Although the grantor retained annuity trust (GRAT) is an excellent estate-planning technique, it can be complicated to create, depending upon the client and assets involved. Hard-to-move assets can mean problems. Questions about when the GRAT is created impact annuity payments. Clients can drag their feet, then suddenly be impatient for the GRAT, causing a terrible time crunch. One handy tool to help with such difficulties is the “revocable GRAT.” It also can help advisors plan now for a client who may be incapacitated later. And it might permit settlors to grant to a GRAT an option on property.

So what exactly is a revocable GRAT? Simply put, it's a gift that is incomplete so long as the grantor can revoke it. During the revocability period, the trust is not a full-fledged GRAT.1 When the grantor is ready to make the GRAT operative, steps are taken to make the trust irrevocable, and thus become an actual GRAT. Why bother going through these machinations? Why bother with a revocable GRAT at all? There can be significant advantages.

FUNDING HURDLES

Conceptually, GRATs are relatively straightforward. But they are difficult to implement if the assets to be contributed to them are not easily transferable.

For a trust to qualify as a GRAT, the grantor must have the ability to transfer assets to it. Similarly, the GRAT trustee must be able to transfer the assets to the remainder beneficiaries and to the grantor as the annuitant (if in-kind annuity payments are required). Therefore, advisors must address any restrictions on the assets' mobility (such as restrictions on interests in limited liability companies or limited partnerships, in buy-sell agreements, or imposed on stock that has not been registered). If necessary, consents must be obtained so that the assets can be moved. Unusual consents may be required in special circumstances — such as from lenders or possibly governmental agencies.

When it comes to mobility, hedge funds and private equity investments can be particularly problematic. Some funds require legal opinions, consents and even fees for transfers of interests. Such assets are also extremely difficult to value, especially on a timely basis. Some hedge funds, for example, provide financial information only on a periodic basis. While a lack of information can be irritating if the GRAT is funded early in a year, it can be a real problem for gift-tax reporting if the GRAT is funded late in the year. And it can be a nightmare for purposes of determining the amount of an in-kind annuity payment, especially if the trustee is trying to make sure the annuity payment is made within the grace period following the due date.2

MULTIPLE ADDITIONS

Let's assume that you have a client who has decided to create a GRAT funded with assets that have mobility problems. If there are two or more assets to be contributed to the GRAT, the advisor needs to be certain that the assets are contributed at the same time, as two separate contributions probably would violate the requirement that a GRAT not permit additional contributions.

An advisor may be comfortable that, under a step-transaction theory, an instrument purporting to irrevocably assign the two assets is effective as of that date, in which case there should not be a concern about additional contributions.3 But we've seen circumstances in which reliance on the simultaneous effect of such an instrument might not be wise, or could at least be subject to questions after the fact. Especially troublesome are situations in which additional third-party consents are required before the transfer can be completed.

In such cases, a revocable GRAT might be an ideal solution — or at least conservative approach — to funding the GRAT. The revocable GRAT can be created for state law purposes. The assets in question then are contributed to the trustee of that revocable GRAT. Once all of the consents have been received, and there is no question that the GRAT trustee has title to the multiple assets, the grantor can make the GRAT irrevocable. The GRAT then is deemed to be created on that date, and there is no issue as to multiple fundings. The Internal Revenue Code Section 2702 rules should not apply during the period in which the trust is revocable, as the funding of the revocable trust should not be a completed gift.4

ANNUITY PERIOD

Revocable GRATs can also help avoid another question about funding: the question of when a GRAT is deemed created for purposes of making the annuity payments. Say, for example, that a GRAT instrument defined the annuity period as commencing upon the date the trust was executed based upon the belief and expectation that such date was also the date on which the asset was formally transferred to the GRAT. What if the asset turns out not to be transferred until the next day? Does that mean that the GRAT has an annuity period one day short of the specified term in the GRAT instrument? If so, what is the result? What if the delay in formal transfer of title means that the gift is incomplete during the interim period, especially if the transfer is revocable under applicable state law? What if the delay means that the transfer is not complete until the following month, when the IRC Section 7520 rate is higher than the prior month for which the annuity percentages were calculated?

