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Sept 1993

Sophisticated estate planning using GRITS, GRATS, and GRUTS. (Grantor Retained Income Trust; Grantor Retained Annuity Trust; Grantor Retained Unitrust) (High Net Worth: The Accoutrements of Success) (Cover Story)

by Kramer, Eric M.

    Abstract- Individuals can transfer their personal residence, closely held businesses and other income-generating assets to other entities without losing income rights while reducing their future estate taxes by using different trusts. One of these is the Grantor Retained Income Trust (GRIT), an irreversible trust with a termination data that is triggered either through the expiration of a set number of years or the death of the grantor. However, IRS Sec 2702 prohibits usage of GRITs when making transfers to family members. According to its provisions, this kind of transfer is a gift and is therefore subject to gift taxes. IRC Sec 2702(e)(3) provides an exception to this statute. It states that any transfer of a personal residence is not governed by IRC Sec 2702. Moroever, grantors can simply use either the Grantor Retained Annuity Trust and the Grantor Retained Unitrust.

Taxpayers, especially those who pay a great deal of taxes, are always looking for the extra income tax induction to save a dollar here or there. Yet, they often fail to consider the potentially most destructive tax of all--estate taxes.

As the size of the potential estate grows, so does the potential estate tax and the need for sophisticated planning. Sooner or later the "T word" must enter the picture. Three types of trusts in which the grantor retains income rights are especially useful: Grantor Retained Income Trust ("GRIT"), Grantor Retained Annuity Trust ("GRAT"), and Grantor Retained Unitrust ("GRUT"). They usually involve the transfer of the personal residence, closely held business, and other assets which generate income and have substantial value and appreciation potential.

While GRITs have been with us for some time, GRATs and GRUTs are relatively new estate planning devices. Although the Revenue Reconcilation Act of 1990 repealed the "anti-freeze" rules of IRC Sec. 2036(c), new Chapter 14 (IRC Secs. 2701-2704) virtually eliminated the use of GRITs in the family planning situation. However, IRC Sec. 2702 provides exceptions which should be considered when putting together the plan. The basic function of such trusts in estate planning is to transfer assets to those who would have inherited the estate had there been no trusts established, but a lower net transfer tax (gift and estate) cost.

The Grantor Retained Income Trust

A GRIT is an irrevocable trust with termination date which will be triggered at the earlier occurrence of 1) the expiration of a set number of years or 2) the death of the grantor. The purpose is to take advantage of the IRS acturial tables weighted in favor of an income interest. The trick is to choose a period of years that will produce a substantial value for the retained interest but which the grantor is likely to outlive. For the gift tax purposes, he value of the retained interest is subtracted from the value of the assets placed in trust. The difference is subject to tax. For example, if a property owner transfer $1 million in trust and retains the right to receive the income from the property for 10 years, approximately 30%, or $300,000 would be subject to gift tax. If the grantor survives the income-retention period, the principal passes to the remainderman without any further gift or estate tax consequences. If the grantor dies prior to the expiration of the income-retention period, the trust assets will generally period, the trust and be included for estate tax purposes as if the GRIT had never been created.

GRITs became popular in the 80's for several reasons when the IRS tables for computing the income interests changed from 6% to 100%. As a result, the income interest to the extent actual earnings did not equal or exceed 10% was overvalued, and the remainder interest subject to gift tax was undervalued. GRIT popularity also increased because of the increase in the unified credit which allows more property to be transferred without the imposition of a Federal transfer tax. In the example above, although there was a transfer of $1 million, only $300,000 would be subject to gift tax. If the $600,000 Federal exemption equivalent is available, no Federal gift taxes would result.

