Level 4 Planning - QPRTS and GRATS
Situation
The further need to make gifts when the gift tax exemption has already been used for other transfers.
Objectives
- Remove property from the grantor's estate.
- Permit grantor (and grantor's spouse) to continue using the property or the property'sincome for a fixed term.
- Make substantial gifts at little or no gift tax cost.
- Freeze the value of the property transferred.
- Permit the grantor to maintain control over the property during the fixed term.
Tools & Techniques
- Qualified Personal Residence Trust ("QPRT").
- Grantor Retained Annuity Trust ("GRAT").
Disadvantages
- Trust is irrevocable.
- Grantor loses access to property at end of fixed term.
- Heirs lose stepped-up basis on appreciated property.
- If grantor dies during the fixed term, the property in trust is included in the grantor's estate.
Qualified Personal Residence Trusts
A Qualified Personal Residence Trust ("QPRT") is established and provides the following benefits:
- The grantor's residence (or second home) is transferred to a trust, but the grantor retains the right to use the residence for a specified number of years.
- After the fixed term ends, the property passes to the beneficiaries named in the QPRT, usually the grantor's children and/or grandchildren.
- If the grantor wants to continue using the residence after the fixed term expires, the grantor can lease it from his or her children at fair market rental rates, which saves more estate tax by removing additional funds from the grantor's estate.
- The creation of the QPRT involves a gift to the grantor's children and/or grandchildren of only the remainder interest. IRS valuation tables are used to compute the value of the grantor's right to remain in the residence for a certain number of years, and the value of that retained interest is subtracted from the value of the residence.
- For example, assume a second home owned by a grantor age 65 is worth $500,000 and the IRS' assumed interest rate is 6.0%. If the grantor establishes a 10 year QPRT, with his or her children as the remaindermen, the total value of the grantor's retained interest is $287,760. Thus, the taxable gift is only $212,240 ($500,000 - $287,760). Of course, this taxable gift can be offset by the grantor's $1,000,000 exemption. Assuming the grantor survives the 10 year term, and the residence appreciates 4% per year to $740,122, the potential estate tax savings at 50% will be $263,941 (($740,122 – $212,240) x 50%).
- The longer the term for the grantor's retained interest, the smaller the gift to the grantor's children and/or grandchildren. However, if the grantor does not survive the fixed term, the residence is included in the grantor's gross estate just as if the QPRT had not been created.
- At the end of the term, the grantor can rent the residence from the children and/or grandchildren. While the rent would be taxable income to the children, the net effect is that the grantor is transferring assets (i.e., rent) to his/her children at income tax rates rather than much higher estate and gift tax rates.
- A QPRT works best for a residence and/or second home that the grantor expects to hold for the foreseeable future or replace if sold.
- A common hedge against death during the term is to insure the grantor's life for an amount equal to the estimated estate tax on the value of the residence. An insurance policy held by an Irrevocable Life Insurance Trust is an ideal hedging strategy.
Grantor Retained Annuity Trust
A Grantor Retained Annuity Trust ("GRAT") is established and provides the following benefits:
- Typically, Subchapter S stock which pays significant dividends and/or partnership interests with good cash flow are transferred to a GRAT. However, virtually any asset can be used. (In order for a GRAT to qualify as an S corporation shareholder, the trust instrument, must include provisions that cause the grantor to be taxed on all of the income earned by the Trust.)
- The GRAT pays the grantor a fixed payment (an annuity), at least annually, for a fixed term of years.
- After the fixed term ends, the property (plus the appreciation thereon) passes to the beneficiaries named in the GRAT, usually the grantor's children and/or grandchildren.
- Only the value of the remainder interest is subject to gift tax. The value of the remainder interest, and therefore the value of the gift, is reduced by a longer term, a larger annuity, an older grantor, and a lower assumed interest rate (published monthly by the IRS).
- For example, assume Subchapter S stock worth $500,000 (after applicable valuation discounts) is placed in a 10 year GRAT. If the grantor is age 65, and the IRS' assumed interest rate is 6.0%, the following results occur:
| Annual Payment | Gift Tax Value of Remainder Interest |
| $30,000 (6%) | $300,680 |
| $42,500 (8.5%) | $217,630 |
Note: If the Subchapter S stock is expected to produce a 6% return, that same stock discounted by 30% for lack of marketability and minority interest will, on its discounted value, produce a 8.5% return.
- If the grantor does not survive the fixed term, the property in the GRAT is included in the grantor's gross estate.
- A common hedge against death during the term is to insure the grantor's life for an amount equal to the estimated estate tax on the value of the property in the GRAT. An insurance policy held by an Irrevocable Life Insurance Trust is an ideal hedging strategy.
Special Section
"Stretch Out" IRAs
When an IRA account owner dies, the assets in his/her IRA will usually be subject to Federal and State income taxes, and Federal and State estate taxes. Substantial sums (i.e., 70% to 75% of the IRA assets) can be lost to these taxes if the IRA's beneficiary designation has not been carefully planned. The IRA account owner's objective should be to postpone, for as long as possible, the distribution of funds from the IRA (provided such funds are not needed to live on). This allows IRA assets to grow income tax deferred, thereby taking full advantage of the power of income tax free compounding.
Usually, naming the IRA owner's spouse as primary beneficiary affords the greatest flexibility in prolonging the distribution period after the owner's death. This is because upon the IRA owner's death, the spouse can elect to roll the IRA into his/her own existing IRA — both income and estate tax free! The spouse can then select new beneficiaries for the rollover IRA, such as his/her children and/or grandchildren. The surviving spouse can then defer distributions from the rollover IRA until he/she reaches age 70 1/2. Thereafter, required minimum distributions (RMDs) must be taken based on the spouse's life expectancy using the new (and improved) Uniform Table.
Upon the death of the surviving spouse, the children/grandchildren can withdraw the balance in the IRA over their life expectancy. If the spouse dies after age 701?2, the children can withdraw the balance in the IRA over their life expectancies. This approach makes it possible for the children/grandchildren to continue enjoying income tax deferred compounding for several years after the surviving spouse's death.
The "stretch out" IRA described above — deceased spouse to surviving spouse, surviving spouse to children/grandchildren — is usually the most effective (and popular) way to defer income taxes and thereby create wealth. However, there must be sufficient liquid assets in the surviving spouse's estate outside of the IRA with which to pay the estate tax that will be due on the IRA assets at the surviving spouse's death. Otherwise, the assets in the IRA will have to be distributed to the beneficiaries to pay the estate tax. In such case, the income tax deferral will be lost. Frequently, funds with which to pay the estate tax on IRA assets are provided through gifts to an Irrevocable Life Insurance Trust.