What is a Grantor Retained Annuity Trust?
A grantor retained annuity trust (GRAT) is a financial instrument used in estate planning to minimize taxes on large financial gifts to family members. Under these plans, an irrevocable trust is created for a certain term or period of time.
The individual forming the trust establishes a gift value when the trust is created. Assets are placed under the trust and then an annuity is paid out to the grantor every year. When the trust expires and the last annuity payment is made, the beneficiary receives the assets and pays little or no gift taxes.
Grantor retained annuity trusts (GRATs) represent an opportunity for a client to transfer appreciating assets to the next generation with little to no gift or estate tax consequences. Wealthy families can use GRATs to freeze the value of their estate while transferring any future appreciation to the next generation free of tax. Additionally, GRATs have little downside.
Understanding Grantor Retained Annuity Trusts (GRATs)
Grantor-Retained Annuity Trust (GRAT) is a form of Grantor-Retained Trust set up by individuals to reduce taxes on an estate. To create a GRAT, a grantor creates an irrevocable trust that is for a limited period of time, paying taxes at the outset of the trust.
The grantor receives a non-variable sum as annuity payments based on the fair market value of the trust assets, according to a rate set by the Internal Revenue Service (IRS) regulations (in contrast to GRUTs where payments vary based on the performance of the trust). At the end of the trust’s lifetime, the assets are passed to the beneficiaries without estate or gift taxes.
GRATs have a few unique elements to them. First, the trust must earn interest equal to or higher than the rate set by the IRS. If the interest rate is lower or the grantor dies before the trust ends, the trust will be closed with the assets going to the estate, not the beneficiaries.
Second, the trust must be irrevocable in order to receive the tax benefits of a GRAT. Lastly, the grantor may exchange similar investments with the trust to make sure that the trust makes the required amount of interest every year.
Why use a GRAT?
The goal of a GRAT strategy is to freeze a portion of an estate’s value today, allowing future appreciation on those assets to pass to heirs estate-tax-free. Over the term of the trust, the individual, also known as the grantor, receives a stream of income (in the form of an annual distribution).
So, if individuals or families own assets that they expect to appreciate in value, but that they don’t necessarily want to gift away outright, it may make sense to shift the potential future growth of those assets to heirs using a GRAT.
GRATs tend to be particularly effective in low-interest-rate environments, so for those who hold the view that interest rates will rise from here, now may be a good time to explore GRATs and whether this strategy could make sense.
How a GRAT works
Here’s an overview of the GRAT strategy:
- The grantor forms a GRAT by transferring assets, particularly those with high expected appreciation potential, to an irrevocable trust for a set period of time.
- Applying IRS factors for valuing annuities, life estates and remainders, the GRAT’s value is split into two: the annuity stream and remainder interest. Often, the value of the annuity stream is set to equal the value of the assets transferred into the GRAT to construct a “zeroed-out” GRAT.
- The grantor receives annuity payments from the GRAT. The trust is expected to produce a minimum return of at least the IRS Section 7520 interest rate. If it doesn’t, the trust uses principal to cover the annuity payment and the GRAT fails, returning trust assets back to the grantor.
- Assuming returns of the GRAT do surpass the Section 7520 rate during the fixed time period, all remaining assets and accumulated asset growth are distributed directly to beneficiaries gift-tax-free after the final annuity payment is made.
Benefits and Drawbacks of Utilizing Grantor Retained Annuity Trusts
Grantor retained annuity trusts are generally used by wealthy individuals in order to pass their assets to the next generation. Especially if these assets are expected to grow at a high rate, such as shares in a startup or other growth companies.
Benefits of using GRATs include:
- They reduce the overall size of the estate and the effects of growing assets.
- They help minimize tax liability.
Drawbacks of using GRATs include:
- If the trustor or grantor passes away before the end of the term, the trust assets are returned to the trustor’s estate, resulting in an increased tax burden at transfer.
- Legislation regarding GRATs continuously evolves; therefore, trustors must maintain their understanding of the structure and limitations of GRATs over time.
What happens when the GRAT terminates?
