Q: What is a Grantor Retained Annuity Trust (GRAT)?
A GRAT is a tool used by people who want to reduce estate and gift taxes on assets they own. It is a trust that holds assets and, if implemented correctly, shields the asset’s growth from transfer tax. A GRAT consists of:
- Asset(s) contributed to a trust by the grantor.
- An annuity that compensates the grantor for a specified number of years.
Your assets go into the trust, and you, the grantor, receive an annuity as compensation. This annuity provides you with income during the life of the trust. After the trust expires, any remaining assets pass to the trust’s named beneficiary.
Q: What’s a grantor and what’s a grantor trust?
All trusts have a grantor. Grantors are the individuals who create and fund the trust.
Although all trusts have a grantor, not all trusts are grantor trusts, which refers to fact that the grantor, not the trust, pays income tax on the trust’s income.
When setting up this trust, a grantor makes an irrevocable transfer to the trust with a named beneficiary. However, the grantor retains an ownership interest during the trust’s lifetime. In GRATs, this interest is an annuity that pays the grantor an annual payment based on the fair market value of assets contributed to the trusts (determined using the Section 7520 rate which is set monthly by the US Dept of Treasury).
A grantor trust is different from a non-grantor trust, which taxes the income received by the trust or deducts income distributed to the beneficiary who pays the tax. Because the grantor in a grantor trust pays income tax on the trust’s income, the annuity payments are not taxable to the grantor.
Q: What happens if a grantor dies with GRAT annuity payments left (before the end of the GRAT term)?
This is known as mortality risk. It is a potential downside of GRATs. If the grantor dies before the trust expires, all remaining trust assets will be included in the grantor’s estate. This defeats the primary purpose of the GRAT: shielding asset growth from estate tax.
Q: How do I know if I should use a GRAT in my estate plan?
GRATs are useful as a tool to shield asset growth from estate tax. However, they are a precise tool; a GRAT works best when:
- Your estate exceeds (or is expected to exceed) the estate tax exemption.
- You have high-growth assets to place in the GRAT that are growing faster than the Section 7520 rate.
Use caution if:
- Your assets may decline in value.
- Your risk of death is high before the GRAT terminates.
Q: What’s a zeroed-out GRAT?
When you contribute assets to a GRAT, you are making a gift that may be subject to gift tax or can reduce your lifetime gift tax exemption. The value of the gift equals the fair market value of the assets contributed to the GRAT, minus the present value of the annuity payments due over the GRAT term.
If the annuity is large enough, it can completely zero-out the gift. This means your GRAT beneficiary can receive the remaining trust assets free of estate and gift tax.
In a zeroed-out GRAT, the annuity equals or exceeds the fair market value of the asset to avoid gift tax on the transfer to the trust. This means that your beneficiary will inherit the asset’s appreciated value in excess of the annuities after the trust ends. If the GRAT assets grow at a rate higher than the IRS’s section 7520 rate (5% in March 2024), there will be assets to pass on to the beneficiary.
Q: Can we be sure that zeroed-out GRATs will exist forever?
No. Legislative attacks targeted GRATs in recent years. In September 2021, the tax-writing House Committee on Ways and Means attempted to limit the utility of GRATs. The committee proposed a minimum required GRAT length (ten years) and limitations on zeroed-out GRATs. Fortunately, the proposals were not passed by the House.
Q: If the GRAT has illiquid assets, where do the annuity payments come from?
GRAT annuity payments can be made with illiquid assets.
For example, assume you funded your GRAT with a large quantity of pre-IPO stock. You do not want to liquidate the stock because you believe it is currently undervalued. In the absence of cash in the trust, your annuity payments could consist of a portion of the shares instead of cash.
Q: When will the GRAT beneficiary receive their assets?
The earlier of:
- Death of the grantor.
- Expiration of the trust – unless to have the remaining assets stay in trust for the beneficiary and future generations.
Q: What is a "rolling" GRAT?
You can use rolling GRATs to protect yourself against the risk of mortality. Rolling GRATs are short-term GRATs and they lower the mortality risk because they expire sooner, locking in the estate tax savings. Wayne Zell describes rolling GRATs in Your Multimillion Dollar Exit:
“You can use rolling GRATs to continuously move the annuity payments and the appreciation on those annuity payments out of your estate. In other words, you set up a new GRAT into which you deposit the annuity payments received from the first GRAT, and any appreciation on those deposits further escapes gift and estate taxes.”
Wayne Zell, Your Multimillion Dollar Exit (page 169-170).