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How to Do a Grantor Retained Annuity Trust

Original post by Leslie McClintock of Demand Media

A grantor retained annuity trust (GRAT) is a trust that is designed to shield assets from creditors, while allowing a tax efficient way to transfer wealth from one generation to another. The plan works if actual returns in the trust exceed those assumed by the IRS for the purpose of calculating capital gains tax.

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Authorization

While the IRS has designated some kinds of tax avoidance trust techniques as abusive, the GRAT is specifically authorized by Congress in the tax code. Any attorneys drafting GRAT trust documents should be familiar with Internal Revenue Code Section 2702(a)(2)(B) and 2702(b).

Plan Documents

Because the drafting of trust documents is considered the practice of law, you must use a licensed attorney to draw up the plan documents. However, unless the attorney specializes in tax law, you may want to have the attorney work in close cooperation with a tax professional. The documents must name a family member as a beneficiary. However, in a GRAT, the grantor, which is the party that creates the trust and transfers assets into it, retains the right to receive an income from the trust for a specific period of time.

Gift Taxation and GRATs

When the grantor transfers assets into a GRAT, the IRS assesses a gift tax on the amount of the transfer, plus an assumed interest rate on the principal held within the trust. In the case of a GRAT, the trust will transfer income back to the grantor for a specific period of time in the form of an annuity. The IRS subtracts these payments, plus interest, from its assumed value calculation, and assigns a gift-tax liability at that time.

GRAT Income Planning

The fact that the IRS assesses a gift tax liability on GRAT transfers based on a conservative interest rate assumption creates a gift tax planning opportunity. The grantor has an attorney design the trust to provide an income schedule sufficient enough to empty the trust, if the trust's assets earn the returns assumed by the IRS. This causes the IRS to assume that the gift tax value of the trust is zero. By investing the GRAT's corpus, or property, in riskier assets, however, the grantor might be able to realize greater returns than the IRS anticipates. If this happens, the trust will have assets still within it at the end of the income period. The remainder of the trust is then transferred to the beneficiaries, with no gift tax due.


                   

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About the Author

Leslie McClintock has been writing professionally since 2001. She has been published in "Wealth and Retirement Planner," "Senior Market Advisor," "The Annuity Selling Guide," and many other outlets. A licensed life and health insurance agent, McClintock holds a B.A. from the University of Southern California.


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