At the end of the GRAT period, the assets remaining in the GRAT can either pass outright to heirs or remain in trust for the benefit of heirs. If a series of rolling GRATs has been established, the grantor may wish to have the balances consolidated into one trust, for ease of administration.
This trust can also be treated as a grantor trust for income tax purposes, meaning the grantor would continue to pay the income taxes and further reduce their taxable estate.
It may also be possible to exchange or purchase assets or receive distributions without realizing income or capital gains. This trust can be structured to make assets available to heirs with as much or as little restriction as preferred.
While GRATs are typically intended to benefit descendants, a grantor’s spouse may also be included as a beneficiary. Doing so would ensure that the funds are available if the need for them arose, while allowing the assets to be passed on to heirs outside of the surviving spouse’s estate, if access to the funds is not needed.
Risks of using a GRAT
As with most estate planning techniques, there are risks to consider before deciding whether this strategy is appropriate.
In order for the appreciation in the GRAT to pass to heirs free of estate and gift tax, the grantor must survive the term of the GRAT. If the grantor passes away during the term of the trust, most, if not all, of the assets in the GRAT, and any appreciation on those assets, will be included in the estate for estate-tax calculation purposes.
A significant advantage of setting up a series of rolling GRATs instead of a single GRAT is that several of those GRATs would likely have already reached maturity, and the grantor would have received the satisfactory result of transferring the growth on at least some of the assets outside of their estate.
Lack of asset appreciation
If the assets that the grantor contributed to a GRAT do not outperform the hurdle rate, the GRAT will simply return the assets back to the grantor over the period of the trust. Because the grantor used little to no lifetime federal gift and estate tax exclusion (assuming the GRAT was structured as a “zeroed out” trust) and continued to pay income taxes as if the assets were still in their name, the grantor would experience minimal, if any, adverse tax consequences.
Rather, the grantor would have incurred fees and expenses to establish and administer a trust that did not perform successfully.
The IRS permits GRATs, provided the terms of the trust adhere to applicable Department of the Treasury regulations intended to benefit descendants and a grantor’s spouse.
However, it is such a powerful wealth transfer tool that over the years the Treasury, and more recently Congress and the current administration, has proposed various restrictions on GRATs, though these restrictions have not yet been implemented.
These proposed restrictions include requiring a term of at least 10 years and a remainder interest greater than zero, and prohibiting a decrease in the annuity amount during the term of the GRAT.
Note: Recent proposals by Congressional legislators and the current administration have targeted GRATs with proposals that would significantly impact the viability of GRATs.
Generation-skipping transfer tax
GRATs present several attractive qualities, but minimizing or eliminating the generation-skipping transfer tax (GSTT) is not one of them. If GSTT is allocated to the full value of the GRAT when it is set up and funded, it will in effect be “wasted” as the annuity payments come back into the estate.
If the grantor leaves the assets outright or in trust for the benefit of their children only, rather than for the benefit of multiple generations, GSTT will not be a concern. However, when opting to leave assets for multiple generations with the expectation that the assets will continue to grow, a grantor may wish to allocate the GSTT exemption at the termination of the GRAT or work with an attorney to address this risk.
The benefit of GRATs can be explained through a simple example:
Consider Max, who is 70 years old and is a recent retiree. He owns shares in a high-growth tech startup with the current value of the position valued at $10,000,000.
Max wants to transfer the shares to his child, Sam, in a tax-advantaged manner and has decided to utilize a GRAT. The shares are placed into an irrevocable trust, with a term of ten years. Each year, a $500,000 payment is paid out to Max.
After ten years, the value of the shares has increased to $20,000,000. A total of $5,000,000 has been paid out to Max, with the remaining value of the trust at $15,000,000.
We can see that the trust’s value has increased by $5,000,000, from $10,000,000 to $15,000,000.
Sam is able to receive the $5,000,000 gain free of tax.
In the above example, very simplified figures are used. However, it should be noted that the structure of the trust and the payment amount are much more complex in practice. The $500,000 payment would normally be calculated with the assumed return rate of the U.S. Internal Revenue Service, which is derived from market interest rates. Therefore, the interest rate environment is also a consideration in utilizing GRATs.