If the GRAT instrument defines the commencement of the annuity period based upon the “date of funding,” and the “date of funding” is defined as the date on which the transfers are completed for gift tax purposes, then most of these questions may not be a concern. But the use of a revocable GRAT could be structured to substantially reduce — if not eliminate — all of these questions, especially if the GRAT instrument uses a formula to calculate the annuity percentages.

INDECISIVE CLIENTS

Clients themselves create another timing issue that can be solved using revocable GRATs. Many clients like the idea of a GRAT, but have not quite made the final decision to create one. Questions remain. The client deliberates. Which assets should be contributed? How should the GRAT remainder be disposed of? Once the client decides, though, he's usually eager to complete the process as quickly as possible, putting considerable time pressure on his advisors. Advisors themselves sometimes make the time crunch worse by pointing out that the IRC Section 7520 rate for the following month is published around the third week of the current month. If the rate goes down, it can be advantageous to wait to create the GRAT in the next month, but if the rate is set to increase, it makes more sense to create the GRAT in the existing month.5

In these cases, revocable GRATs may not only help the client, but also the advisor. If the only question is the asset to contribute, the GRAT instrument can be prepared and multiple assets can be transferred to the trustee. When the client decides which assets to transfer, and which to retain, it can be easier to remove unwanted assets than to make the GRAT irrevocable. If, on the other hand, the client is certain about which assets to contribute, the assets can be transferred to the trustee of the revocable GRAT, and all but the remainder provision of the trust instrument can be prepared in advance. The client and drafter then can focus on writing the provisions to distribute the remainder, without worrying that they will subsequently have to address funding complexities on a short deadline.

INCAPACITY

It's not immediately obvious, but a revocable GRAT also can be helpful with clients who later may become incapacitated. If everything concerning the GRAT can be pinned down while there is no question of capacity, then there is no issue. But if advisors and clients want to make contingency plans for a GRAT to be created after the client might become incapacitated, a revocable GRAT is worth considering. It might be possible to grant to an attorney-in-fact sufficiently broad powers to engage in estate planning. But would the attorney-in-fact be permitted to create a GRAT, and choose the assets to contribute? Perhaps it would be better for the settlor to choose the remainder disposition, and transfer assets to a revocable GRAT (perhaps erring on the side of “over funding”). The attorney-in-fact then might be given the power to (1) withdraw assets from (but not contribute assets to) the revocable GRAT for the principal's benefit, and (2) make the revocable GRAT irrevocable. Such a structure would, of course, require the use of a formula for calculating the annuity percentages.

OPTIONS

A revocable GRAT also might allow a settlor of a GRAT to grant to the GRAT an option on the settlor's property. Some creative minds have sought to fund GRATs with options, as doing so can effectively result in a GRAT with a very short-term economic horizon. Options can also increase a GRAT's volatility. Those seeking either result may have considered it impossible for the settlor to grant an option to a GRAT because a gifted option might not be considered enforceable under state law, thereby making the settlor's transfer of an option to a GRAT an incomplete gift.6 Because a GRAT may not receive multiple contributions, the settlor may not be able to solve this issue by contributing or loaning funds and then having the GRAT purchase the option from the settlor (at least without a valuation risk).

By using a revocable GRAT, though, the grantor could fund the GRAT with cash. The GRAT trustee then could use funds to purchase from the settlor the option, which could then make the option enforceable under state law. The grantor could then make the GRAT irrevocable, thereby accomplishing the desired result of giving the GRAT a short-term option on the grantor's property.

