The Grantor Retained Annuity Trust: A Jackpot for Taxpayers Who Want to Limit Gift Tax Liability

By:
Daniel Mazzola, CPA, CFA
Published Date:
Aug 1, 2014

When asked if she ever bought a lottery ticket, humorist Fran Lebowitz replied negatively: “I figure you have the same chance of winning whether you play or not.” She might be surprised to learn that a few people do, in fact, win the lottery each year. Winners are typically brought before the public and photographed holding an oversized check, on which the face amount of the jackpot is inscribed boldly. Presumably, they live a happy life thereafter. But regardless of whether their remaining days are blissful, many need help figuring out how to deal with their newfound wealth.

One of the first things winners learn is that their prize money is subject to taxation. In the United States, lottery prize money is classified as gambling winnings and is considered taxable income, just like wages from employment and interest earned at a bank. Taxation on lottery winnings can be as high as 50 perecent, depending upon where one is domiciled. The federal government automatically withholds 25 percent of the prize, with states and cities also taking their share. Furthermore, if the winner decides to share some of the largess with family or friends, he would have to pay gift taxes. The gift tax rate is currently 40 percent, and although an individual is able to give away millions of dollars in her lifetime (the federal gift tax exemption for 2014 is $5.34 million), a lottery winner can easily exceed this threshold.

There is not much the lottery winner of a significant cash prize can do regarding income taxes, but he can reduce gift taxes by establishing a grantor retained annuity trust (GRAT). This allows the winner to share prize money with heirs with virtually no gift tax, and it is one of the most powerful, tax-efficient wealth transfer tools available today. A GRAT is particularly effective with any asset likely to appreciate in value.

Overview of a GRAT

The basic premise behind a GRAT is that the person establishing the trust (i.e., the grantor) receives an annuity payment spread over the life of the trust equal to the initial value of the contribution, plus an assumed rate of interest. Normally, a bequest to an irrevocable trust triggers a gift tax because the grantor is giving up ownership and control of the asset. With a GRAT, however, the annuity payments offset the value of the gift, minimizing the liability. A GRAT should be structured so that the annuity payment stream is equal to the value of the asset contributed, plus interest. Theoretically, all assets contributed will be returned to the grantor and nothing will be left for beneficiaries when the GRAT expires.

When the term ends, the grantor no longer retains any interest in trust assets or income, and remaining assets are passed gift tax-free to designated beneficiaries.

For example, consider a benevolent Powerball lottery winner who has the prescience to use a GRAT. In New York state, winning tickets must be presented within one year of the ticket’s draw date, allowing the winner plenty of time to establish a GRAT. The winner, who (for simplicity’s sake) paid $20 for his ticket, places said ticket in a GRAT with a five-year term. The amount of the annuity payment is then computed, with the intent that the total of these payments will equal the trust principal ($20) plus a rate of interest set by the IRS.

This IRC section 7520 rate is 2.2 percent in July 2014, and its corresponding annuity factor for a five-year term is 4.6862. Thus, the annuity payment for each of the five years is $4.27 ($20 divided by 4.6862). Because the value of the annuity payment stream equals the trust principal plus interest, the value of the remainder interest (i.e., the prize money represented by the winning lottery ticket) is zero for gift tax purposes. There is no tax liability on a transfer of an asset worth millions of dollars.

Utilizing a GRAT

The use of a GRAT is not limited to the winner of a Powerball lottery ticket. Its deployment is appropriate in any situation where an individual wants to share the future appreciation of an asset with the next generation while limiting gift tax liability. For example, a grantor funds a GRAT with a $1 million stock portfolio that she anticipates will materially grow in value and under its terms receives an annuity for 10 years of $75,000. Using the IRC section 7520 rate of 2.2 percent, and a factor for a 10-year term of 8.8893, the grantor’s retained interest is worth $666,698 ($75,000 x 8.8893), with the remainder interest valued at $333,302.

Thus, the right to receive $75,000 each year for 10 years is worth $666,698. The right to receive the remainder at the end of the 10-year term, $333,302, is subject to gift tax upon creation of the trust. Assuming the assets in the GRAT generate a return rate greater than the IRC section 7520 rate, the remaining value of the original bequest will result in a gift that exceeds its initial value when placed in the trust. As an example, at a 4 percent growth rate, $579,786 can be transferred at a gift tax cost of only $333,302. If the portfolio assets perform as expected, the increased value will be passed on to beneficiaries without further gift tax implications.

An essential element for a successful GRAT is that the grantor must outlive the term of the GRAT. Advisors and attorneys have dealt with this issue by setting the GRAT for periods as short as two years. Congress, however, is weighing legislation that would require the term of a GRAT be a minimum of 10 years. Another factor for the GRAT to function as planned is for trust assets to earn a return higher than the current IRC section 7520 rate. Finally, regardless of the amount of the annuity actually received, the grantor is taxed on the trust income while the GRAT remains in existence.

A Beneficial Option

Preserving and transferring wealth creates a challenge for many individuals and families. Many of our clients want to share wealth with heirs, but doing so results in the loss of a substantial portion of the bequest due to gift or estate taxes. A grantor retained annuity trust is a means to transfer the full benefit of an intended bequest by maintaining its future appreciation potential.


Daniel G. Mazzola, CPA, CFADaniel G. Mazzola, CPA, CFA, is an investment advisory representative with American Portfolios Advisors Inc. He is a Chartered Financial Analyst, Certified Public Accountant and Certified Financial Planner. Mr. Mazzola is a member of the NYSSCPA Personal Financial Planning Committee. His website is http://www.danmazzola.com.

 
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