The current market conditions created by the COVID-19 pandemic have forced businesses across the country to grapple with a number of difficult challenges. With the stock market dropping to historic lows and closely-held family businesses experiencing a downturn in shareholder equity, many business owners may have doubts about the future of their companies. These same negative market conditions, however, have a silver lining in that they present an opportunity for business owners to take advantage of an estate planning tool known as the Grantor Retained Annuity Trust (GRAT). All of the factors that make the GRAT an attractive estate planning tool—such as low interest rates, depressed market values, and the potential for recovery on the horizon—are present now, providing the perfect time to consider the positive benefits of establishes a GRAT.
A GRAT is a trust mechanism by which the grantor transfers wealth and future appreciation in certain property to the grantor’s chosen beneficiaries (generally the grantor’s children) while receiving tax-free annuity payments over a span of years from the trust. Although gifts are generally subject to gift tax, a “zeroed-out” GRAT, otherwise known as a Walton GRAT, is a GRAT in which the value of the gift to the beneficiaries is reduced to zero. Put more simply, a Walton GRAT allows a grantor to transfer appreciation of value to beneficiaries tax free.
Another benefit of the GRAT is that the grantor is not required to completely surrender ownership and control of the property transferred to the trust. In fact, by the end of the trust term, the grantor may receive a majority of the assets previously transferred to the GRAT back from the trust. Any assets remaining in the GRAT at the expiration of the GRAT term will be transferred tax-free to the beneficiaries of the GRAT.
The basic mechanics of the Walton GRAT are as follows. The grantor contributes to the GRAT assets that will appreciate meaningfully over the trust term. The GRAT holds the assets so contributed and pays fixed annuity payments to the grantor, which annuity payments are made in-kind using the very assets contributed to the GRAT. At the end of the trust term, after the grantor receives the final annuity payment, the trust transfers all appreciation of the assets to the beneficiaries. No matter how much the assets held by the GRAT have appreciated over the trust term, the value transferred to the designated beneficiaries will be tax-free.
For purposes of federal income tax, the grantor and the GRAT are viewed as the same person. As such, the grantor will pay income tax on the GRAT’s income. Furthermore, because the GRAT and the grantor are viewed as the same person, the GRAT may hold subchapter S corporation stock without threatening the corporation’s S election.
Two factors that determine the effectiveness of a GRAT and the value of assets that may be passed on to the designated beneficiaries gift and estate tax-free include (1) the interest rate imputed by the Internal Revenue Service on the assets of the trust and (2) the rate of anticipated growth of the trust assets. With interest rates at historic lows and current market values in limbo, now is an ideal time to establish a Walton GRAT. We would be happy to answer any additional questions you may have on the mechanics of the Walton GRAT.