Zeroed Out Alaska Grantor Retained Annuity Trusts



General Concept. A GRAT is an estate planning tool that can remove from the settlor's estate much of the future appreciation of an asset without any gift or estate tax cost and with little risk. A GRAT is funded with assets expected to substantially appreciate and/or which produce significant cash flow. Unlike some other estate planning tools, a GRAT is specifically permitted by tax law and the Internal Revenue Service has established drafting guidelines.

An Example. You create a GRAT funded with assets such as closely held stock, limited liability company interests, or the appreciating or cash-producing assets. The trust would provide for annual distributions to you for the fixed number of years stated in the trust. These payments are not subject to income tax and would be made with cash generated by the assets, to the extent cash is available, with the excess being made by payments in assets in kind.Hopefully, the assets will appreciate during the term of the trust or produce good cash flow, or both. At the end of the term of years, the remaining assets of the GRAT will be distributed according to your dispositive directions stated in the trust. For example, the remaining assets may be distributed to trusts for your children. These distributions will be free of any gift or estate tax. However, if you die before the end of the GRAT term, the trust property will be included in your gross estate for estate tax purposes. Then, you will not have gained anything from creation of the GRAT, but you will also not have lost anything. Given that interest rates currently are low, now is a particularly good time to use a GRAT.

You will create the GRAT and will serve as its initial trustee. You will decide the appropriate term for the GRAT or might create several GRATs with different term lengths. (The longer the term, the smaller the payments need to be; but, as noted above, you must survive the term for this technique to work.) Assume that the value of the assets you will contribute to the GRAT is approximately $1,000,000. Also assume a GRAT term of five years. During each of the years, the GRAT will make an annual distribution to you, and that amount will increase twenty percent over the prior year's distribution as is permitted by the Internal Revenue Service. This graduated increase each year is advantageous because it allows assets to remain in the GRAT and grow for a longer period of time. As a result, more of the growth of these assets will remain in the GRAT at the end of the GRAT term. If you do not survive for the full five years, the remaining payments would be made to your estate.

The amount of the annual payments is calculated based on a specific federal interest rate. Assume that interest rate is 5.2 percent. Based on this interest rate and the appraised value of the assets, the GRAT would make the following annual distributions to you:

YearAnnuity Payment to Settlor

The Benefits of a GRAT. A GRAT provides a relatively risk free method for transferring the increase in value from growing assets to the settlor’s descendants (or other beneficiaries) without incurring any gift tax.

Zeroed Out GRAT. The GRAT is structured so that the total of the annual annuity payments received by you is equal in value to the value of the assets which you transferred to the GRAT. As a result, no gift occurs when you fund the GRAT. Initially, the IRS contested this result and argued that a certain amount of gift did occur upon funding a GRAT structured as described above. However, in the recent Walton case, a unanimous United States Tax Court rejected the IRS' contentions and held that no such gift occurred. The IRS did not appeal this decision.

The above described type of GRAT is called a “zeroed out GRAT.” That is, no gift occurs when the GRAT is created. Therefore, such a GRAT provides a method for you to transfer certain assets to your beneficiaries without paying any gift tax or using up any of your applicable credit amount. Growth / Cash Flow. The critical factor that makes a GRAT successful is whether the assets transferred to the GRAT can grow and/or produce income faster than the federal interest rate in effect at the time the GRAT is funded.

If the annual growth rate were less than the federal rate, then there would not be enough assets to pay all of the annuity payments. However, there is no penalty for such a situation. The trustee is just unable to make the complete annuity payments, and the GRAT ends.

If, on the other hand, the assets grow faster than the federal rate, then there will be a significant amount of assets left in the GRAT at the end of five years that will pass, gift and estate tax free, to the settlor’s descendants. For example, the following chart illustrates that if the growth rate were nine percent per year, there would be $166,447 left to pass to family members tax free:

YearOpening BalanceAssumed GrowthAnnuityClosing Balance

Using various growth rates, the chart below shows how much would be left in the GRAT after the five year period depending on the annual growth rate.

Growth RateAssets Remaining in Trust
5.2% $-0-
7.0% $75,121
9.0% $166,447

In the event that the settlor were to die within the five year period, then the assets in the GRAT will be included in the settlor's taxable estate for federal estate tax purposes. However, this simply puts the settlor's estate in the same position in which it would have been had the settlor never created the GRAT.

