The estate planning process can be one of the most tedious and frustrating parts of developing a comprehensive financial plan. And, this can be particularly true for wealthy individuals. It took a lot of hard work and dedication to acquire your wealth, and you want to transfer as much of it as you can to your beneficiaries. As a result, having a large estate means you’ll have to pay quite a bit in gift and estate taxes.
Fortunately, there are a few steps you can take to reduce your taxes greatly. One such example is establishing a grantor retained annuity trust (GRAT).
What is an Annuity Trust?
Since annuities account for a large portion of GRATs, let’s begin with them. An annuity is a financial arrangement, typically with an insurance company, where you contribute funds or assets, such as shares of stock, to an account. These are known as premiums. You are then paid every month in equal installments by the account. Payments can happen immediately or at a later date.
As a result, an annuity trust is a type of trust in which an individual contributes funds or assets. From there, the trust then distributes an annuity to a beneficiary on a regular schedule. In a grantor-retained annuity trust, the person establishing the trust is the grantor. As a result, you receive the annuities from the trust when you retain those payments.
What is a Grantor Retained Annuity Trust (GRAT)?
“A GRAT is an irrevocable trust for a fixed term of years,” explains Jes Lambert, a member of Choate’s Wealth Management Group. FYI, the Social Security Administration defines a trust fund, as “a legal arrangement regulated by State law in which one party holds property for the benefit of another.” This trust is called a “grantor retained annuity trust” because the grantor contributes property to the trust while retaining the right to receive annuity payments in return.
Typically, annuity payments are made annually on or near the anniversary of the funding date. “But the rules provide that the actual payment to the grantor may be made at any time within 105 days after the annuity date,” adds Lambert. It is, however, not possible to make the annuity payments in advance. It’s important to consider the grantor’s cash flow constraints when determining which assets will be used for GRAT funding.
Ideally, cash flow should be modeled before funding if cash flow is an issue. Additionally, annuity payments are structured to return to the grantor the value of the assets contributed to the GRAT plus any interest required.
“Because the grantor gets back assets equal in value to what he or she put in, there is no gift upon the funding of a GRAT,” states Lambert. “What this means is that a GRAT uses up no gift tax exemption.”
“The key to a successful GRAT is that if the assets contributed to the GRAT appreciate at a rate higher than the statutory interest rate,” she adds. Often, this is referred to as the “hurdle rate. What happens at the end of the GRAT term? All appreciation in those assets is gifted to the named remainder beneficiaries, free of gift and estate taxes.
How Does a GRAT Work?
The following is an overview of the GRAT strategy, courtesy of NerdWallet;
- In a GRAT, an individual transfers assets into an irrevocable trust. This is for a specific period of time. And, these assets should have high appreciation potential.
- In the GRAT, the two parts of its value are the annuity stream and the remainder interest. This value can be calculated by applying IRS factors for valuing annuities, life estates, and remainders. Typically, the GRAT is “zeroed out.” Usually, this by setting the annuity stream to equal the value of the transferred assets.
- From the GRAT, annuity payments are received by the grantor. The trust should produce a minimum return at least equal to the IRS Section 7520 interest rate. If not, the trust will use the principal to pay the annuity. And, the GRAT will fail, reverting the trust assets to the grantor.
- After the final annuity payment is made, all remaining assets and accumulated asset growth are gifted free of gift tax to beneficiaries. But, this is assuming GRAT returns exceed the Section 7520 rate.
Why Use a GRAT?
Those facing significant estate tax liabilities at death can benefit most from GRATs. What happens in such situations? An estate freeze may be achieved by shifting a portion or all of the appreciation to their heirs through the use of a GRAT. If, for instance, an asset valued at $10 million was expected to double in value to $12 million within two years. In such a case, it could be tax-free transferred to an heir.
Additionally, Craig Smalley, an author, and estate planner said that a GRAT permits a corporation owner to preserve control of the business and “freeze the assets’ value and to remove it from the owner’s taxable estate.” However, Smalley cautions that if the owner passes away during the term of the GRAT, the current stock value is returned to the owner’s estate and taxable.
What’s more, individuals who own stock in start-up businesses tend to find GRATs particularly attractive. The reason? Stock price appreciation for IPO shares almost always exceeds the IRS assumed rate of return. Thus, the grantor’s lifetime exemption from estate and gift taxes is not diminished. And, in turn, more money can be passed on to beneficiaries.
Facebook founder Mark Zuckerberg used this method when he placed his company’s pre-IPO stock into a GRAT. We do not know the exact figure, but Forbes estimated the value of Zuckerberg’s stock at $37,315,513 at the time.
