Are GRATs Still Foolproof? The Importance of a Timely and Accurate Appraisal
Estate planners routinely use “grantor trusts,” which are trusts fitting into criteria set out in the Internal Revenue Code (Code) to minimize federal transfer taxes. A grantor trust is disregarded as a separate entity for federal income tax purposes, so the grantor pays all income tax generated by the trust. The trust is drafted, however, to avoid being included in the grantor’s estate for federal estate tax purposes. This structure allows for the appreciation of assets free from income tax for the trust beneficiaries. One technique which effectively utilizes grantor trust status for tax planning purposes is a Grantor-Retained Annuity Trust (GRAT). Although the tax consequences of a GRAT should be clear if the rules of IRC 2702 are followed, the Internal Revenue Service (IRS) recently cast doubt on some of the certainty provided by GRATs in Chief Counsel Advice 202152018.
On December 30, 2021, the IRS released Chief Counsel Advice 202152018 (the “CCA”). The CCA took the unprecedented position, drawing an analogy from the Atkinson case (a case where a Charitable Remainder Annuity Trust was disqualified for failing to make any annuity payments), that the use of an improper appraisal of an illiquid asset caused the GRAT annuity interest to not be a qualified interest. Therefore, the annuity retained by the grantor was valued at zero, and the transaction was a 100 percent gift — the transaction failed. The IRS’ position is out of step with regulations allowing taxpayers to define the qualified annuity interest as finally determined for federal tax purposes and allowing for provisions in the governing instrument to address incorrect valuations of trust property.
Although the IRS took an aggressive position in CCA 202152018, it is worth noting that the taxpayer used an appraisal dated seven months prior to the date of the transfer to the GRAT. The appraisal was also prepared for purposes of a nonqualified deferred compensation plan arrangement rather than for gift tax purposes. Additionally, the taxpayer engaged in merger negotiations and had received multiple offers at the time the transfer was made to the GRAT, but the merger was not addressed in the appraisal. The final offer, accepted several months later, was three times the value used to determine the annuity amounts for the GRAT. The dated and inaccurate appraisal drew the ire of the IRS. Unfortunately, the taxpayer also took inconsistent positions with respect to the value of the asset, by using a qualified appraisal matching the tender offer price in a separate transaction where the taxpayer transferred company shares into a charitable remainder trust immediately prior to closing.
The IRS did not respond favorably to the taxpayer’s use of an inaccurate and dated appraisal for transfer tax purposes while simultaneously claiming a charitable income tax deduction based upon the tender offer price. Had the taxpayer obtained a proper appraisal based on full information as of the date of the transfer of the shares to the GRAT, and had the taxpayer used the same value for the GRAT and the CRT, perhaps the IRS would not have intervened. The appraisal was outdated and did not take into consideration all the facts and circumstances of a pending merger, leading the IRS to conclude that the retained interest was not a qualified annuity interest under IRC Sec. 2702.
Despite the aggressive stance of the IRS in this case, the GRAT remains an effective and statutorily sanctioned wealth transfer planning technique. With an estate tax exemption of $12,060,000 and historically low interest rates (which seem likely to rise), the time to move forward with GRAT planning is now. It is important to note that the estate tax exemption reverts to $5,000,000, adjusted for inflation, on January 1, 2026. With the 2026 sunset on the horizon, taxpayers have limited time to make full use of any remaining lifetime gift tax exemption for GRAT planning purposes.
As demonstrated in CCA 202152018, a timely and accurate appraisal of the illiquid asset used to fund the GRAT is of paramount importance. Taxpayers should not try to save money by using a dated and inaccurate appraisal. It is worth spending a few extra dollars on a current appraisal which takes into account all facts and circumstances in order to avoid IRS scrutiny. The CCA also highlighted the importance of proper GRAT administration.
The Ins and Outs of GRATs
A GRAT is typically used to transfer a rapidly appreciating asset to children. It is possible for the taxpayer, as grantor, to retain all or most of the income, while simultaneously providing a means for transferring the asset to trusts for the benefit of children with minimal transfer tax. As previously mentioned, in some cases, the income, deductions and credits of the trust may be attributed directly to the Settlor as though the trust did not exist, under what are known as the “Grantor Trust Rules.” (Code Secs. 671 to 679). A trust is a grantor trust if the Settlor holds certain rights, interests, or powers over the trust. As a general rule, a GRAT can be structured to be a wholly grantor trust.
While the GRAT is sanctioned by statute, there is some mortality risk with this technique. The taxpayer must survive the term of the GRAT in order for the future appreciation of the assets to pass to the remainder beneficiaries free from transfer tax.
A GRAT is created by transferring one or more high-yield assets, which are expected to appreciate, into an irrevocable trust. The grantor retains the right to an annuity interest for a fixed term of years. S corporation shares, limited partnership interests, or LLC membership interests are often used to fund GRATs. When the GRAT term ends, the assets in the trust, including all appreciation, pass to trusts established for the benefit of the grantor’s children.
GRATs provide a fixed annuity payment, usually expressed as a fixed percentage of the original value of the assets transferred in trust. The taxpayer will have steady and consistent payments. It is important to note that a GRAT may not satisfy its annuity obligations with a note or other debt instrument.
All income and appreciation in excess of the amount required to pay the annuity will accumulate in the GRAT for the benefit of the grantor’s children, as remainder beneficiaries. As a result, it may be possible to transfer assets to children when the trust terminates with values that far exceed their original values when transferred into the trust and, more importantly, that far exceed the gift tax value of the transferred assets. All appreciation of the asset at the end of the GRAT term passes to the children free of transfer tax.
The annuity calculation involves several components. The value of the transferred asset minus the value of the retained annuity interest (the value of the fixed annuity interest paid to the grantor over the duration of the GRAT), results in the remainder interest, which is subject to gift tax in the year the trust is created. The annuity amount can be manipulated by adjusting the term of years of the GRAT and the annuity percentage. The larger the annuity percentage and the longer the term of the GRAT, the smaller the value of the taxable gift.
Since GRATs are structured as grantor trusts, the grantor pays all the taxes on the GRAT’s income, including the excess income remaining in the trust. The grantor’s payment of the income tax, shifts wealth to the grantor’s children and the trust assets are preserved. This is because the grantor’s payment of the income taxes is effectively a tax free gift and the value of the trust continues to appreciate, unreduced by income taxes.
There are some potential disadvantages to a GRAT. Since the GRAT is a grantor trust, the grantor will be taxed on all income and gains. Although this can be advantageous from a wealth transfer planning standpoint, it could pose a cash-flow and liquidity problem for the grantor.
Once again, if the grantor does not outlive the GRAT term, the desired estate tax advantages will not be achieved. A GRAT is an irrevocable trust and during the GRAT term the assets of the trust, except for the annuity, are out of the reach of both the grantor and the remainder beneficiaries. GRATs are also not effective vehicles for making gifts to grandchildren. The grantor’s GST tax exemption cannot be allocated to the GRAT until the end of the GRAT term. As a result, all of the future appreciation of the GRAT assets may not be protected from the grantor’s GST tax exemption.
If you have any questions about Grantor-Retained Annuity Trusts or other high-end transfer planning techniques, please contact the authors.