Grantor-Retained Interest Trusts: GRATs, GRUTs, GRITs, and QPRTs
Grantor-retained interest trusts are irrevocable trusts that allow the grantor to save on both gift and estate taxes while still benefiting from trust income during the term of the trust, which can be a term of years or for the life of the grantor. Grantor retained interest trusts will only save on gift taxes if they satisfy the requirements of IRC §2702.
A grantor-retained interest trust is a trust where the grantor transfers assets to an irrevocable trust and receives the income earned by the trust annually or is permitted to live in a residence, depending on the type of trust, for the term of the trust. Upon trust termination, the beneficiaries receive the remainder of the trust assets. This saves on gift or estate taxes by removing the property from the grantor’s estate, if the grantor does not die before the end of the trust; otherwise, the property will be includable in the grantor’s estate, thereby negating the main advantage of a grantor-retained interest trust. It also removes any appreciation of the property from the grantor’s estate. However, because it is a gift and not a bequest, it does not receive a stepped-up basis when the grantor dies unless it is includable in the grantor’s estate. A gift tax return must be filed for the year in which the trust is created. However, to prevent abuse and to value the gift for gift tax purposes, there are specific rules that must be followed to gain the tax advantages.
When property is transferred to a trust for the benefit of the donor's family, IRC §2702 limits the value of all retained interest in the trust that are not qualified interests to 0. Hence, the value of the gift = the total value of the property; no credit is given for any retained value, so there is no savings in gift tax. Otherwise, the value of qualified interests is determined under IRC §7520. In other words, the value of a retained qualified interest = the present value of the gift as determined by IRS interest rate tables.
IRC §2702 and §2704(c)(2) defines the donor's family as the spouse, any ancestor or lineal descendent of the individual or the individual spouse, and any sibling or their spouses.
However, §2702 does not apply to:
- incomplete gifts
- charitable remainder annuity trusts and pooled income funds
- charitable lead trusts
- certain charitable remainder unitrusts
- personal residence trusts.
There are 3 different types of grantor-retained interest trusts that are qualified interests: grantor-retained annuity trusts (GRATs), grantor-retained unitrusts (GRUTs), grantor-retained income trusts (GRITs). A qualified interest includes a qualified annuity interest; qualified unitrust interest; or a qualified remainder interest. The present values of these qualified interests are valued at 120% of the applicable federal midterm interest rate in the month in which the value was determined. Qualified annuity interests are an irrevocable right to receive a fixed sum (annuity interest) at least annually or a fixed percentage of the trust value (unitrust interest), determined annually. Excess income can be distributed to the donor but does not change the value of the retained interest, and therefore, does not save on gift tax. Withdrawal rights or the issuance of notes or any other type of debt does not count as a payment. Payments must be made before the filing date of the trust income tax return without regard to extensions. The amount paid cannot exceed 120% of the amount or percentage from the preceding year. A qualified remainder interest is the noncontingent right to receive all or some share of the trust property on termination of all or some share of the trust.
The trust interest must be qualified so that the present value of the gift can be determined. For instance, if the trust allowed the grantor to withdraw any amount of money at any time, then there would be no way to determine the present value of the gift. Since a gift tax return must be filed in the year the trust is created, there would be no way to report the value of the gift, unless the trust distributions are fixed or the remainder interest is determinable. This is also why assets cannot be transferred to the trust after it is created.
What all 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 is now more than $5 million.
The way these trusts work is that the grantor places property in the trust for a set duration, 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. There is no step up in basis, since the property is not transferred by an estate, but by a living person: the grantor. However, the basis will be increased for the donee by any gift tax paid.
Grantor-retained trusts are 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 of the trust, which is the retained interest. 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.
Although these trusts can pay distributions exceeding the annuity or unitrust amounts to the grantor, the value of the gift of the remainder interest is not reduced by the excessive payment, so there is no reduction in gift taxes.
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, including any appreciation, 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 likely 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. Although the payment from a GRAT is fixed, it does not have to be the same every year. The only limit is that the annuity paid does not exceed 120% of the amount paid in the prior year.
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. Tax law changes have eliminated this tax savings if the assets were given to certain family members, including the spouse, descendants 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 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 irrevocable 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 or 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 property's present value and the grantor's age. Hence, the QPRT resembles the other grantor-retained trusts, where the residence serves as the principal and the use of the home serves as income. The present value of the gift, calculated by using interest rates published by the IRS, reduces the value of the gift for gift or estate tax purposes. Additionally, any appreciation in the value of the residence over the term of the trust is not taxed.
Example: you leave your $1 million house to your daughter through a QPRT over a 10-year period. Through calculations based on IRS interest rates, the present value of your gift is determined to be $700,000. Therefore, only $700,000 will be subject to either a gift or estate tax, which may be offset by the unified tax credit, depending on the value of your total gifts or estate property. If your home appreciates to $1.5 million by the end of the trust term, then the $500,000 of appreciation is not counted either as a gift or as part of the estate, since the trust owns it. If you choose to continue living in the house after the 10 years, then you can pay rent to your daughter, which will further reduce the value of your estate.
However, if the grantor dies before 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.