Grantor trusts take many forms; here we explore the similarities and differences between GRATs and IDGTs, including tax and estate planning implications.
This article was originally published on June 25, 2015. It was updated to use 2016 tax rates in the GRAT and IDGT examples.
If you are thinking about transferring assets to your children and/or grandchildren, you may want to consider using either a grantor retained annuity trust (GRAT) or an intentionally defective grantor trust (IDGT). Both of these estate planning tools can be used to “freeze” the value of the assets you transfer, while allowing you to retain a cash flow stream for a period of time. There are similarities between the two vehicles, but there are also significant differences. First, let’s look at the basics of each.
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What is a GRAT?
A GRAT is an irrevocable trust that allows you, as the grantor, to transfer assets to the trust and retain the right to receive a fixed annuity payment for a term of years. Payments can be equal each year or they can increase up to 120 percent annually. Once it is established, you cannot contribute any additional property to the GRAT. At the end of the term, the remaining trust assets are distributed to your beneficiaries.
GRAT tax implications
For gift tax purposes, your asset transfers are treated as making a gift of the present value of the remainder interest in the property. It is also possible to “zero out” the gift value so there is no taxable gift. An interest rate formula (determined by Internal Revenue Code (IRC) Section 7520) is used to calculate the value of the remainder interest. If the income and appreciation of the trust assets exceed the Section 7520 rate, assets remain at the end of the term to pass to your beneficiaries. With the current low rates (1.8 percent for June 2016), GRATs can be very effective for transferring wealth to the next generation with little or no gift tax consequences.
A GRAT example
Sally would like to make a gift of $1 million to a GRAT in June 2016. She has made large taxable gifts in the past so she would like to minimize the value of the remainder interest. She would also like to retain an annuity for seven years. In order to zero out the value of the gift, Sally would need to receive an annuity payment of $153,327 each year. Assuming the assets earn 3 percent income annually and grow at a rate of 5 percent, the trust will have assets of $350,920 at the end of the seven-year term. The leftover assets would pass to Sally’s beneficiaries.
If you pass away during the term of the GRAT, its entire value can be included in your estate. If any gift tax exclusion was used upon funding the trust (i.e., the GRAT wasn’t zeroed out), the exclusion is restored so the trust’s assets aren’t counted twice. As a result, you may not be in any worse position for having established the GRAT. To minimize the risk of assets being included in the estate, shorter GRAT terms are generally selected for older individuals.
Since a GRAT is a grantor trust for income tax purposes, you will report the trust's taxable income and deductions on your personal income tax return as if you still owned the trust assets directly. A grantor trust is disregarded for income tax purposes and will not pay taxes.
After the GRAT term, if the trust continues for the beneficiaries, it may or may not be labeled a grantor trust depending on the original terms. Structuring it as a grantor trust can be advantageous because it allows assets to grow without the burden of income taxes.
What is an IDGT?
An IDGT is also an irrevocable trust that is “defective” for income tax purposes (i.e., a grantor trust) but effective for estate tax purposes. As the grantor, you would make a gift of either cash or assets to the trust; those assets are held for the benefit of your beneficiaries.
IDGT tax implications
Under the terms of the trust agreement, you (or possibly a third party) retain certain powers that cause the trust to be treated as a grantor trust for income tax purposes. These powers do not cause the trust assets to be includible in your estate.
Depending on the agreement, you might retain the power to swap trust assets with other assets of equivalent value. In some cases, the grantor is able to borrow from the trust without adequate interest or security (but not both). You would be treated as the owner of the trust for income tax purposes.
Why a grantor trust?
Why is it so important that the trust be a grantor trust? Because transactions between a grantor and his or her trust are ignored for income tax purposes. As a result, you can sell assets to your grantor trust without recognizing a gain on the sale.
