How to Give Your Heirs a Bundle Tax-Free

GRATs let you retain ownership while passing on gains

If the only thing standing between your heirs and their inheritance is the hefty gift taxes you'd have to pay upon transferring your wealth, consider establishing a Grantor Retained Annuity Trust (GRAT).

A GRAT is a trust that allows you to retain ownership of an asset while passing most of the gains it earns to your heirs--free of gift and estate taxes. GRATs are especially attractive now. While they have long been used to minimize gift taxes on wealth passed to the next generation, a recent court ruling lets GRATs avoid these onerous taxes altogether. Meanwhile, thanks to today's low interest rates, the assets you put into a GRAT don't have to grow much in order for your heirs to see a payout. Finally, a GRAT can protect you if the recently repealed estate tax returns--or if you don't live to see it phased out in 2010. "For people who have wealth, it's a home run," says Kevin Flatley, an estate planning and taxation expert at FleetBoston Financial.

ABOUT TO JUMP. The first step in setting up a GRAT is to select an asset to put into the trust. Possibilities include anything from shares in public companies to illiquid investments such as real estate, stock options, or privately held stock. Choose an asset with good prospects for appreciation over the trust's lifetime, which typically lasts two to five years.

Here's how it works: Say you put $1 million worth of a stock into a five-year GRAT. Then, every year, you withdraw 20% of your initial deposit--or stock valued at $200,000. When the GRAT expires, you have taken back shares worth whatever the value was on the day you started the trust--thereby leaving you with a gift-tax bill of zero.

But if you take everything back, what's left for your heirs? The idea is that the asset you put in the trust has grown significantly, while you took back only the value of your original deposit. For the most part, the appreciation goes to your heirs free of gift and estate taxes.

There is one caveat: You are also required to withdraw some of the appreciation that your investment earns. How much? The amount is calculated by taking 120% of the federal midterm rate, an interest rate the U.S. government derives from the rates on three- to seven-year bonds. The rate changes monthly. For July, it's a relatively modest 6.2%, which is a good rate to lock in. Thus, if your investment earns more than 6.2%, your heirs receive the excess gains tax-free. Just a year ago, the hurdle was a harder-to-clear 8%.

Let's suppose your $1 million worth of stock grew to $1.25 million at the end of the first year. You take back $200,000 in principal plus $62,000 worth of stock to meet the 6.2% rule. The other $188,000 in appreciation remains in the trust and will eventually go to your heirs, provided the stock maintains its value. The process is repeated every year until the trust expires.

If the GRAT earns less than 6.2% or loses ground, there's no penalty. Aside from the $1,000 to $10,000 it costs to establish the trust (fees depend on the GRAT's complexity), you will be no worse off than if you had not established the GRAT in the first place. The trust will simply pay you back what's left of your investment by the time it expires.

Because a successful GRAT is one that appreciates a lot, it's best to select an asset that you think is on the verge of a rapid runup. "You should expect to move a couple hundred thousand dollars to your heirs to make the strategy compelling," says Beth Rodriguez, a wealth strategist at J.P. Morgan Chase.

As always, candidates for a GRAT include beaten-down stocks that are poised for rebounds. Shares in family limited partnerships and privately held companies are also good prospects. In part because such investments cannot be easily traded, they can often be put into a GRAT at a discount to their true value, says Joanne Johnson, vice-president of the Private Client Group at J.P. Morgan Chase. For example, say an appraiser assigns a 30% discount to $100,000 of stock in a private company that you hold in a family limited partnership. Because GRAT owners generally take back the value of what they put in, you would receive $70,000 worth of stock--or 70% of $100,000--plus 6.2% of the $70,000 investment's annual return. Still, as long as the value of the stock holding doesn't dip below $70,000, the GRAT is likely to pass on some of the value that's locked up in the 30% discount to your heirs tax-free.

If you have more than one asset you want to give to your heirs, it's best to set up a separate GRAT for each one. To see why, take the example of someone who combines two $100,000 investments into a single two-year GRAT. In year one, the GRAT pays its owner half its value, or $100,000, plus 6.2% interest. If investment A soars by 20%, to $120,000, while investment B falls by 20%, to $80,000, the GRAT shows no overall gain. Therefore, nothing goes to the heirs. But with two separate GRATs, the heirs stand to receive a payout as long as one investment earns more than 6.2% a year.

GRATs also offer important tax advantages beyond the chance to avoid gift and estate levies. If properly constructed, they allow you to pay capital-gains and income taxes on the investments in the GRAT on behalf of your heirs. Why is that a good idea? Because the IRS does not consider such tax payments a gift, they are another way to transfer wealth free of gift and estate taxes to the next generation, says Fleet Financial's Flatley.

To see why this is a big deal, imagine that you had the foresight to put $100,000 worth of Microsoft stock into a five-year GRAT in January, 1992. By 1997, after the GRAT reimbursed your $100,000 contribution and paid you the 8.2% interest rate that prevailed in January, 1992, the account would have been worth about $100,000. Your heirs could have cashed in every penny free of gift and estate taxes.

"DEFECTIVE" TRUST. But if they did sell the stock, they would owe a 20% capital-gains tax on the difference between what you paid for it and what they sold it for. That tax would reduce the value of your gift. If, instead of distributing the GRAT's proceeds at the end of its term, you roll them into a so-called defective trust, you can foot your heirs' tax bills. Meanwhile, if your GRAT sells its holdings, you pick up the taxes on that, too.

The major risk you run with a GRAT is that you might die before your trust ends. In that situation, it's as if the GRAT never existed: Its entire value--including returns--is included in your estate and subject to estate tax. "We usually do a GRAT for two to three years and get the appreciation out of an estate," says Al King, director of estate planning at Citigroup. Then you can put the same asset into another GRAT.

Before settling on a GRAT, however, ask yourself whether you can afford to give up much of the earnings potential on your investment. After all, while low interest rates and the opportunity to avoid gift taxes make GRATs more attractive than ever, you don't want to give away something you might need to fund your own retirement.

By Anne Tergesen

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