Passing on a thriving family-owned business you have worked hard to build is a time-honored tradition. However, the irony is that because it is successful, your bequest can carry with it a double-edged sword. Without a prior plan for transferring the business that considers potential tax consequences for your beneficiaries, your gift may actually turn into a nightmare.

One way in which you can ease the tax burden of such a transfer is through a Grantor Retained Annuity Trust (GRAT). This is a method by which the business owner or “grantor” creates an irrevocable trust into which shares of the business, which have the potential to appreciate over time, are transferred at a discounted rate. As the grantor, you retain the right to receive income from these shares for a predetermined period of time. The trust stays in effect until either the predetermined income period ends or the grantor's death.Ifthe grantor dies before thetrust term expires, the trust assets revert into the grantor’s estate and are then subject to estate taxes, and are not transferred at a discount

The actuarial value of the grantor’s retained interest (present value of income payments) is computed using the discount rates found under IRC section 7520.This discounted value is subtracted from the fair market value of the trust to determine the amount subject to gift tax. If the grantor lives beyond the preset income period, the business may eventually be transferred to the next generation having been significantly reduced in value for estate and gift tax purposes.

When setting up the trust, it is possible to select the combination of income payment and trust term that will result in the present value of all future payments equaling the amount initially contributed.Essentially the trust would have no assets when the trust term expires, and therefore no gift tax would ever be levied.If trust assets outperform section 7520 rates, which is the underlying goal, remaining assets will be transferred to beneficiaries free of gift and estate taxes.

There are certain requirements for a GRAT that are spelled out in Treasury Regulations Section 25.2702-3(d):

1. The payment retained by the grantor should equal the greater of a designated dollar amount or designated percentage of trust assets at inception, or a designated percentage of the annual value of the trust assets. The idea is that you are not structuring the trust to deliberately leave a huge chunk of potentially reduced value assets to your heirs.

2. Payments may be made on either the anniversary date of the trust or the taxable year-end of the trust. In either situation, payments must be paid at least annually or more frequently, such as semi-annually, quarterly, or monthly.

2. The trust can only make distributions to the holder of a qualified interest in the trust.

3. The term must be for the life of the term holder, for a specified term of years, or for the shorter (but not the longer) of those periods. If the trust is structured to provide for successor term interests for the benefit of the same term holder, these are treated as the same term interest.

4. The trust must prohibit the commutation (prepayment) of the interest of the holder.

5. No additional contributions may be made to the trust.

Because the gift tax on the remainder interest was paid when the GRAT was established, whatever appreciation the assets have realized passes tax-free to the beneficiaries. To reduce the amount of the remaining interest passed to beneficiaries, the grantor may opt for a longer trust term or larger annual payout. For a GRAT to be effective the trust must continue to pay the annuity each year and the grantor must live longer than the term of the trust.

Be sure to seek the advice of a qualified legal and/or tax professional before moving forward with any estate planning strategy.

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