DRAFTING

If you've warmed to the idea of using a revocable trust, you might ask, “What should be in the trust agreement?” Much of that answer will depend upon state law considerations, personal preference and specific circumstances, but a drafter should consider these recommendations:

  • Make the trust revocable — It should be obvious by now, but the grantor should have the express power to amend the trust agreement, to withdraw assets and to revoke the entire trust. Some state laws provide that a trust agreement that is silent with respect to revocation is revocable; other state laws provide the opposite result. We recommend that an express power of revocation be included in the trust document.

  • Anticipate death and incapacity — Advisors should structure the trust to serve as the equivalent of a revocable living trust and carry out the wishes (testamentary and otherwise) of the grantor, should the grantor become incapacitated or die before the trust is revoked or made irrevocable.

  • Include, but customize, GRAT provisions — The GRAT should contain all of the provisions that are designed to make the trust qualify as a GRAT. But some of the provisions that practitioners have designed to meet the GRAT rules will need to be tailored so as to apply only after the trust is made irrevocable. For example, GRATs contain a standard provision prohibiting additional contributions.7 Such a provision should apply only after the trust is irrevocable, or it should be expressly amended if additional assets are contributed to the trust while it is revocable. The drafter also might choose to state that the assets in the revocable GRAT will be used to create a new trust when the period of revocability ends. (A GRAT must meet the definition of, and function exclusively as, a qualified interest from the creation of the trust.8 This rule applies when the trust is created for transfer tax, not state law, purposes, but it might still be prudent to create a new trust for state law purposes. It also may be advantageous to create a new trust for purposes of IRC Section 2035(e)).

  • Set forth how to amend the GRAT to make it irrevocable — The revocable GRAT should have clear provisions for how the grantor can amend the trust and make the GRAT operative — by making the GRAT irrevocable. Requiring a signed, witnessed and notarized instrument delivered to multiple trustees might cause unnecessary delay if the signing of a single sheet of paper would suffice. State law must, of course, be considered on this point.

  • Use a formula — Because it will not be clear at the time of drafting when the revocable GRAT will become operative as a GRAT, the drafter must decide how to define the annuity payments. There are several options.

The trust instrument could simply contain a placeholder for the annuity percentage, possibly with one (or two) sets of annuity percentages defined based upon the current and following month's Section 7520 rates. We always use graduated GRATs with a full increase of 20 percent of the prior year's payment. Most commentators who favor graduated GRATs have offered the elegant and simple justification that graduated GRATs permit more backloading of the payments, which permits more assets to appreciate within the GRAT for the benefit of the remainder beneficiaries. The premise that graduated GRATs outperform regular GRATs can be proven mathematically, at least for a two-year GRAT, when the rate of return exceeds the IRC Section 7520 rate. When the rate of return falls below the IRC Section 7520 rate, the regular GRAT actually outperforms the graduated GRAT, and can, in some instances, still produce a positive remainder — if the trustee defers payments.

Consider different formulas. For example, there is a “defined value” type formula:9 The “annuity amount” for each of the two years shall be the minimum amount necessary for all of the annuity amounts payable to the annuitant to have a fair market value, as determined using the Section 7520 rate in effect for the month the trust is created and based on the tables thereunder, equal to $100 less than the initial fair market value of the property transferred to the trustee as finally determined for federal tax purposes, and with the second-year annuity amount being equal to 120 percent of the first-year annuity amount.

Or an advisor may choose to use a mathematical formula. For example: The “annuity amount” for each year shall be an amount determined by multiplying $100 less than the initial fair market value of the property transferred to the trustee, as finally determined for federal tax purposes, by the fraction (1+R)2 / (2.2+R) for the first year, and for the second year by 120 percent of the fraction for the first year amount, where “R” shall be equal to the IRC Section 7520 rate, expressed as a decimal, for the month in which the trust is made irrevocable.”

Both of these formulas are designed for a two-year GRAT with a 20 percent graduated second payment and should produce a taxable gift of $100.