When Are GRATs Popular?
“In a low-interest-rate environment, many individuals use GRATs to pass asset appreciation to their family members,” notes the wealth management experts at J.P. Morgan. When the appreciation of the contributed assets exceeds the IRS hurdle rate, the excess can be transferred free of gift tax. According to the IRS, a hurdle rate is an interest rate that changes monthly. The lower the rate, the smaller the increment necessary to pass value to beneficiaries, they add.
“In addition, the financial downside to a GRAT is often limited to the transaction costs of creating it (legal, accounting and, if funding it with illiquid assets, appraisal fees),” they state. If the GRAT assets do not appreciate by the prescribed hurdle rate, the only consequence is that all assets will be taken back by the grantor. Often, this is in the form of annuity payments. And no assets will have been transferred to the remainder beneficiaries.
A GRAT has been the subject of legislation in recent years which aims to mitigate some of its advantages. “Although none of these proposals have been enacted so far, individuals may want to capitalize on this strategy now, in case legislation is passed in the future,” the J.P. Morgan team suggests.
What is the Right GRAT Length?
When the GRAT is established, the grantor chooses its term. While a GRAT has no standard duration, a two-year period is the most common duration for many clients, says LAmbert. Nevertheless, longer GRATs are other common practices, and some clients opt for 3, 5, or 10 years GRATs.
At the same time, there are a number of factors that affect the choice of a GRAT term. Shorter-term GRATS are preferred by grantors since they allow grantees to capture investment gains. Moreover, this allows them to transfer GRAT beneficiaries more rapidly.
Furthermore, a longer-term GRAT allows the grantor to lock in very low-interest rates. If the assets held in the GRAT are expected to increase in value over a long period of time. As a result, this could be more financially beneficial.
“As I mentioned, the GRAT term ends when all of the required annuity payments have been made,” Lambert emphasizes. At that point, any remaining GRAT assets (investment appreciation over and above the hurdle rate) will pass to the grantor’s chosen beneficiaries. In most cases, the remainder beneficiaries are the grantor’s children or a trust that has been established on their behalf.
How Do You Fund a GRAT?
Generally, GRATs are funded with assets that are expected to appreciate in value over the trust’s term. Tax effectiveness is determined by the performance of the investments against a “hurdle rate” set by the IRS. It is most common for GRATs to be backed by single security or a basket of correlated securities. Examples include family business shares, pre-IPO stocks, or individual equities. During the lifetime of the GRAT, the Grantor receives an annuity payment from the GRAT. Usually, this is on an annual basis. But, it can be more frequent.
Think carefully about whether it makes sense to create separate GRATs for each of the assets you intend to fund, advises Fidelity. If one of these assets is in a separate trust and the other isn’t, one may beat the hurdle rate — even if the other doesn’t. But, the blend of the rate of return for these assets may not beat the hurdle rate. This occurs if both assets are in the same trust and one is adversely affected by the other.
As per IRS regulations, the annual annuity payment is calculated by summing the initial contribution to the GRAT plus a rate of return. Again, this is known as the “hurdle rate.” The amount of funding in some GRATs is equal to the actuarial value of the annuities plus the IRS-required assumed rate of return. Known as a “zeroed-out” GRAT, this gift to the remainder beneficiaries has no actuarial value.
Rolling GRATs
In lieu of establishing one long-term GRAT, some individuals and families may prefer to establish a series of shorter-term GRATs. These are called a “rolling GRAT,” adds Fidelity. One major advantage of establishing a rolling GRAT is that the principal stays in one trust longer. Although this isn’t necessarily in the same one. Here, grantors receive greater distributions in the final years of the cumulative term. Distributions from the initial trust roll over into subsequent trusts, rather than being returned to them.
The likelihood of one or more short-term GRATs beating the hurdle rate is significantly higher when there are multiple short-term GRATs than one longer-term GRAT. Each of the shorter-term GRATs is made up of annuity payments, which can be directed to, or rolled into, the successive GRATs established as funding sources.
Taking into account market volatility, rolling GRATs may be preferable for investments that are riskier, such as stocks. “If a single, longer-term GRAT was initially funded near a stock market peak and the stock prices subsequently declined, it would be difficult to beat the hurdle rate on an average-annual-return basis,” they state. Rolling-GRAT strategies might be less affected by a stock market decline, since as new GRAT funds are raised each year and invested in the stock market at lower prices, those funds may have a better chance of capitalizing on a recovery.
There is a disadvantage to rolling GRATs in that the hurdle rate has not been locked in, and could increase over time when new GRATs are created. As long as the assets in the trust outperform the hurdle rate, this strategy remains effective even if the hurdle rate rises. In addition, establishing and administering multiple GRATs might result in additional fees for legal and administrative services.
