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Grantor Retained Annuity Trust (GRAT)

Definition

Grantor Retained Annuity Trust (GRAT) is a type of trust that allows a person, the grantor, to transfer assets to beneficiaries, often with little to no tax penalty. The grantor puts assets into the trust and receives an annuity payment for a specific period of time. At the end of that period, the remaining assets go to the named beneficiaries, usually the grantor’s children.

Phonetic

The phonetics for the term “Grantor Retained Annuity Trust (GRAT)” would be: Grantor: /ˈgranˌtôr/Retained: /rɪˈteɪnd/Annuity: /əˈn(y)o͞oədē/Trust: /trəst/GRAT: /græt/

Key Takeaways

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  1. GRAT is an estate planning technique: A Grantor Retained Annuity Trust (GRAT) is a financial instrument used in estate planning. This strategy allows an individual to make large financial gifts to family members without any liability for U.S. gift tax.
  2. How GRAT works: By transferring property or assets into a GRAT, the grantor creates a trust that provides income to the grantor for a fixed period of time (annuity). The remaining assets, upon the end of the annuity period, would be transferred to beneficiaries (children, other family members) tax-free.
  3. Risk factor: GRATs have certain risks. If the grantor dies before the end of the annuity term, the assets are included in the taxable estate. Hence, it is essential to set the annuity term appropriately. Also, if the trust’s investment return does not exceed the annuity payments, there is no tax advantage for beneficiaries.

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Importance

The Grantor Retained Annuity Trust (GRAT) is an essential financial instrument in estate planning. It enables significant financial and estate tax savings, making it critical for high-net-worth individuals who intend to pass assets to their heirs. A GRAT allows the grantor to contribute assets into the trust and receive an annuity payment for a certain period. If the assets’ value appreciates beyond the IRS’s assumed rate of return, the surplus can be transferred to the beneficiaries tax-free upon the trust’s expiry. Thus, a GRAT becomes a strategic tool for controlling and minimizing estate tax liability, thereby helping individuals maximize the wealth transferred to their successors.

Explanation

A Grantor Retained Annuity Trust (GRAT) is predominantly used as an estate planning tool, typically by high-net-worth individuals, to minimize the taxation on large financial gifts to their family or other beneficiaries. The chief aim of a GRAT is to allow these assets to be passed on to beneficiaries without incurring federal estate tax. By setting up a GRAT, the grantor essentially removes assets from their estate, while still receiving an annual income stream for a specified term of years, possibly reducing the amount of estate that would be subject to estate tax upon their death.Under a GRAT, an irrevocable trust is created for a certain term or period, during which time the grantor receives annuity payments. After the trust term expires, the beneficiaries receive the assets tax-free. The Internal Revenue Service (IRS) calculates the retention of an annuity through a certain interest rate called Section 7520 rate, helping to calculate the annuity payments. If the assets in the trust appreciate at a rate higher than this set IRS rate, the additional value can be transferred, tax free, to the beneficiaries. Therefore, GRATs are commonly used when interest rates are low or when the grantor believes their assets will experience high growth rates.

Examples

1. Walton Family’s Walmart Stocks: The Walton family, the heirs to the Walmart empire, reportedly used Grantor Retained Annuity Trusts (GRATs) to pass on approximately $100 billion of Walmart stock to their heirs, saving billions in estate taxes. They did this by setting up multiple GRATs, where the old stock was transferred into the trust and new stock was given back in the form of an annuity. When the stock value increased, the additional growth transferred to the heirs tax-free.2. Facebook Co-founder Dustin Moskovitz: Dustin Moskovitz, one of Facebook’s co-founders, reportedly used a GRAT to manage his sizeable wealth. After Facebook’s initial public offering, the value of his shares grew significantly. To avoid large estate taxes, Moskovitz established a GRAT, into which he transferred a portion of his Facebook shares. The rising value of these shares ultimately passed to the trust beneficiaries, mostly free from estate tax.3. Sheldon Adelson’s Casino Empire: Sheldon Adelson, the late casino tycoon and former CEO of Las Vegas Sands Corp, used GRATs to pass on his wealth to his heirs with minimal tax implications. He placed his Sands stock in the annuity trusts, and when the stocks appreciated, the value passed onto his heirs mostly free from estate tax. He reportedly saved approximately $2.8 billion in estate taxes using this strategy.

Frequently Asked Questions(FAQ)

What is a Grantor Retained Annuity Trust (GRAT)?

A Grantor Retained Annuity Trust (GRAT) is a type of estate planning tool used in the United States. It allows a person (the grantor) to potentially reduce taxes on financial gifts to his or her beneficiaries.

How does a GRAT work?

The grantor deposits assets into the GRAT and then receives annual annuity payments for a specified number of years. After the term of the GRAT expires, the remaining assets are distributed to the beneficiaries.

Why would someone set up a GRAT?

The main objective is to reduce the amount of taxable gift a person gives their beneficiaries. GRATs typically contain assets expected to appreciate in value, as the appreciation of the assets can potentially pass to the beneficiaries free of additional tax.

What are some risk factors associated with setting up a GRAT?

The most significant risk is that the grantor must survive the term of the GRAT; otherwise, the assets return to the grantor’s estate, and the tax benefits are lost. Additionally, if the GRAT’s assets do not appreciate in value as expected, the tax benefits will also be lessened.

Are there any restrictions on who can be a beneficiary of a GRAT?

GRATs are typically used to gift assets to family members or other individuals. Non-person entities, like charities or trusts, can also be beneficiaries but different rules may apply.

Can the value of the annuity payments from a GRAT change?

No, the annuity payments remain constant through the term of the GRAT and are determined at the time the trust is established.

How is the amount of tax calculated for a GRAT?

The tax is calculated by using an interest rate provided by the IRS called the Section 7520 rate. This determines the value of the annuity payments, with the remaining trust property considered a gift to beneficiaries.

What happens if the grantor does not survive the term of the GRAT?

If the grantor dies before the GRAT term ends, the trust assets remain a part of the grantor’s estate. This means the potential tax-saving benefits of the GRAT would not be realized.

Related Finance Terms

  • Irrevocable Trust: A type of trust in which its terms cannot be modified, amended or terminated without the permission of the grantor’s named beneficiary or beneficiaries.
  • Annual Exclusion Amount: The specified amount that a person can give to another person in a year without incurring a gift tax or eating into their lifetime exemption.
  • Annuity: A financial product that pays out a fixed stream of payments to an individual, primarily used as an income stream for retirees.
  • Trust Assets: Assets that are placed inside a trust for protection. They can be real estate, stocks, bonds, mutual funds, cash, or other types of investment vehicles.
  • Trust Beneficiary: The person or entity who receives the benefits of a trust. They are often the recipients of income from the trust, or may have access to the principal.

Sources for More Information

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