GRANTOR RETAINED ANNUITY TRUST ("GRAT")

General Planning Memorandum

What is a GRAT? - Central bullet points summarizing planning involving a grantor retained interest trust ("GRAT") include the following:

• A GRAT is a trust created to move wealth to children without gift tax.
• Appreciation of GRAT property must significantly outperform the IRS interest rate to secure any substantial benefit.
• Grantor who creates a GRAT in most cases must survive the GRAT term to secure the estate planning transfer tax benefit.
• The GRAT may be structured so that there are no additional income tax costs.
• Potential long term benefit from GRAT planning is illustrated on the attached chart.

A GRAT is an irrevocable trust. Its intended purpose is to transfer of property to children or trusts for their benefit with either little or minimal gift or estate tax. A GRAT is successful if and when the property transferred to it outperforms the IRS interest rate in effect in the month when the GRAT is created.

Mechanics to Create a GRAT - The grantor creates the GRAT trust and transfers property to it. The grantor then is to receive back a portion of the property through annuity payments over a fixed number of years (typically, 3-8 years). The annuity is the right to receive a specified amount every year for the fixed number of years. The amount the grantor receives back over the course of the fixed GRAT term is typically equal to the grantor's contribution plus a time value of many factor. At the end of the GRAT term, any trust property, including appreciation, which has not been returned to the grantor through the annuity payments, is then distributed to the grantor's children or trusts for their benefit.

Selection GRAT Assets - Typically, equity investments are used to fund a GRAT because of their potential for appreciation (compared to fixed income securities). This may include more traditional equity marketable securities but also many include more speculative private equity investments. Stock in closely held private companies may also be used.[1]

Grantor Annuity Payments - Typically, a GRAT is structured so that the grantor receives back over the fixed GRAT term an amount equal to the value of the property transferred to the GRAT plus an interest factor. The periodic annuity payments are calibrated to pay back to the grantor the grantor's initial contribution plus a return equivalent to the IRS interest rate. These payments may be structured in equal amounts to be received annually, or may be structured to be in increasing amounts each year (but subject to a maximum annual "ramp-up" of 20%). The annuity payments may be made either in cash distribution, or other property (i.e., through in kind distribution of specific property held in the GRAT).

Gift Tax Issues - Typically, the GRAT trust is structured to "zero out" the GRAT gift. The gift to a GRAT, if any, is equal to the difference between the fair market value of the initial GRAT assets less the present value of the annuity payments to be distributed back to the grantor. The level of the GRAT annuity is typically set by a formula equivalent to the value of the property contributed to the GRAT by the grantor. This is called a "zero out" GRAT because it results in a nominal or no taxable gift. Because the GRAT annuity is determined by formula, the annuity amount will adjust if the initial value of the assets transferred to the GRAT is adjusted on tax audit or otherwise. On account of this adjustment, gift tax exposure to the grantor is limited.

GRAT Termination - When the fixed GRAT term is reached, the remaining GRAT property (i.e., whatever is left after the grantor's last annuity payment) passes to the grantor's children or trusts for their benefit. If the GRAT assets have outperformed the IRS interest rate, the excess growth is distributed to the grantor's children (or trusts for their benefit) free of estate and gift tax. Alternatively, if the GRAT assets have not appreciated faster than the IRS interest rate, all the GRAT property is returned to the grantor through the grantor's annuity payments without any tax consequence.

Trustee Control - Upon GRAT termination, the grantor's children's interests may be distributed to them either outright or in trust. If held in trust, a trustee designated by the grantor may control distributions to the grantor's children far into the future. Provisions for trustee replacement may also be included. For a married couple, either husband or wife may create a GRAT and specify that, at GRAT termination, the other spouse is trustee of the continuing trust for children (and, if desired, there may also be provision for that spouse to be a discretionary trust beneficiary). Where appropriate, flexibility for an additional income tax planning advantage may be available for the grantor (rather than the grantor's children) to remain taxable on the trust income under the grantor tax rules for income tax purposes.

Income Tax Issues - A GRAT does not pay any income tax and causes no additional income tax liability. Under the grantor trust rules for income tax purposes, all income, deductions, and credits attributable to GRAT property are reported on the grantor's return as if owned directly by the grantor. On account of this, the grantor's children will receive the benefit of GRAT asset growth on an essentially income tax free basis. Distribution of the annuity payments to the grantor over the fixed GRAT term (whether in cash or in kind) does not cause an additional income tax.

Death of Grantor - The grantor must survive the entire fixed GRAT term for the intended benefit to be secured. If the grantor does not, the GRAT property (including appreciation) is in most cases subject to estate taxation in the grantor's estate, essentially as if the GRAT transaction had not been entered into.[2] Some grantors may purchase term life insurance to cover risk of death during the GRAT term. If the grantor survives the fixed GRAT term, then the full intended benefit (depending on market performance) may be obtained.

Potential Benefit - The benefit of a GRAT is that wealth may be transferred to the grantor's children essentially gift and estate tax free. The size of this benefit depends on how much the actual appreciation in value of the GRAT property exceeds the IRS interest rate. As a result, a GRAT is best suited for property which is anticipated to appreciate at an annual rate significantly greater than the IRS interest rate. The attached illustration shows the potential upside of a "zero out" GRAT for periods of 3, 5 and 8 years. For illustration, it assumes an IRS rate of 5% and a beginning GRAT principal of $1,000,000. Various rates of annual growth ranging from 6% to 25% are projected in computing the potential benefit for children at the end of the specified period.[3]

Mutliple GRAT Planning - More sophisticated GRAT planning may involve the creation of several different GRAT vehicles, typically with different composition of equity securities, and sometimes for different periods of years. In long term GRAT planning with multiple GRATs, this sometimes includes a "rolling GRAT" (or "re-GRAT") strategy where all property distributed to the grantor in satisfaction of annuity payments is immediately transferred back into new GRATs on a regular basis.

Revised: January 2008

[1] In some cases, a GRAT may also be funded, in whole or in part, with a family limited partnership or LLC holding equity investments.

[2] Under an earlier IRS position, if a grantor died during the GRAT term, the entire property in the GRAT was included in the grantor's estate. In June 2007, the IRS issued proposed regulations stating that the portion of the GRAT assets included in the grantor's estate would be as much as is necessary to produce the retained annuity in perpetuity. For a long term GRAT whose assets have appreciated substantially, the result is that there may be a significant tax-free transfer of wealth even if the grantor dies during the term.

[3] The tax rules assume that a GRAT will grow at a rate equal to the IRS interest rate at the time the GRAT is established, regardless of actual growth over the term of the GRAT. As a result, the lower the IRS interest rate at the time the GRAT is created, the lower the annuity rate has to be in order to create a "zero out" GRAT, and vice versa.

Illustration -- Benefit for Children at End of GRAT

Illustrations below are based on the following assumptions:

• Initial property transferred to GRAT: $1,000,000

• Minimal taxable gift is made when "zero out" GRAT is established

• There is a "ramp up" of 20% each year in the annuity payment to grantor.

• 5% IRS interest rate