In a victory for taxpayers, the Tax Court, in Walton v. Commissioner, 115 TC 589 (2000), disagreed with the Internal Revenue Service and sanctioned the creation of a grantor retained annuity trust ("GRAT") in which the remainder interest (and the amount subject to gift tax) was valued at zero. However, the IRS never indicated if it would fight that Tax Court decision. Recently, in Notice 2003-72, the IRS announced that it would accept the result in Walton and not contest the creation of "zeroed-out" GRATs.
A GRAT can reduce the gift tax cost of passing assets to a donor's intended recipients. The donor would transfer property to the GRAT while retaining an annuity from that property for a term of years. The IRS recognizes that only the value of the remainder interest (i.e., the property remaining after the annuity term) is subject to gift tax - a value computed using certain IRS assumptions at the time the GRAT is created. If the donor outlives the annuity term, then all property remaining in the trust at the end of that term passes to the GRAT's remaindermen - and the value of that remaining property can, depending on the economic performance of the assets during the annuity term, exceed its assumed gift tax value, thus passing that excess free of gift tax.
The donor can reduce the gift tax value of the remainder interest by his or her choice of annuity term and amount - which would be especially important to individuals who have little or no applicable credit left and wish to minimize any gift tax payable. In fact, it is mathematically possible to create a GRAT with an annuity so large that the remainder interest (and therefore the gift tax) is zero. But, despite the mathematical possibility of zeroed-out GRATs, the IRS took the position that a GRAT remainder interest always had some value, so the gift tax cost was never zero. With IRS acquiescence in the Walton decision, zeroed-out GRATs can safely be used for estate planning purposes.
A zeroed-out GRAT would work as follows: assume you fund a GRAT with $1,000,000 in November 2003 and retain an annuity of $123,290 for 10 years. Based on those assumptions, your gift would have zero value, because the remainder passing to your beneficiaries at the end of 10 years is assumed to be exhausted by the annuity payments to you. However, if you survive the 10-year term and there are assets remaining in the GRAT, those assets would pass to your beneficiaries free of federal gift tax.
For a zeroed-out GRAT to be effective in passing value free of gift tax, the assets in the GRAT must outperform the assumed rate of growth at the creation of the GRAT (4% in the example above), which can vary from month to month, based on prevailing interest rates. For example, if the assets in the zeroed-out GRAT in the above example grew at an annual rate of 6% instead of 4%, $165,000 would pass to the remaindermen at the end of the 10-year annuity term, free of gift tax.
If you would like more information about GRATs and how they may be used to help achieve your particular estate planning goals, please feel free to contact any member of our Tax and Trusts & Estates group.