What are the Benefits of a Grantor Retained Annuity Trust?
In setting up a GRAT, you will reap a number of benefits. Those who may need a steady stream of income in retirement can benefit from the annuity component.
GRATs are most beneficial, however, for transferring large amounts of money to beneficiaries while paying little or no gift tax. As long as the gift does not exceed the federal gift tax exemption, a gift is an important consideration in estate planning. The exemption for 2022 will be $16,000. This means an individual can make gifts up to that amount per year without paying gift tax. If the gift exceeds the exemption amount then the gift tax applies.
GRATs allow you to give a beneficiary more than $16,000 without triggering a gift tax. This is particularly beneficial for wealthy individuals who have substantial estates. The use of a GRAT gives you the opportunity to transfer more assets or properties in a shorter time period. GRATs also avoid or reduce the estate and gift tax liability that would otherwise be associated with such a large transfer.
Additional benefits of GRATs;
- Legal precedent supports the use of GRATs, as mandated by the Internal Revenue Code.
- It is not necessary to pay the annuity in cash; it can be paid with the property.
- As a tax-free gift, the remainder is approximately equal to the appreciation during the term of the GRAT.
- If the Grantor outlives the term of the GRAT, the remainder is excluded from the Grantor’s gross estate.
- Annuity streams from existing GRATs can be used to fund “cascading” or “rolling” GRATs. A new GRAT is created for each annuity payment received. The Grantor decreases the chances that the appreciation of the assets. This is if the Grantor dies before the GRAT expires, will be attributed to their taxable estate by keeping the term of the GRAT short.
- Taxes on sales and other income within the GRAT are payable by the Grantor. In other words, the Grantor paying the tax for the trust can also play a role in estate planning. This is because it leaves more assets inside the trust for the beneficiaries. To put it simply, it is basically an additional tax-free gift.
- By swapping assets with the GRAT during its term, the Grantor can lock in appreciation before its expiration. In particular, if the grantor is concerned about downside volatility over the balance of the term. Or, if the grantor experiences excessive appreciation early in the GRAT’s life, replacing or switching out the appreciating asset with cash or other assets can freeze the inside value of the GRAT.
Are There Risks Involved With a Grantor Retained Annuity Trust?
Utilizing a GRAT has some cons as well.
Mortality risk: The estate tax.
As you create a GRAT, you also choose the trust’s term or duration. When the trust’s term is over, the remaining assets become the beneficiaries’ property. Just take note that you’re responsible for all assets in the trust if you pass away before its term expires.
It’s because of this that set the term can seem unwise.
Creating a GRAT in the first place was driven in part by yielding a large capital gain on your assets over longer terms. So, let’s say you have a long-term GRAT of 20 years. If so, the more likely you are to suffer serious health problems as you age, and the more likely you are to die before the term is over.
As a general rule, careful consideration of the Grantor’s age, health, and other risk factors is necessary when setting the trust’s term.
Underperformance risk.
What happens if the assets in the GRAT depreciate below the IRS’s assumed return rate? In this scenario, any tax benefits of the GRAT would be nullified.
Since you typically only avoid gift taxes on capital gains, it makes sense to only put high-yielding assets into your GRATs. Establishing this type of trust might not be worth it if your assets are not seeing significant appreciation. Given the cost and effort associated with drafting a GRAT, it may not be worth it. And you might be able to gift the funds or assets in a more traditional way.
In short, there will be no appreciation to transfer to beneficiaries, and the grantor will retain ownership of all property in the trust. Typically the legal and accounting fees incurred to establish the GRAT are lost to the Grantor.
Gifted assets retain their cost basis.
Your beneficiaries will be required to pay capital gains taxes on the full gain associated with the asset if or when they eventually sell it. Taxes are not only due to the gain realized at the time the asset was received, but also on future gains. In this case, the beneficiaries of the gifted property will likely have to pay a lot of income taxes.
Despite that, your capital gains tax (maximum 23.8%) may still be less than the estate tax you’d have to pay (currently 40%). Furthermore, if your beneficiaries are in lower tax brackets than you, you may be able to reduce your total income tax burden.
Legislative risk.
Historically, GRATs have been viewed as a “loophole for the wealthy.” Because of this, GRATs have been an attractive target for future tax reform legislation. “Specifically, former President Barack Obama, in his fiscal 2010 and 2011 budgets, proposed requiring GRATs to have a minimum term of 10 years and a residual value greater than zero (eliminating zeroed-out GRATs),” states Megan M. Burke, CPA, Ph.D. “Similar restrictions were contained in the Small Business and Infrastructure Jobs Tax Act of 2010, H.R. 4849, which was passed by the House of Representatives.”
