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INTRODUCTION
In the grantor retained annuity trust ("GRAT") the grantor transfers assets--perhaps, real estate or securities--to a trust, retaining a right to distributions of a fixed amount for a described term, after which the trust property goes to the donee-remaindermen or, alternatively, continues in trust for their sole benefit. The amount of taxable gift on the transfer is determined under the subtraction method, as described in IRS regulations,(1) but, where the donees are members of the grantor's family,(2) subject to the special rule in sec 2702 limiting the subtraction for the retained interest to a qualified retained annuity. Any other retained interest--with exceptions not relevant here--are valued at zero.(3)
DETERMINING WHEN THE GRAT MAKES SENSE
Whether the GRAT is effective as an estate planning strategy, when compared with other means of transferring property, depends almost exclusively on the rate of return realized by the trust on its investments: does it exceed the discount rate utilized in sec 7520 in valuing the annuity (the "sec 7520 rate"), adjusted for mortality where required?
The way this works might best be explained through the use of certain imagery suggested by Prof. Mitchell Gans in his article relating to sec 2702.(4) He proposes that you view the trustee of the GRAT as having established two pots of money at the time the trust is funded. One contains an amount equal to the taxable gift on the transfer to the trust--the "remainderman pot." The other contains the balance of the contributed funds--the "annuity pot."
Assuming an annuity for a term certain, if the trust investments yield a rate of return exactly equal to the sec 7520 rate used in valuing the retained annuity, then the annuity pot, augmented by that return, would be exactly sufficient to service the annuity obligation to the grantor, leaving neither a surplus nor a deficiency at the end of the annuity term. The remainder pot, consisting of the original contribution to it plus the return during the annuity term, would be distributed in its entirety to the remaindermen. Thus, the result would be identical to that which obtains had an amount equal to the taxable gift been given directly to the remaindermen.
If, however, the rate of return realized by the trust is greater...