A Severe But Not Fatal Blow

IRC Sec. 2702 effectively eliminates GRITs involving transfers to family members. IRC Sec. 2702 provides that any transfer in trust to or for the benefit of a member of a transferor's family is a gift, and the value of any retained interest which is not a qualified interest shall be treated as "zero." A "qualified interest" is any annuity interest (GRAT), unitrust (GRUT), and any non-contigent remainder interest if all the other interests in the trust consist of a GRAT or a GRUT. Consequently, the entire value of any assets placed in trust to benefit a family member will be subject to gift tax unless it is a qualified interest. For example, if a parent transfers $1 million in trust for a child and retains the right to receive the income from the property for 10 years, the entire $1 million is subject to a present gift tax. There is no discount for the right to receive the income. However, if the interest is in the form of an annuity or unitrust amount, discounts apply.

Members of the Family

IRC Sec. 2702(e) refers to IRC Sec. 2704(c)(2) which defines the term "member of the family" to mean with respect to any individual, A) such individual's spouse, B) any ancestor or lineal descendent of such individual or such individual's spouse, C) any brother or sister of the individual, and D) any spouse of any individual described in subparagraph B) or C) above.

The following examples illustrate the rule and indicate whether it applies:

1. A parent creates a trust for a child and retains the right to the income for eight years--IRC Sec. 2702 applies.

2. A parent creates a trust for a grandparent and retains a right to the income for 12 years--IRC Sec. 2702 applies.

3. A grandparent creates a trust and retains the right to the income for 15 years, remainder to grandchild--IRC Sec. 2702 applies.

4. A husband creates a trust and retains the income for 15 years, remainder to his second wife's son--IRC Sec. 2702 applies because his second wife's son is a lineal descendant of his spouse.

5. A wife creates a trust retaining the right to the income for 12 years, remainder to her husband's sister--IRC Sec. 2702 does not apply.

6. A parent creates a trust and retains the right to the income for eight years with the remainder to a nephew--IRC Sec. 2702 does not apply.

Where IRC Sec. 2702 does not apply, the old common-law rule governs.

Determining the Value of the Gift

"The value of any retained interest which is a qualified interest shall be determined under IRC Sec. 7520. The rates to use are applicable Federal rates" for determining the present value of an annuity, an interest for life or a term of years, or a remainder or reversionary interest" and are published monthly by the IRS. These rates are then used to determine the amount of the gift. Rather than using IRS Publication 1487, Actuarial Values--Alpha Volume, to manually determine the gift, many practitioners use computer software. For purposes of determining gain, the basis of the property is the same as it would be in the hands of the donor. The same rule applies to determine loss except when the basis is greater than the fair market value at the time of the gift. In that case, the fair market value is used IRC Sec. 1015(a).

The Personal Residence GRIT

A significant exception (the origins of which are unknown) in IRC Sec. 2702(e) (3) provides that a transfer of a personal residence by the grantor will not be subject to the above rules. Although not discussed here, an incomplete transfer would also not be subject to these rules. An example of an incomplete transfer would be a transfer to a revocable trust.

What is a Personal Residence?

Although not defined in IRC Sec. 2702, the final regulations have settled the debate over what is a personal residence. Treas. Reg. Sec. 25.2702-5 (c)(1) defines a personal residence of the grantor (within the meaning of 280A(D)(1), but without regard to 280A(D)(2), or an undivided fractional interest in either. The grantor may create only two house trusts and one must consist of the grantor's principal residence. Each personal residence must be placed in a separate trust.

Since the regulations refer to IRC Secs. 280A and 1034, the definition of a personal residence includes a condominium, a boat (with living arrangements), a mobile home, and a cooperative apartment (see PLRs 9151046, 9249014). When occupied by the grantor, it must not be used for purposes other than a personal residence. The regulations allow the personal residence to be used partially as a home office. For example, if the grantor maintains an office in one room of the residence, and the room meets the requirement of IRC Sec. 280A(C)(1) for the deductibility of expenses related to such use, the residence is a personal residence Treas. Reg. 25.2702-5(d), Example 1.