At some point after you have made a gift to the trust, you can sell appreciated assets to the trust in exchange for a promissory note. As a general rule, the sale should be no more than nine times the amount of the gift and the terms of the promissory note can be flexible. The note can call for interest-only payments for a period of time and a balloon payment at the end, or it may require interest and principal payments. Interest is generally charged at the applicable federal rate (AFR) based on the length of the note (the July 2016 mid-term AFR is 1.43 percent for loans of three to nine years). Since this is a grantor trust (as are spousal access trusts, GRATs, and most irrevocable life insurance trusts [ILITs]), the interest income on the note between yourself and the trust is not recognized.
If the income and growth of the trust assets exceed the interest rate on the note, the excess is passed on to the beneficiaries free of any gift tax.
For estate tax purposes, the trust assets are not part of the grantor’s estate, but if the note has an outstanding balance it is a part of the estate.
How to determine the best trust for you
Several factors come into play when deciding which type of trust makes the most sense for you.
Benefits of GRATs
First, it is possible to zero out a gift to a GRAT but not an IDGT. In addition, a new IDGT requires some taxable gift. So if you’ve used most or all of your gift tax exclusion, a GRAT may be a better option.
Another GRAT benefit is related to valuation risk of the IRS asserting a different value for the contributed asset. If the transferred asset is closely held stock, partnership, or limited liability company interests where there is valuation risk, a GRAT will self-adjust when there is a change in the valuation. The annuity payment would simply adjust to account for the change. With a gift and sale to an IDGT, if there is a valuation adjustment, the difference would generally be treated as an additional gift to the trust. If you used most of your exclusion on the gift to the trust, gift tax may be due.
Another consideration is that GRATs are specifically addressed in the IRC. Unfortunately, IDGT transactions are not and the IRS has not ruled on the gift/sale technique. There are also unresolved income tax questions regarding sales to an IDGT if the grantor dies while the note is still outstanding. Therefore, a GRAT may be a safer choice.
Benefits of IDGTs
First, if the asset transferred is an interest in a closely held business, a GRAT may be more difficult to administer. If the cash flow from the entity isn’t sufficient to make the required annuity payments, a portion of the business interest must be distributed back to the grantor (which requires an updated valuation) or the GRAT must borrow the funds from a third party. A GRAT cannot issue a note payable to the grantor.
On the other hand, an IDGT can provide for much more cash flow flexibility. The note can be structured for a long period, or it could provide for interest-only payments. When business interests will be transferred, flexibility in making payments back to the grantor gives an IDGT the upper hand.
Also, if the IDGT’s note to the grantor is structured as short-term (fewer than three years) or mid-term (fewer than nine years), the interest rate will be lower than that of a GRAT. This means more of the trust’s appreciation will pass on to the beneficiaries of an IDGT than a GRAT.
Estate tax consequences
There are estate tax consequences if the grantor dies before the end of a GRAT’s term or before the IDGT note is paid off. As discussed previously, all of a GRAT’s assets may be included in the grantor’s estate if he or she dies during the term of the contract. Conversely, only the outstanding note balance from the IDGT is included if the grantor dies before the note is paid.
Generation-skipping tax
A final factor to consider is your interest in benefiting multiple generations. Due to the structure of a GRAT, the generation-skipping transfer (GST) tax exemption cannot be allocated until the end of the GRAT term. The GST exemption should be allocated so distributions to grandchildren and more remote descendants don’t incur a tax. Since the exemption cannot be allocated until the end, it is not possible to know how much will be needed, and the value of the trust could exceed the available exemption.
It is possible to allocate GST exemption to the initial gift to an IDGT. Therefore, an IDGT is a much better vehicle for transferring assets to children and grandchildren.
How we can help
Consult with your trust professional, tax practitioner, and/or wealth advisor to answer all of the relevant financial and nonfinancial questions for your particular situation. Have an estate-planning attorney draft your trust document to ensure it includes all the necessary provisions to accomplish your goals to connect your estate and financial plans.