NOTE: In 2010, the Federal Estate Tax does not apply.

Valuation of Contributed Assets. In order to determine the annual annuity payment, we must first determine the value of the assets which the settlor contributes to the GRAT. Often, it will be necessary to obtain an appraisal of such assets. Each year, the trustee will make annual payments to the settlor. If cash or marketable securities exist and are sufficient to fund such payments, then no further appraisals will be necessary. However, if assets in kind are used to make the annual payments, then the fair market value of these assets will first need to be determined. Again, often this will require an appraisal of such assets.

Built in Gift Tax Safeguard. Valuation is a central issue in the estate planning area. With respect to the funding of a GRAT, the IRS may argue that the fair market value of the property contributed was greater than fair market value which was determined and which has been used to determine the annuity payments. In such a situation, the GRAT structure provides a unique benefit. The IRS regulations allow the GRAT payments to be defined in terms of a percentage of the assets initially contributed to the GRAT. If the IRS determines that the initial value of the assets contributed to the GRAT is greater than that which was determined, then the amount of the annuity payments are adjusted. This should avoid the risk of the settlor having to pay any future gift tax with respect to the settlor’s contribution of assets to the GRAT.

Discounted Assets. The contribution of discounted assets to a GRAT may make the GRAT more effective. For example, the settlor may decide to contribute a minority interest in the settlor’s family limited liability company or in an S Corporation. Often, appraisers value such interests on a discounted basis. That is, the valuation of the interest is significantly less than such interest's pro rata share of the total assets of such company. Nevertheless, such a contributed interest is entitled to a pro rata share of the earnings and growth of the company. This may result in the percentage “growth” experienced by the GRAT being significantly greater than that experienced by the entire company.

Planning Short Term GRATs. A short term GRAT, such as a two year term, offers certain advantages. It minimizes the chance that a year or two of poor performance will adversely affect the overall effectiveness of the GRAT. Therefore, one planning approach is to use a series of short term GRATs. The other advantage is that a shorter term reduces the chance that the grantor will die during the term of the GRAT.

Long Term GRATs. A longer term GRAT allows the annuity payments to be less each year when designing a zeroed out GRAT. This may be important if cash flow is limited. Also, a long term GRAT has the advantage of locking in a low interest rate for a longer period of time.

Using Increasing Annuity Amounts. The regulations permit different annuity payments each year as long as the payment in any year does not exceed the payment in the preceding year by more than twenty percent. This allows for lower payments in earlier years and larger payments in later years. This may be advantageous because of limited cash flow in early years and anticipated greater cash flow in later years. Also, this approach keeps more assets and their appreciation in the GRAT.

Single Asset GRATs. Placing only one asset in each GRAT protects against a poor performing asset bringing down the benefits of a better performing asset.

Income Tax Aspects. Under present law, for income tax purposes, the settlor (grantor) is treated as the owner of all of the assets in the GRAT during the annuity term. Therefore, transactions between the settlor and the GRAT are not considered taxable events for purposes of the income tax. As a result, when the settlor funds the GRAT, and when annuity payments are made to the settlor, there are no income tax consequences to either the settlor or to the trust. That is, the settlor does not recognize any capital gain upon funding the trust, nor does the settlor have any interest income when annuity payments are made to the settlor. Further, the trust does not recognize any capital gain when making annuity payments with assets in kind, nor does the trust have interest deductions when it pays interest to the settlor.

When the trust assets produce income, the income is taxed to the settlor. The settlor's payment of the resulting income tax is not considered a gift by the settlor to the trust. This allows the trust to grow free of the burden of income taxes. It also allows the settlor to make additional tax free gifts to the beneficiaries of the trust.

Alaska Asset Protection. In Alaska, if the grantor desires asset protection for the assets in a GRAT, then a spendthrift clause can be added to the GRAT instrument. Under a recent Alaska statutory amendment, the GRAT assets and the future annuity payments cannot be reached by the grantor’s creditors.

If you have any questions about an Alaska GRAT,
you may contact us by using the information set out below:

1029 West Third Avenue, Suite 600
Anchorage, Alaska 99501
(907) 276‐6015
FAX: (907) 278‐6015