If the grantor wishes to place a vacation home into trust, the grantor must occupy the residence for the greater of 14 days or 10% of the number of days for such year where the vacation home is rented at fair market value. For example, assume the grantor owns a vacation condominium that is rented for six months during the year but is treated as the grantor's personal residence under IRC Sec. 280A(d)(1) because the grantor occupies it at least 18 days per year (10% x 183) and provides no substantial services in connection with the rental of the condominium. If the grantor transfers the condominium to an irrevocable trust, meeting the requirements of a qualified personal residence trust, and retains the right to use the condominium during his or her lifetime, the trust is a qualified personal residence trust Treas. Reg. 25.2702- 5(d), Example 2.

Although a transfer may be made of a personal residence into trust, the tangible personal property located in that residence may not.

Exhibit 1 provides an example of a parent who transfers a house in trust for the benefit of a family member. The term of the trust as provided in the exhibit could be for one year, or up to ten years. Although there is a no maximum term, the longer the term, the greater the chance of the grantor dying during the term. If the grantor dies during the term interest, the entire amount of the trust reverts back to the estate. In this example, if the trust is established for period of ten years, the gift is only $215,094, even if the property value increases or decreases after the transfer into trust. The IRC Sec. 7520 interest rate in Exhibit 1 is 6.6%. If interest rates rise, GRITs become more attractive. As shown in Exhibit 2, when the interest rate increases to 10%, the value of the gift is $157,135, a decrease of 27%. TABULAR DATA OMITTED

Valuing the Residence Transferred

An appraisal should be obtained to determine the value of personal residence. Any mortage outstanding at the time of transfer into trust should be deducted from the fair market value of the personal residence. Mortage payments made by the grantor will probably be additional gift to the remainderman. However, only the portion that is principal will be considered a gift. Although many practitioners favor the use of the Crummey Power to take advantage of the annual exclusion, no such power is available in this type of trust. Therefore, a gift tax return is due upon the transfer of property into trust and, ignoring any possible annual exclusions, each year the grantor makes payments towards the mortgage. However, the amont subject to gift taxes is not the actual amount paid towards principal. Rather, it is the actuarial amount determined in the same manner as the original transfer. Each portion which is deemed principal will eat into the grantor's unified credit. In circumstances where the grantor can pay off the mortage before a transfer into trust, it is available to do so.

Trust Expires

Generally, if a grantor retained the right to live in the premises rent free after the trust term, pursuant to an express or implied agreement by the parties, the property would remain includable in the grantor's estate under IRC Sec. 203(a) (1) Sec also Rev. Rul. 70-155, 1970-1 C.B. 189. Recently, PLR 9249014 addressed this issue. The grantor wished to transfer his cooperative apartment into a house GRIT while retaining the right to reside there for a term of ten years. At the end of the term, the grantor was to enter into lease agreement with the remaindermen (grantor's two sons), where the grantor would have the right to continue to reside in the cooperative apartment after the trust term ended. The lease agreement provided that the grantor pay a fair market value rent as determined by an appraisal, and would pay real estate taxes, maintenance, utilties, and repairs. With respect to the interest retained by the grantor after the ten year term, PLR 9249014 stated as follows:

"If the grantor survives the 10-year term provided by the Trust, IRC Sec. 203(a) (1) will not apply because the grantor will not have retained an interest in the penthouse for a period nonascertainable without reference to his death or which did not in fact end before his death. However, this ruling is conditioned upon our uderstanding that the amounts the grantor will pay as rent to his sons after the termination of the Trust will in fact be equal to fair market value rent, taking into account the terms of the lease. Otherwise, Rev. Rul. 70-155 may be applicable.

This PLR clarified several other outstanding issues:

* Since the grantor was entitled to receive all trust income, the grantor will be treated as the owner of the income portion of the trust. Under IRC Sec. 671, the grantor will be entitled to any allowable deductions for mortage interest, taxes and other deductions applicable to the personal residence during the trust term and allocable to the income portion of the trust. The grantor will be entitled to those deductions whether the grantor makes the payments directly or the trust makes the payments. After the trust term ends, the grantor's sons will be entitled to those deductions.

