If you are thinking about selling your business in the next few years, consider implementing some estate planning techniques now that will enable you to shift some of the sale proceeds to your descendants or other beneficiaries. One of the techniques that we successfully use is a GRAT.
What is a GRAT?
A grantor retained annuity trust (“GRAT”) is an irrevocable trust in which you (the “grantor”) retain the right to receive an annuity payment for a term of years, or for life, or for the shorter of the two. At the end of the term, any assets remaining in the GRAT pass to your beneficiaries. When you create a GRAT, you will be making a gift to the beneficiaries equal to the actuarial value of the remainder interest.
How is a GRAT structured?
We usually create a GRAT as a short-term, “near zeroed-out” GRAT. We prefer short term GRATs, somewhere between two and five years. By “near zeroed-out,” we mean that the annuity payment to the grantor is essentially equal to the value of the property contributed to the GRAT, plus interest calculated as required by federal tax law.
Usually, the beneficiaries of a GRAT are the grantor’s children or a trust for their benefit. If a trust is a beneficiary, the terms of the trust will determine when the beneficiaries receive distribution of the trust assets.
What are the advantages of a GRAT?
There are many benefits that can be achieved by using a GRAT. First, the assets contributed to the GRAT are valued at today’s value, and the annuity paid to the grantor is based on that value.
Therefore, the GRAT freezes the value of the assets to be paid to the grantor and passes to the GRAT beneficiaries the appreciation on the property. As long as the grantor survives the term of the GRAT, the appreciation on the GRAT assets is removed from the grantor’s estate.
Second, because the annuity payment required by the GRAT is generally structured to be almost equal to the initial value of the contributed property, the amount of the gift made by the grantor is generally very small.
What are the disadvantages of a GRAT?
The biggest perceived disadvantage of a GRAT is that the grantor must survive the term of the GRAT in order to keep the GRAT assets out of his or her estate. If the grantor dies during the term of the GRAT, some proportion of the value of the GRAT assets is included in the grantor’s estate for estate tax purposes. However, with careful planning, the value of the GRAT can be removed from the grantor’s estate.
Secondly, a GRAT is a type of “grantor” trust, meaning that the grantor is treated as the owner of the trust assets for income tax purposes. Therefore, if the GRAT sells assets, the grantor will be responsible for the payment of any income tax due on the sale, even though the grantor does not receive any benefits (other than his or her annuity) from the GRAT. (This, however, is an additional benefit for the GRAT beneficiaries, as they will retain all of the sales proceeds unreduced by income tax.)
Another potential disadvantage is that making the required annuity payment may present some difficulties if the GRAT does not have sufficient cash. In that event, the annuity payment might be made by returning a portion of the assets, in kind, to the grantor. That will somewhat undermine the performance of the GRAT, but often the grantor will minimize that problem by contributing the returned business interests to a new GRAT. (This is often referred to as a “rolling GRAT” strategy.)
When might you want to consider using a GRAT, and why?
If you are contemplating a sale of a business in the near future, and you believe the current value of the business is less than it will be when a sale occurs.
If you have already used your lifetime gift exemption of $1 million, or wish to save your exemption for other gifts in the future.
Now is an opportune time to set up a GRAT, because the IRS’ required interest rate is very low (2.8% in June, 2009).
How a GRAT works: An Example
Suppose you have a business that is currently valued at $5 million. You anticipate selling the business in the next few years and believe that with hard work, you can grow the business to $10 million.
You decide to establish a GRAT with a term of four years, and contribute 50% of your interest in the business to your GRAT. A trust for your children is the beneficiary.
A “near zeroed-out” GRAT established in June 2009 with a four year term might look something like this:
Now suppose that the business is sold before the end of the GRAT term for the projected $10 million. The results may be projected as follows:
For a gift of $885, the grantor has transferred from his estate to his beneficiaries over $2.3 million.
The Time is Short
If you think a GRAT is appropriate, the time to act is now, while the value of your business may be lower due to economic conditions and the required interest rates are also low. Furthermore, recent discussions in Congress indicate that some limitations may be placed on GRATs. Specifically, GRATs may be required to have a minimum term of ten years. This will limit the use of GRATs in certain circumstances.
There are other wealth-shifting techniques that can be used in conjunction with the sale of a business. If you contemplate such a sale in the near future, we can help you choose the technique that is best suited to meet your goals.