Split interest trusts can effectively remove appreciating assets from the grantor’s estate at little or no transfer tax cost. They can also serve to shift income, since all income generated by the property held in trust will continue to be taxed to the grantor during the trust term. As discussed in Part I, these trusts also possess attractive asset protection features. Because of their ability to reduce transfer taxes, split interest trusts have been the subject of treasury regulations and also recent proposed legislation.
In creating a split interest trust, the grantor transfers property to a trust and retains a “qualified annuity interest” in the case of a Grantor Retained Annuity Trust (GRAT), or a “qualified unitrust interest” in the case of a Grantor Retained Unitrust (GRUT). The trust continues for a predetermined length of time, which the grantor is expected to outlive.
At the inception of the trust, the grantor makes a taxable gift of a remainder interest, the value of which is calculated by reference to IRS valuation tables. This gift will not be brought back into the grantor’s gross estate provided the grantor outlives the trust term. If the grantor does not outlive the trust term (or if the trust does not qualify as a GRAT, GRIT or GRUT), then the estate would owe gift tax on the entire value of the property transferred to the trust, not just on the present value of the remainder interest.
At the end of the designated trust term, the property will pass to trust beneficiaries without imposition of gift tax. Moreover, since the value of the gifted remainder interest (and the donor’s corresponding gift tax liability), is computed at the beginning of the trust term, to the extent the trust property has appreciated in value during the trust term, this appreciation will also escape gift tax.
Effective for gifts and certain other transfers made after April 30, 1989, and for estates of decedents dying after that date, the present value of any annuity, interest for life or for a term of years, or a remainder or reversionary interest, is determined by reference to IRS tables found in IRC Sec. 7520. These tables are based on an interest rate that is 120 percent of the applicable federal midterm rate (AFR) for the month in which the valuation date falls and for the most recent mortality experience available. The AFR for May 1998 is 6.8 percent.
To illustrate, assume the grantor transfers property worth $1,000,000 to a GRAT, and retains the right to receive $100,000 in yearly income, with payments to be made annually at the end of the year. Assume further the AFR in effect for the month the trust is created is 9.6 percent. From this, one calculates the present value of the remainder interest to be $374,840. This amount must be reported as a gift by the grantor on a Form 709 gift tax return. (Since the statute of limitations for transfers to split-interest trusts is suspended if the transfer is neither shown as a gift nor disclosed in adequate detail, the gift tax return should be accurate and detailed.) If the grantor outlives the trust term, he will have divested his estate of property worth $625,160 (and also any appreciation in the value of the property during the trust term) at zero gift tax cost. (The remainder interest and the amount of the taxable gift when property is transferred to a GRUT is determined in a similar fashion, but with reference to different IRS valuation tables.)
In deciding whether to use a GRAT or a GRUT, it is instructive to note that the GRUT requires yearly revaluations, while the GRAT does not. Another factor to consider is which type of trust will yield the smaller taxable gift at the outset. One must finally consider whether the assets funding the trust are likely to outperform the Sec. 7520 interest rate during the trust term.
As noted, the valuation table used to value the remainder interest in a GRAT is based the Sec. 7520 rate at the inception of the trust. To the extent the trust assets outperform that rate — currently 6.8% — the present value of the remainder interest for gift tax purposes will be undervalued. As the difference between the asset performance and the Sec. 7520 rate increases, so too does the value of the property which will ultimately pass to the remaindermen free of gift tax. Conversely, to the extent the Sec. 7520 rate exceeds the rate of growth of the assets in the GRAT, the present value of the remainder interest will be overvalued at the outset, and the actual gift tax liability will be greater than the gift tax liability based on the value of property actually received by the remaindermen at trust termination.
The GRAT is therefore most attractive when the trust assets are expected to significantly outperform the Sec. 7520 rate. Assuming that the trust assets will outperform the Sec. 7520 rate, and a GRAT is chosen, the grantor must next determine the annuity amount. Choosing an annuity amount that is sufficiently high such that the remainder interest is zero will result in a “zeroed-out GRAT.” If a zeroed-out GRAT is used, none of the grantor’s lifetime exemption will be depleted. However, if the trust assets do not outperform the Sec. 7520 rate, the remainder interest at trust termination will be zero, and the trust beneficiaries will be left with nothing.
If trust assets are not likely to outperform the Sec. 7520 rate, the GRUT is preferable since the trust assets will be revalued on a yearly basis. Their failure to appreciate at the Sec. 7520 rate will be reflected in a lower annuity paid to the grantor. The grantor and the remaindermen thus share in both the appreciation or depreciation in the value of the assets transferred to the trust. The GRUT is generally preferable when the appreciation of the trust assets cannot be predicted at the outset of the trust term. By virtue of the yearly revaluation of trust assets comprising a GRUT, the unitrust amount received from the grantor may fluctuate if the value of assets themselves change significantly on a yearly basis. Since yearly revaluations will be required, assets funding a GRUT should be readily capable of yearly revaluation, and should not require an appraisal.
Having chosen the type of trust, the grantor must next choose the length of the trust term. Recall that if the grantor fails to outlive the trust term, a portion of the trust property will be included in his gross estate by virtue of the retained life estate rule of IRC Sec. 2036(a). This result would negate the tax savings sought in using the split interest trust. On the other hand, using an excessively short trust term is also self-defeating, since the value of the remainder interest which is subject to gift tax increases as the trust term decreases. Accordingly, the length of the trust term should be one which the grantor is likely to outlive, yet should not be so short that the grantor’s outliving the term would result in only marginal gift tax savings. If the grantor cannot be expected to live at least ten years, then the use of a split interest trust may not be warranted.
The split interest trust also results in the gift tax-free shifting of the income tax liability of the trust. This result is dictated by the grantor trust provisions of the Code, which treat all income of such trusts as taxable to the grantor. To the extent trust income exceeds the annuity (or unitrust) amount, the remaindermen benefit, since the grantor is paying income taxes on property that they will eventually receive. However, the flip side is that grantor may be required to pay tax on “phantom” income which is not distributed to him.
The qualified personal residence trust (QPRT) is a split interest trust in which the grantor’s interest is in the form of use of a personal residence or vacation home for a term of years. Although recent regulations place significant restrictions on its use, the QPRT continues to be an effective vehicle for transferring ownership of a residence to family members at a reduced gift tax cost. Since the grantor of a QPRT is treated as the property owner for tax purposes, all deductions and elections available to the grantor, e.g., exclusions from gain on sale, like-kind exchanges, and deductions for real estate taxes, are available to the grantor, as if no trust had been formed. The remainder interest of a QPRT may also be protected from the claims of creditors, thus imbuing the trust with asset protection value.
Although recent Treasury Regulations prohibit the transfer of a residence from a QPRT to the grantor or the grantor’s spouse either during the income term or at its expiration, the grantor may nevertheless lease the property at the expiration of the term. In order to avoid inclusion in the grantor’s estate, however, the lease should be at fair market value.
A QPRT may provide that the grantor’s spouse receive the residence upon the death of the grantor either during the income term or at its expiration. The grantor may also retain a power of appointment, exercisable in his Will, in which he may direct distribution of the residence to any person, including the grantor’s estate.