* If all expenses paid by the grantor during the term of the trust are in fact properly payable by him as a life tenant, the payment of those expenses will not constitute rental income to the grantor's sons.

* Although the grantor was not able to transfer legal title to the shares and proprietary lease because the apartment building disapproved his request to do so, the grantor's assignment of his shares and rights under the proprietary lease and holding such shares and rights as "nominee" for the trust represented a completed gift.

Exchanging Assets with the Trust

In Rev. Rul. 85-13, 1985-1 C.B. 184, a grantor created an irrevocable trust and later proposed to transfer a promissory note to the trust in exchange for the trust corpus. The revenue ruling held that the grantor was considered to be an owner of the trust property for income tax purposes. As a result, the revenue ruling clarified several significant issues:

* A transfer between a grantor and grantor trust will not be considered a sale for tax purposes.

* The transfer will not cause inclusion of the trust in the grantor's estate for estate tax purposes.

This ruling was restated recently in PLR 9239015 with respect to a GRAT, and referred to Rev. Rul. 85-13 to confirm its holding.

This presents significant opportunities with respect to a house GRIT, as well as GRATs and GRUTs. For example, a grantor transfers a personal residence into trust and retains the right to live there for a term of 10 years. Assume that at the end of the term the house is distributed to the grantor's cchildren and the cost basis of the residence is $50,000. If at the expiration of the term, the children sell the residence for $500,000, the result is a taxable gain of $450,000.

Alternatively, the grantor transfers $500,000 into the trust in exchange for the residence and before the expiration of the term. As a result--If

* the grantor subsequently dies with the residence in his estate there is a step-up in basis to fair market value.

* If the rsidence is sold at date of death value, there is no taxable gain, and

* The trust property is not included in the grantor's estate for estate tax purposes if the grantor survuves the term of the trust.

Adding Assets to the Trust

The trust indenture may permit additions of cash to the trust in a separate account so long as this amount does not exceed the paymentof trust expenses and improvements to the residence for a six-month period. If the trust purchases a new residence, the grantor may contribute money to the trust to be held for no more than three months, provided the trustee previously enterred into a contract to purchase the residence. If the residence is later sold, the proceeds must be held in a separate account and either used to purchase a new residence within two years fro mthe date of sale or returned to the grantor.

The trustee will be liable for any negligence. Therefore, the trustee should continue insurance coverage on the residence in the event of destruction or damage. If the proceeds from sale, damage or destruction are not rolled over into a new residence, the trust will cease to qualify as a qualified personal residence trust. In the event the personal residence is damaged or destroyed, the proceeds of insurance may be paid to the trust and held by the trustee for two years provided the truste2e intends to use the insurance proceeds to repair, improve, or replace the personal residence. The trust must provide that cash held in excess of the amount stated above must be distributed, at least quarterly, to the grantor. In addition, the trust must also provide that, upon the termination of the grantor's interest, any cash in the trust held for the payment of expenses must be distributed to the grantor Treas. Reg. Sec. 25.2702-5(e).

The End of the Trust Term

The trust may provide that the residence continues in further trust for the spouse. Assuming the property was originally held in the grantor's name, no problems should arise. If the property was in joint name and transferred to the grantor and then into trust, the IRS could argue under IRC Sec. 2036 that the grantor's spouse transferred the property to the grantor and retained a lifetime interest after the team of the trust. If the residence was originally owned by the grantor, the grantor's spouse should be able to remain in the residence for the rest of his or her life. A spouse may also allow the grantor to remain there as the spouse's guest. This should not cause inclusion in the grantor's estate Gutschiss v. Commissioner, 46 T.C. 554 (1966).

