A GRAT is a trust into which property is transferred and which provides for the payment of a fixed sum of money from the trust at least annually to the grantor, who created and funded the trust. The trust further provides that at the end of the term of the trust the principal is to be distributed to beneficiaries other than the grantor.

At the time the trust is funded, the grantor has made a gift to the beneficiaries of the trust. The value of that gift for gift tax purposes is the fair market value of the property transferred into the trust as of the date of transfer, less the present value of the stream of payments retained by the grantor. This is a gift of a future interest and does not qualify for the $10,000 annual exclusion. The present value is greater when the retained annuity payments are larger and when the term of the trust is longer.

Provided that the grantor lives longer than the term of the trust, the property in the trust at his or her death is not included in his or her estate. Of course, the value of the gift will be added back into the grantor's estate tax calculation as an adjusted taxable gift, but at the reduced date of gift value.

On the other hand, if the grantor dies during the term, the property in the trust at its date of death value is included in the grantor's gross estate for estate tax purposes.

Because a GRAT permits payment of both income and principal to satisfy the annuity payments retained by the grantor, a GRAT should be treated as a grantor trust for income tax purposes. This means that the grantor will be taxed on income and realized gains even if those amounts are greater than the annuity payments. This may further enhance the effectiveness of the GRAT to transfer wealth to the next generation in that the grantor will be making tax-free gifts of the income tax that is attributable to the property in the trust if the payments are less than income.

The general rule is that all interests are valued according to their actuarial present values using the valuation rules of IRC section 7520. Under these rules a discount rate is applied based on 120% of the applicable federal midterm rate for the month in which the trust is funded and the mortality factors from Table 80CNSMT if the interests have a life contingency.

The ultimate distribution of the trust property may be made to family or non-family members. If family members are beneficiaries then the right to have trust assets revert to the transferor's estate in the event of the transferor's premature death may be valued at zero when computing the gift tax value of the transfer.

Also, if family members are beneficiaries the retained annuity interest's value cannot exceed the actuarial value of an annuity for the shorter of the specified term of life, even if the trust calls for payment of a term-certain annuity. This lowers the value of the retained interest and increases the value of the taxable gift.

GRATs are effective for a person who wishes to retain, for a limited period of time, all or most of the income from high-yielding and rapidly appreciating property, which he or she also wishes to transfer with reduced gift and estate tax consequences.

First published on Jan. 31, 2000.

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