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Favorable IRS Ruling Allows Substitution of Assets in GRAT

In Private Letter Ruling 200846001, the IRS ruled favorably for the
taxpayer with regard to a Grantor Retained Annuity Trust, or “GRAT,”
that contained a provision allowing the grantor, or creator of the
trust, to substitute assets of the GRAT for other assets of equivalent

A Grantor Retained Annuity Trust is a “freeze” technique used by
individuals with taxable estates.  Assets that are expected to
appreciate in value are contributed to a grantor trust.  A grantor
trust is a trust that is disregarded for income tax purposes – meaning
it is treated as the alter-ego of the taxpayer.  Because the grantor
trust is disregarded for income tax purposes, there is no recognition
of gain when the assets are transferred to the GRAT.  The grantor
retains a beneficial interest in the GRAT, thus the name Grantor
Retained Annuity Trust.  The beneficial interest comes in the form of a
series of payments, or an annuity, that will be paid back to the
grantor.  At the end of the annuity term, any remaining assets in the
GRAT are distributed, either outright to or in trust for, the remainder

Let’s look at a simple example of how this might work in order to
see the estate planning benefits.  A taxpayer creates a start-up
business that is currently valued at $1 million.  The taxpayer expects
the value of the business to explode in the future.  For purposes of
this illustration we will assume a 20% growth rate.  The taxpayer
transfers the business to a GRAT with a five-year term.  As part of the
transaction, the taxpayer will receive a $222,109 annuity payment for
each of the next five years.  Given that this is a start-up company,
this payment would probably be paid by returning some of the stock of
the start-up company to the taxpayer each year.  Using a formula
provided by the IRS, we can calculate that the present value of the
five payments of $222,109 is $1 million.  Because the present value of
what the taxpayer gets back is equal to what the taxpayer put into the
GRAT, there is no gift tax to be paid as a result of the transfer. 
However, if the company does in fact increase in value by 20% annually,
the value of the remaining stock at the end of the five-year period
would be $835,477.  The taxpayer would have frozen the value of the
assets contributed to the GRAT, effectively getting the $835,477 out
free of gift tax.

An advantage of the “zeroed-out” GRAT (this is a GRAT where no gift
tax is owed) is that it is a “no harm, no foul” planning strategy in
the event the assets do not appreciate as anticipated.  This is
especially important in our current uncertain economic environment. 
Had the start-up business in the example turned out to be a bust, there
would be no loss to the taxpayer since there was no use of gift tax
exemption to shelter the failed gift.

The taxpayer in PLR 200846001 wanted to contribute the shares of two
separate companies to the GRAT.  The GRAT contained a provision
allowing the grantor to substitute trust assets for other assets of
equivalent value. This provision, which is defined under IRC § 674, is
commonly used to make a trust a grantor trust for income tax purposes. 
In order to qualify as a GRAT, there must be a provision in the GRAT
prohibiting additional contributions to the trust after its formation. 
The taxpayer desired to contribute the stock in two publicly traded
companies on the initial funding of the GRAT, but retain the right in
the future substitute shares of company 1 for an equivalent value of
shares of company 2 or shares of company 2 for an equivalent value of
shares in company 1.  The taxpayer’s advisors were concerned that while
the right to substitute assets is not a problem for income tax purposes
under IRC § 674, it might cause the GRAT to be disqualified under IRC §
2702, or cause inclusion of the GRAT assets in the grantors estate
after death under the provisions of IRC §§ 2036 or 2038.  The IRS ruled
that the substitution of assets would not disqualify the GRAT under IRC
§ 2702, or cause inclusion under IRC §§ 2036 or 2038.

A GRAT is a very powerful planning tool for individuals with taxable
estates, especially those individuals who have or plan to use their
lifetime $1 million gift tax exemption amount on other planning
strategies.  It is a freezing technique that allows the future
appreciation of assets to be removed from the estate of the taxpayer at
little to no cost.

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