Property Held Jointly Between Husband and Wife

Although there are no real cases on point, a suggestion would be to transfer the property as tennants by the entirety to tenants-in-common. Each spouse could then create his or her own qualified personal residence trust. After the term of the trust, the property may either remain in further trust for the children or distributed to them outright, but should not continue in trust for the other spouse for the reasons described about with respect to IRC Sec. 2036. To avoid my generation skipping transfer tax consequences, the property should be transferred to the surviving children. If they are all predecease the grantor, the trust balance should be distributed to the estate of the survivor of them. This will avoid any generation skipping transfer tax problems.


A transfer to a trust while retaining a qualified interest (GRAT or GRUT) will also avoid the harsh gift tax valuation rules of IRC Sec. 2702.

In a GRAT, the grantor transfers property to an irrevocable trust in return for the right to receive fixed payments on at least an annual basis based upon the initial fair market value of property. Although the assets may increase in value during the term of the trust, the fixed amount will not change. For example, if a grantor transfers $1 million in trust and retains the right to receive 15% of the initial fair market value of the property for ten years, the grantor must receive $150,000 each year during such period.

In contrast, GRUT provides that the grantor is to receive a fixed percentage of the fair market value of the property in the trust which is revalued each year. Therefore, as the trust property increases or decreases in value, the amount returned to the grantor each year will fluctuate. For example, if a grantor transfers $1 million into trust and retains a 15% interest for ten years, then in year one, the grantor must receive $150,000. If the assets increase in value to $1.2 million in year two, the grantor must receive $180,000. In year three, if the trust decreases to $900,000, the grantor must receive $135,000.

In some circumstances, it may be advantageous to take a lower amount in the early years with the anticipation there will be a substantial increase in income on the back end. The regulations provide that the stated dollar amount or fixed fraction may increase 20% each year over the amount payable in the preceding year Treas. Reg. Sec. 25.2702-3(b) (1) (ii).

Income in Excess of the Annuity

An annuity interest or unitrust interest does not fail to be a qualified annuity interest merely because the trust permits income to be paid in excess of the contractual amount. However, the right to receive this excess income is not a qualified interest and is not taken into account in valuing the qualified annuity interest Treas. Reg. Sec. 25.2702-3.

There are certain requirements which are applicable to both GRATs and GRUTs under Treas. Reg. Sec. 25.2702-3(d) as follows: 1. To qualify as a GRAT or a GRUT, the interest retained by the grantor may not equal the lesser of a fixed amount of the initial trust assets or a fixed percentage of the annual value of the trust assets. However, the trust may provide that the payment may equal the greater of a stated dollar amount or fixed percentage of the initial trust assets or a fixed percentage of the annual value of the trust assets.

2. Distributions may only be made from the trust to the holder of a qualified interest.

3. The governing instrument must fix the term of the GRAT or GRUT. The term must be for the life of the term holder or a specified term of years, or for the shorter (but not the longer) of those two periods. Successor term interests for the benefit of the same individual are treated as the same term interest.

4. The trust must prohibit the use of a communication power.

5. In a GRAT, no additional contributions may be made to the trust. A GRUT may permit additional contributions since the trust assets are revalued each year.

The GRAT and GRUT at Work

Initially, assets are transferred into trust and the grantor retains a fixed amount for a certain number of years. The valuation of the gift is determined based upon the remainder value of the property transferred into trust. Since the trust now owns the property, the trustee must make payments according to the trust identure.

Payments may be made monthly, quarterly, semi-annually, or annually. The manner of payment will determine the amount of the gift. As the payments are due, the trustee will distribute the amount to the grantor until the end of the retained period. If the income is in excess of the retained amount, the trust could provide that the difference be distributed to the grantor. However, this would only increase the grantor's estate and serve no useful purpose.

Should You Transfer More Than One Asset into a GRAT? Although administrative costs would be less, it is probably a better idea to have a separate trust for each asset. All assets do not perform in the same manner and those that perform poorly will require some or maybe all the principal be returned. However the annual amounts well and exceed the annual amounts paid to the grantor, will increase the amount received by the beneficiaries, tax free.

