Usually, when a taxpayer transfers assets to an irrevocable trust for the benefit of another person, the transferor pays gift tax on the full value of the property transferred to the trust. However, in some cases, the value of an interest in the trust that is retained by the transferor (the "grantor") may be subtracted from the value of the property transferred to the trust in determining the amount of taxable gift made upon creation of the trust. That is, the gift tax is imposed on the value of the partial interest transferred and not on the value of the partial interest retained.
Under the general rule of Section 2702 of the Internal Revenue Code, the value of an income interest retained by a grantor (the person creating the trust) is zero when the remainder interest in the property is transferred to or acquired by a member of the transferor's family. Where the section's general rule applies, it causes the entire value of the property, a partial interest in which is transferred to or acquired by another family member (reduced only by what such other family members pays for the interest), to be subject to immediate gift taxation because it values what the grantor retains at zero.
The above rule of Code Sec. 2702 does not apply to a trust from which the grantor retains an annuity stream (a so-called "grantor retained annuity trust" or "GRAT") that falls within the statutory special rule for such interests.
In order to create a GRAT, an individual transfers cash or other property to an irrevocable trust (the GRAT), and retains the right to receive an annuity from the GRAT for a term of years, with the GRAT property thereafter passing to (or continuing in trust for) others, such as the individual's children.
When a GRAT is created, the individual is deemed to have made a gift to the other persons (e.g., the individual's children) who have an interest in it. The value of that gift is determined by subtracting the value of the individual's retained annuity from the value of the property transferred to the GRAT. Therefore, if the value of the individual's retained annuity represents a relatively large part of the total value of the property transferred to the GRAT, the amount of the gift to the other beneficiaries will be relatively small. Code Sec. 2702(b) provides that the annuity stream retained by a grantor in a trust will have its value calculated for gift tax purposes under the rate determined under Code Sec. 7520.
If the individual dies during the retained annuity term, it is the position of the Internal Revenue Service that all or a portion of the GRAT property will be included in the individual's estate. However, if the grantor survives the annuity term, the property should pass to or for the benefit of the other trust beneficiaries (e.g., the individual's children) without payment of any additional gift tax or estate tax.
The amount of the gift deemed made upon creation of a GRAT is calculated, as stated above, by subtracting the value of the individual's retained annuity interest from the value of the property transferred to the GRAT. Generally speaking, the value of the retained annuity interest usually will depend on (1) the value of the property transferred to the GRAT, (2) the Code Sec. 7520 rate for the month in which the property is transferred to the GRAT, (3) the amount of each annuity payment to be made, and (4) the period of time for which the annuity is to be paid.
A taxpayer may structure a GRAT so the value of the remainder, and therefore the amount of the taxable gift the taxpayer will have made by transferring property to the GRAT, is very small.
The gift made in a GRAT is a gift of a future interest and, therefore, cannot be protected from tax by the so-called gift tax annual exclusion. However, the gift in the GRAT will be protected from gift tax to the extent of any remaining gift tax exemption. Even if no exemption remains, the gift tax payable upon creation of a GRAT may not be regarded as significant if the GRAT is structured so that the amount of the gift is small.
As a general rule, the use of a GRAT will be effective only if: (1) the grantor of the trust lives beyond the term for which he or she has retained the right to receive annuity payments from the GRAT; and (2) the GRAT earns more than the applicable Code Sec. 7520 rate during the retained term. Interest rates are at historic lows with the Section 7520 rate for December 2020 at 0.6%. The efficacy of GRATs is enhanced when interest rates are low.