If a gift of a remainder interest in a trust is made to a beneficiary who is a descendant, the asset must pay you a market rate of return during the term of the trust. In many cases, this takes most of the leverage out of the gift of the remainder. The retained interest must be an annuity interest based upon the original value (a grantor retained annuity trust, or GRAT), or a unitrust interest based upon the market value each year (a grantor retained unitrust, or GRUT). Under the right circumstances, the value of the gift for transfer tax purposes can be close to zero.
A GRAT is particularly attractive if it can be funded with stock in a pass through entity (S-corporation, limited liability partnership, etc.) with a historically low rate of dividends or distributions, which is expected to generate higher rates of return in the future.
A GRAT will be a grantor trust, which means that the grantor must pay income taxes on all of the income of the trust, not just the income used to pay the annuity. Consider this example:
Closely held stock having a fair market value of $1 million, is transferred to a GRAT paying a guaranteed 8% annuity to the grantor for 20 years. Assume that if the federal and state income tax rate is 50%, and that the donor would owe $80,000 in tax annually from the income generated by the S corporation. The GRAT is required to pay the donor 8% of $1 million, or $80,000, which the donor, in turn, uses to pay the income tax. 20 years later, when the GRAT terminates, (a) the GRAT would have accumulated $1 million if the stock is in the GRAT consistently, (b) the donor has paid virtually no transfer tax, (c) the donor’s estate has not really been augmented at all by the annuity (since it went to pay income taxes), and (d) even if the stock had not appreciated during the 20 years, the trust would still be worth $1 million. In effect, the donor will have transferred $1 million dollars paying no transfer tax. If the underlying value of the stock increases during this period, the results are more dramatic. Perhaps this technique can be made even more attractive if the property continues to be held in trust (as a grantor trust) following the termination of the retained interest.