9011 / How can a grantor retained annuity trust be used in family business succession planning?

Trust entities can be useful in business succession planning, whether the trusts are revocable or irrevocable. The two forms of trust are not mutually exclusive, and in many instances, a succession plan may contain more than one trust entity. The decision to have one or both depends on the business owner’s goals, how much control the senior generation wants, when the assets will be transferred to the heirs and other restraints that are imposed.

A grantor retained annuity trust (GRAT) is an irrevocable trust to which the business owner transfers shares in his business while retaining the right to a fixed annual annuity payout for a stated term of years.

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Planning Point: In response to a comment on the IRS’s proposed GRAT regulations, the final regulations include and use interchangeably both the term “GRAT” (which does not appear in the statutes or the regulations) and its Treasury Regulation citation, § 25.2702-3(b).¹

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At the end of the term, the property remaining in the GRAT (the appreciation and income in excess of the annuity amount that is to be paid to the business owner) will pass to the trust beneficiaries (often the owner’s children or grandchildren). Only the value of the remainder interest is subject to gift tax.

The amount of the taxable gift to the beneficiaries can be reduced by structuring the trust with a larger annuity payout or a longer stated term. Further, the value is dependent on the IRS Section 7520 interest rate in effect at the time the trust is established—a lower interest rate can also reduce the value of the taxable gift.

A GRAT may be structured so that there is little or no gift tax payable on the value of the remainder interest that passes to the trust beneficiaries. For gift tax purposes, this is known as a “zeroed-out” GRAT. If the zeroed-out GRAT produces a return in excess of the annuity amount payable to the business owner, the GRAT will succeed in passing on the reminder interest (the trust’s excess income and appreciation) to the trust beneficiaries at little or no gift tax cost to the business owner. If the zeroed-out GRAT fails to produce a return in excess of the annuity amount and the remainder beneficiaries receive nothing, there is minimal downside risk since there was little or no gift tax cost to the business owner upon establishing the zeroed-out GRAT. The primary risk of using a GRAT (especially a short term GRAT) to transfer business interests is that if the business owner fails to survive the stated term, the GRAT may be included in his estate and subject to estate taxes.

The Ninth Circuit confirmed this result. In a case where the GRAT creator died before the GRAT terminated, the court held that there was no actual transfer of the trust property. She had created the GRAT structure to transfer interests in a family business to her daughters, receiving a $302,529 annuity payment annually for 15 years. The business generated enough income so that the value of the partnership interest was not decreased by the monthly annuity payments. Under IRC Section 2036(a), because the decedent was still enjoying the economic benefit of the property at death, the entire GRAT value was included in her gross estate. The court rejected the argument that the value should be excluded because the statute does not specifically list “annuities” as property that may be pulled into the estate.²

See Q 9012 for a discussion of the use of intentionally defective grantor trusts in family business succession planning.