Can a GRAT or GRUT be a Permissible Subchapter S Shareholder? Generally, to avoid termination of S corporation status, the shares of stock must be transferred to a qualified subchapter S trust IRC Sec. 1361(d). However, the grantor may transfer stock to a grantor trust and continue as an S corporation. In PLR 9152034, a trust was considered a grantor trust because the reversionary interest exceeded 5% of the trust's value. There are several other powers which will qualify the trust as a grantor trust IRC Secs. 671-678. In particular, the power to substitute assets of equivalent value will qualify the trust as a grantor trust see Rev. Rul. 85-13 and PLR 9239015.

What Happens at the Expiration of the Grantorhs Retained Term? Several options are availeble.

* An outright disposition could be made to the intended beneficiaries.

* The trust could continue in further trust either for a surviving spouse and/or children. Although not adviseable, the grantor may be able to retain the power to invade principal subject to the ascertainable standard under IRC Sec. 2041.

Can the Grantor be a Trustee? At first this might seem improper. In PLR 9239015, however, the grantor was sole trustee of a GRAT. Although the PLR did not discuss the estate tax consequences, if this was improper, the IRS probably would have objected in the PLR. However, should the grantor ever become a trustee, no discretionary powers should be given to the grantor. Otherwise, this could cause inclusion in the estate at death.

What Happens if the Grantor Dies During the Term of the Trust? Although there is no definite authority with respect to GRATs and GRUTs, there is an analogy to the charitable remainder trust area. A review of Rev. Rul. 82-105 and Rev. Rul 76-273 for GRATs and GRUTs, respectively, should be made to determine the amount includable at death.

Can a GRAT Be Zeroed Out? In other word, can properly be transferred to a trust with no gift tax consequences? Although the position of the IRS is essentially no, the trust could be structured to have to negligible gift. However, if the valuation of the gift is zero, the IRS will apply Rev. Rul. 77-454. The IRS reasons that a trust cannot be reduced to zero because there is always the possibility the grantor may die prior to the expiration of the term of the trust. An an example, in PLR 9239015, the grantor proposed to transfer stock to a GRAT. The terms of the trust indenture met all the requirements of IRC Sec. 2702 and the regulations thereunder. The trust was created on June 29, 1992, when the section 7520 rate in effect was 8.4%. The term of the GRAT was for two years. The grantor retained the power, in a non-fiduciary capacity, to reqcquire trust corpus by substituting other property of equivalent value. The trust properly provided for the first payment to be prorated and paid on December 31, 1992, the first taxable year, and for additional payments on December 31, 1993, and June 29, 1994.

The ruling held--

1. The grantor is treated as the owner of the entire trust for income tax purposes Secs. 671 and 675;

2. Neither the grantor nor the trust will recognize any gain or loss as a result of the grantor's transfer of stock to the trust, the trust transfer of stock to the grantor in satisfaction of annuity payments due the grantor under the terms of the trust, or the grantor's exchange of cash or other property for stock held by the trust; and

3. Based on life table 80GNSMT with interest at 8.4% per annum, the present worth of the right of a person age 54, if living, to receive the payments is equal to 99.171% of the amount transferred. Therefore, since there will be adequate funds based on the present value computation, Rev. Rul. 77-454 will not apply.

Based upon the IRC Sec. 7520 rate in effect then, a gift on only .829% will result.

Final Thoughts on Grantor Trusts in Estate Planning

GRITs and their derivitives, GRATs and GRUTs, are but three possible devices to use in the sophisticated estate plan. The estate tax rate is the highest of all taxes and becomes payable in full upon death; there is no avaraging convention. Taxpayers with high-net-worths whould have a carefully developed estate plan built upon a recently updated will. Tax, financial planning, and/or estate planning professionals are a must when a sophisticated estate plan is contemplated.

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