Jonathan Blattmachr and Diana Zeydel, two highly respected commentators, recently noted that the Internal Revenue Service might challenge whether GRATs can be zeroed-out.10 We believe that you should be able to zero-out a GRAT, but always should structure these trusts with at least some taxable gift so that the GRAT can be disclosed on a gift tax return to commence the running of the statute of limitations.

Also, most practitioners probably are aware that any taxable gift resulting from a GRAT is a future interest and therefore not protected by the IRC Section 2503(b) annual exclusion. Even though the resulting taxable gift might not create a tax liability (because of the use of the grantor's lifetime gift tax exclusion), a gift tax return must still be filed.11 Failure to file a return can result in penalties and additional taxation.12 If the grantor does not owe any taxes, because of the lifetime gift tax exclusion, for example, some may assume there's no downside to not filing. But not filing means that the statute of limitations does not start to run.13 Also, a willful failure to file could be a crime.14

HANDY TOOL

A revocable GRAT is not something that will change the face of estate planning, but it might come in handy in a particular situation. While revocable GRATs are not complex, advisors should consider carefully all of the GRAT requirements, and the particular facts and circumstances of the situation, before recommending and implementing them.

The views in this article are the authors' and do not necessarily reflect those of Jones Day or its clients.

Endnotes

  1. Grantor retained annuity trusts (GRATs) must meet the requirements of Internal Revenue Code Section 2702. A transfer in trust that is an incomplete gift is not, however, a GRAT. IRC Section 2702(a)(3)(A)(i) and Treasury Regulations Section 25.2702-1(c)(1). We do not believe that a revocable GRAT should be subject to the three-year rule by reason of IRC Section 2035(e). That provision as written, however, applies to “any transfer from” a revocable trust, so that is a reason why the terms of the revocable GRAT should state that a new trust is to be created after it is made irrevocable. If a practitioner has any doubt about the three-year rule, consider using a three-year or longer-term GRAT.
  2. Under Treasury Regulations Section 25.2702-3(b)(4), calendar and anniversary date GRATs generally have 105-day grace periods after the specified annuity payment due dates.
  3. Treas. Regs. Section 25.2702-3(b)(5).
  4. IRC Section 2702(a)(3)(A)(i); Treas. Regs. Section 25.2511-2(c). See also Treas. Regs. Sections 25.2702-1(c)(1) and 25.2702-2(d), Ex. 4.
  5. Practitioners need to be aware, however, that valuation swings during such a “wait-and-see” period can more than offset any benefit derived from taking advantage of a lower IRC Section 7520 rate.
  6. Compare Private Letter Ruling 9501004 (Sept. 29, 1994).
  7. Treas. Regs. Section 25.2702-3(b)(5).
  8. Treas. Regs. Section 25.2702-3(d)(1).
  9. See Carlyn McCaffrey, “The Care and Feeding of GRATs — Enhancing GRAT Performance Through Careful Structuring, Investing and Monitoring,” 39th Annual Heckerling Institute on Estate Planning, at paragraph 703.3A (Portuondo ed., 2005); Julie Kwon, Carlyn McCaffrey and Jerry Hesch, “Deciding Upon the Appropriate Estate Freeze Technique and Enhancing Its Performance Through Careful Structuring, Investing and Monitoring,“ 2 A.B.A. Real Prop., Prob. & Trust Law Section, Prob. & Tr. Law Symp. 665, 679 (2005).
  10. See Jonathan Blattmachr and Diana Zeydel, “Evaluating the Potential Success of a GRAT Against Competing Strategies to Transfer Wealth,” 31 Tax Mgmt. Est. Gifts & Tr. J. 115, 124-25 (2006).
  11. IRC Section 6019(a). See also Steve Akers, “Update of Transfer Planning Issues,” 1 A.B.A. Real Prop., Prob. & Trust Law Section, Prob. & Tr. Law Symp. 3, 29 (2004)
  12. IRC Section 6651(a).
  13. IRC Section 6501(a).
  14. IRC Section 7203.