Grantor-Retained Interest Trusts: GRATs, GRUTs, GRITs, and QPRTs

Grantor-retained interest trusts are trusts that allow the grantor to save on both gift and estate taxes while still benefiting from income during the term of the trust, which is usually limited to 15 years or less. There are 3 different types of grantor-retained interest trusts: grantor-retained annuity trusts (GRATs), grantor-retained unitrusts (GRUTs), grantor-retained income trusts (GRITs). What all of these trusts have in common is that the trust property is given as a gift to beneficiaries who will receive it when the trust ends, but the grantor retains an interest in the trust during the trust's existence. The different types of grantor-retained interest trusts differ in the form of income or benefit that the grantor receives. Generally, these trusts are only useful for people with wealth considerably greater than the federal tax exemption for both gifts and estates, which for 2011-2012, is $5 million.

The way that these trusts work is that the grantor places property in the trust for a set period of time, which would be the term of the trust, the grantor receives either income from the trust or gets some other benefit from the property, such as a home, during the term of the trust. When the term ends, then the property goes to the final beneficiaries.

Grantor-retained trusts are basically gifts of a future interest in the property for the beneficiaries. Because one legal requirement for a gift is that the donor relinquishes all control over the property, the trust must be irrevocable. Hence, once the trust is created, the grantor can serve as trustee, but he can no longer change the terms of the trust nor change the beneficiaries. Furthermore, no more property can be added to it nor can any be taken out.

Grantor-retained trusts save on gift taxes because the value of the gift is considerably less than the value of the property, since the beneficiaries will only receive the property when the trust ends. Therefore, the value of the gift when it is given is only the present value of the same property, without including any appreciation, given at the end of the trust.

The value of the gift is also reduced because the grantor, not the beneficiary, receives the income during the term the trust. The IRS determines what the interest rate is for the term of the trust, along with other factors that determine the value of the gift for tax purposes. However, the value of the gift is only determined when the trust is created. Even if the property appreciates substantially, the appreciation will not be subject to gift tax. However, the beneficiaries will have the same cost basis in the property as that of the grantor and will therefore have to pay capital gains tax on any appreciation when they sell the property. Also, there is no annual exclusion on the gift because the annual exclusion only applies to gifts of present interests, not future interests.

Like all inter vivos gifts, grantor-retained interest trusts save on estate taxes because the gifted property is removed from the estate of the grantor.

Grantor Life Expectancy And the Term of the Trust

There are several drawbacks to grantor-retained trusts, besides losing all legal claims to the trust property. If the grantor lives after the trusts ends, then the grantor will no longer receive the income from the trust, but if the grantor dies before the trust ends, then the trust property will be added to his estate, where it may be subject to estate tax, although the trust property will still go to the trust beneficiaries. Hence, grantor-retained interest trusts only makes sense for a grantor wealthy enough to live without the trust income and who is healthy enough to survive the term of the trust.

Grantor-retained Annuity Trusts (GRATs)

To establish a grantor-retained annuity trust, the grantor transfers money, securities, or other property that earns income over the term of the trust. The trustee, who is usually the grantor, pays the grantor a fixed amount annually, which is why it's called an annuity. IRC 2702. The IRS values the gift according to what the interest rates were when the trust was created, the life expectancy of the donor, and the term of the trust.

Even though it is irrevocable, the GRAT can be created so that the grantor pays tax on both income and any capital gains on property sold during the term of the trust.

Grantor-retained Unitrusts (GRUTs)

The main difference between a grantor-retained unitrust and a GRAT is that the grantor is paid a fixed percentage of the trust's assets, which is determined annually. The main advantage of a GRUT over a GRAT is that the GRUT may potentially keep pace with inflation, since, if the nominal value of the underlying assets increases, so does the amount paid to the grantor. Along with the present value of the gift and the life expectancy of the grantor, the value of the gift is reduced proportionately by the percentage paid to the grantor during the term of the trust.

Grantor-retained Income Trusts (GRITs) and Qualified Personal Residence Trusts (QPRTs)

Before 1990, a grantor could set up a grantor-retained income trust, receive all income from the trust until either the grantor died or the trust ended at the end of its term. However, the law changed, eliminating the tax savings if the assets were given to certain family members, including the spouse, descendents and ancestors, siblings, and spouses of these family members. However, GRITs can be used to save taxes if the beneficiaries are other relatives, such as nieces, nephews, or cousins, or friends. The GRIT can also be used to save taxes on gifts to unmarried partners since they are not legally considered to be family.

There is one exception where GRITs could be used to save taxes for family members: the qualified personal residence trust.

The qualified personal residence trust (QPRT) is funded either with the grantor's home, which must be his primary residence, or a vacation home. Both properties can be put into a qualified personal residence trust, but they must be separate trusts. If the vacation home is rented, then the grantor must occupy the vacation home at least 10% of the time that the property is rented out. So if the property is rented out for 100 days during the year, the grantor must have occupied the property for at least 10 days per year. The grantor-retained interest is the use of the property during the term the trust and the receipt of any rent from the vacation home.

During the term of the trust, the grantor retains full use and benefits of the home, including tax deductions for mortgage payments, insurance, real estate taxes, and any property improvements. The IRS values the gift based on the present value the property and the age of the grantor. However, if the grantor dies before the term of the trust ends, then the trust property will be added back to the grantor's estate and the potential tax savings of the gift will be lost.

There is one advantage of a QPRT that isn't available with the other types of grantor-retained trusts: the trust document can be constructed so that a couple can retain a reversionary interest in the property, so if a spouse dies before the end of the trust, the property can be transferred to the deceased spouse's estate and left for the surviving spouse, tax-free, since there is an unlimited marital deduction for transfers to a spouse.