The pursuit of wealth has long been part of the American Dream, and a positive feature of the current $5.34 million estate tax exemption (high by historic standards) is that entrepreneurs have more “run room” before the Federal government becomes a 40% silent partner in the upside of all the work, creativity, striving, and risk they invest in their businesses.

Which most of them think they did build, although some politicians think otherwise.

Although the $5.34 million exemption does protect a great many “steady Eddie” business efforts from the estate tax, some entrepreneurs, inventors, and businesspeople are, by the very nature of what they do, either going to create rather tremendous wealth, or not very much at all.  Estate planning for this “bimodal” situation (a somewhat unlikely very large upside on one hand, and a more likely low-value outcome on the other) can be a challenge.

Examples of those needing to plan for a big but uncertain upside include physicians working on experimental drugs in an FDA approval process, or a developer of a new franchise concept, a founder of a venture-backed startup, or a senior executive holding options or other incentive compensation in a private equity-backed company.

One of the core strategies in tax-aware estate planning for assets that are expected to appreciate rapidly is to transfer them out of the owner’s taxable estate, often to a trust.

Sometimes, however, this sound estate tax planning approach runs into lifestyle funding realities.  Often, a hard-working entrepreneur, inventor, or businessperson wants to enjoy many of the rewards that come with success, rather than giving away all of a venture’s upside into a trust before the venture gets off the ground.

In the current high-exemption planning environment, a grantor retained annuity trust (or “GRAT”) is a type of trust that can be intentionally designed to balance a need for lifestyle funding and financing a secure retirement with avoiding the 40% estate tax on the “upper reaches” of a venture’s potential upside.

In relatively simple terms, a GRAT works as follows: a person (the “settlor”) transfers an asset to the trust.  The terms of the trust provide for a given percentage of the initial value of what is transferred to the trust to be paid to the settlor for a set number of years.  At the end of the annuity term, no further payments are made to the settlor, and any assets remaining in the GRAT are administered for the benefit of the GRAT’s beneficiaries.

The IRS assumes that assets in the GRAT will appreciate inside the trust during the annuity term at the so-called “Section 7520” rate in effect for the month in which the GRAT is funded.

The difference between the value of the assets transferred to the GRAT and the present value of the annuity payments back to the settlor is treated as a taxable gift by the settlor.

By varying the length of the annuity term and the percentage payout to the settlor during the annuity term, the split between the economic value of the assets in the GRAT retained by the settlor and the anticipated remainder value transferred to the beneficiaries can be fine-tuned to reflect the amount of wealth from the transferred assets that the settlor wants to have available for lifestyle purposes.

For instance, an inventor with a drug entering Stage 1 FDA trials could decide that $12 million of upside from that venture (if the drug was approved) would be enough to fund all of the inventor’s lifestyle and retirement goals.  Accordingly, a GRAT payout amount and annuity period could be designed to return up to $12 million in payments back to the inventor, but capture and retain any upside above $12 million inside the trust.

In Part 2 we’ll explore a case study of how this would work in greater detail.  But first: a public service announcement: an important horse race is occurring in Louisville this weekend (we have a little bit of money on California Chrome).  If you are very confident in the upside of your Derby bets, consider putting your ticket into a GRAT before it pays off!

Image above courtesy of State Library and Archives of Florida.