February 21, 2014
Authored by: Curtis Tiffany and Doug Stanley
The use by the founders of Facebook and Twitter of grantor retained annuity trusts (“GRATs”) to reduce estate taxes has been widely publicized. What many founders and entrepreneurs may not realize, however, is that the same techniques may be appropriate for companies with more modest growth potential and that considering the use of a GRAT at an early stage may be advantageous. GRATs have been discussed previously on the blog here.
In essence, a GRAT is a method to “freeze” the value of an asset at a particular point in time so that the future appreciation of that asset’s value escapes estate tax. A grantor contributes assets to a GRAT in exchange for the right to receive fixed annual payments from the GRAT for a number of years (not for life). The amount of each annual payment includes a return of a portion of the principal amount contributed plus an amount of interest (at a minimum rate required by the Internal Revenue Service). If the sum of the annual payments from the GRAT equal the original principal (valued at the time of the transfer to the GRAT) plus the aforementioned minimum interest, the GRAT is referred to as a “Zeroed Out” GRAT and there is no gift made when the asset is transferred to the GRAT. After the final annual payment is made to the grantor, all assets remaining in the GRAT are transferable to the beneficiaries of the GRAT (children, not grandchildren) without the payment of gift taxes and are not considered part of the grantor’s taxable estate (if he or she survives the term of the GRAT).
The benefit of a GRAT is realized when the assets contributed to the GRAT appreciate at a rate greater than the minimum interest rate and the grantor survives the term. The transfer to the GRAT is essentially risk free from a gift and estate tax perspective even if the value of the assets inside the GRAT does not appreciate at a rate that exceeds the minimum interest rate.
Because the minimum interest rate is fixed at the time of the transfer to the GRAT, a low interest environment makes it easier to benefit from a GRAT. In addition, because emerging companies have the potential to rapidly appreciate in value, equity interests in such companies (perhaps non-voting interests) may be suitable for contribution to a GRAT. For these reasons, forming a GRAT at an early stage of an emerging company’s existence may be an appropriate business and estate planning technique, especially in a low interest rate environment. While the benefits of GRATs may justify their use in certain circumstances, there are additional costs, including those to form the GRAT and (in the case where the assets contributed to a GRAT consist of illiquid assets, such as equity in a private company) for initial valuation to determine the appropriate annual payment.
In a low interest rate environment a GRAT can be an effective business and estate planning tool, particularly for founders or investors in emerging companies. Because of the technical nature of the rules applying to GRATs and the costs involved, it is important to discuss the suitability of a GRAT for your particular needs and circumstances with a qualified attorney.