part will be interest income. Each payment made by the purchaser is added to his/her basis in the property and no portion of the payment is deductible to the seller. If the value of the private annuity received by the seller equals the transferred property’s fair market value, then no gift tax will be incurred