There have been several similar proposals put forth by presidential candidates as recently as in the 2020 election. “With interest rates expected to rise in the future and a GRAT-friendly Code that could be subject to changes in the next several years,” adds Burke.
Monitor the ongoing discussions in Congress closely and speak with a tax attorney if a GRAT is on your mind.
What are the Income Tax Implications of GRATs?
Grantors are considered GRAT owners for income tax purposes. As such, the grantor will be taxed on all income and capital gains that the trust will earn during the term of the GRAT regardless of the annuity amount. Since the trust’s assets can grow without income tax dilution, the grantor’s income tax payment is effectively another tax-free gift to the beneficiaries.
A grantor can exchange assets of similar value for assets in a GRAT via a substitution power. To reduce future capital gains taxes incurred by the beneficiaries, low-basis holdings can be substituted for high-basis holdings, which lock in appreciation or eliminates higher-basis holdings. The grantor doesn’t receive a step-up in basis on these assets because they are not included in the grantor’s estate. Similarly, capital gains taxes must be paid by the grantor in this case.
Thanks to financial advisors, though, grantors can catch a break.
Grantors and beneficiaries can reduce the income tax burden by choosing assets and managing taxes. An alternative is to transfer marketable securities such as equities. Equities are particularly enticing because of their liquidity, readily available valuations, and flexibility over annuity payments. And, equities have the ability to realize capital gains and losses.
With proper tax management, grants can be given at market-like returns while minimizing the drag on the grantor and beneficiaries.
How Do GRATs and Estate Taxes Work?
The New York Times called GRATs “the most valuable gift the tax code can give to the ultra-wealthy” because they allow wealthy families to pass wealth through generations without paying estate taxes. Individuals who own property worth more than $11.2 million are subject to the estate tax, and married couples whose assets are worth more than double that amount are subject to it.
In October 2018, The Times published an investigation showing how the parents of Donald Trump avoided inheritance taxes by using GRATs.
As per the investigation, Trump’s parents put half of their properties into a GRAT in the mother’s name and the other half into a GRAT in the father’s name. Their GRATs then distributed two-thirds of their assets to their children. By making two-year annuity payments to their parents, the children purchased the remaining third.
By doing this, the Trump siblings inherited the majority of their parents’ estates without paying any estate taxes.
The Bottom Line on GRATs
An experienced attorney should be consulted when deciding on a grantor retained annuity trust because of its complex nature. At the same time, these trusts can be extremely advantageous for the very rich since they can be exempt from inheritance taxes.
Whle the IRS authorizes GRATs, the IRS has a summary of GRATs on its webpage for Abusive Trust Tax Evasion Schemes – Special Types of Trusts. This explains how GRATs and other reputable trusts to “hide the true ownership of assets and income or to disguise the substance of transactions.”
Frequently Asked Questions About GRATs
1. What is a GRAT?
In an irrevocable trust, a grantor contributes assets and receives an annuity stream for a specified period of time. The remaining assets in a trust are transferred free of estate and gift taxes to the trust beneficiaries at the end of the term.
2. What should the GRAT include?
According to Internal Revenue Code (IRC) section 7520, a GRAT must specify the annuity payment amount, tax rate, and trust term. In order for the trust to succeed, assets must be transferred that have the potential for significant appreciation.
3. When is the annuity payment calculated and how often is it paid to the grantor?
The annuity payment is based on a percentage of the assets allocated to the GRAT. This is determined when the GRAT is created. In order to calculate the final value of the annuity payment, the Internal Revenue Service publishes the 7520 rates on its website each month. The GRAT rate is determined by the rate published in the month of transfer.
Payment of the annuity is made at least annually to the grantor.
4. What is the GRAT term, and what happens if the grantor dies during it?
Generally, the GRAT term is determined at the outset of the trust; it is specified in the trust agreement. As the trust’s terms should be shorter than the grantor’s life expectancy, the trust property remaining in the trust at the grantor’s death will be included in the grantor’s taxable estate if the grantor dies during the trust’s term.
There must be a minimum of two years in the trust. Mainly this is to mitigate the risk that the grantor may not outlive the GRAT term. Also, this addresses the unpredictability of the market.
5. What kind of assets make up the best GRAT contributions?
GRATs can receive a limitless amount of assets. It’s recommended to invest in income-producing assets such as closely-held stock, business interests, bonds, and royalties. The reason? These are more likely to appreciate at a higher rate than the section 7520 rate over the GRAT term.
