What is a Grantor Retained Annuity Trust?

There are several ways to transfer investments that provide asset protection and estate tax planning benefits to the next generation. But one that may be particularly attractive for people with assets anticipated to substantially increase in value is a grantor retained annuity trust (GRAT). GRATs can be especially valuable when interest rates are low or during times of economic uncertainty.

Keep reading to learn how GRATs could serve as your next wealth planning opportunity in any market environment.

 

What is a GRAT?

A GRAT refers to any trust that allows the grantor to retain some power to control the trust's assets, including the power to substitute assets of equal value for the assets held within the trust.

As a result, you as the grantor can make gifts of substantial assets to a grantor trust and protect those assets – and any appreciation that accumulates – from future gift and estate taxes.

The grantor is responsible for paying income tax on any trust income generated during the term of the trust. This actually serves as an additional benefit to the trust beneficiaries because the trust is allowed essentially to grow income, gift and estate tax-free.

 

How Does a GRAT Work?

A GRAT is an irrevocable trust into which you, the grantor, can transfer assets and retain the right to receive – for a specified term – a series of fixed, or increasing, payments.

When your annuity stream ends, your beneficiaries then receive the remaining balance of the trust assets, either outright or in further trust.

With its ability to provide for significant transfers of wealth, this wealth planning tool can be attractive particularly because:

• Your annuity stream is based on a specific amount or a fixed percentage of the value of the trust's assets, allowing for any and all appreciation to be passed to your heirs.
• A GRAT allows you to freeze the value of the asset gifted and gift substantially more than one could through transferring it at death, when estate taxes may be due.

The IRS sets the interest rate that the GRAT must exceed to be successful on a monthly basis, under Section 7520 of the Internal Revenue Code (IRC). This interest rate is sometimes called the “hurdle rate” and is set at 120% of the federal midterm interest rate.

It is important to note that:

• The IRS assumes that a GRAT will grow at the interest rate set at the time you establish the trust. The lower the interest rate set, the larger the potential gift tax-free transfer of assets when the trust term ends.
• The IRS does not take into account the actual growth of the assets in the GRAT. This means any appreciation above the hurdle rate is passed on to trust beneficiaries both gift and estate tax-free.
• Outperforming the federal midterm interest rate is a likely outcome for most investments when rates are extremely low. However, when interest rates are higher, it may be more of a challenge to have your assets appreciate more than the hurdle rate.

In the event that the assets in your GRAT do not outperform the hurdle rate, the assets will be returned to you, the grantor, without any adverse tax consequences.

GRAT Term Requirements

GRATs, which are typically set up for terms of 2, 3, 5 or up to 10 years, have several conditions that must be met to be effective.

First, the grantor must survive the GRAT, so you need to consider your age and health conditions when you select the term. If you don’t survive the full GRAT term, the assets in the GRAT are returned to your estate.

In addition, a GRAT is irrevocable and allows for a one-time contribution. However, you may have more than one GRAT for different assets.

Other GRAT requirements impact payments:

• Payments must be made at least annually to the grantor (you) or your heirs after you pass away.
• Payments are either a fixed dollar amount or a percentage of the initial value of the assets in the GRAT.
• Payments cannot be provided as a loan or prepaid.

 

Who Pays Taxes on a GRAT?

A prime benefit of a GRAT is to hold assets outside your estate so your heirs don’t have to pay estate taxes on that portion of their inheritance.

However, the IRS requires you as a grantor to include income gains and losses on your personal tax return. That benefits your heirs since they will not be required to pay income taxes on the assets in the GRAT.

In addition, while just six states – Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania – have an inheritance tax, a GRAT will not help your heirs even if they don’t live in those states.

State inheritance taxes are paid by the beneficiaries, not by the trust or estate. If you owned property or lived in one of those states, your heirs could be required to pay an inheritance tax on the assets in a GRAT, depending on the state’s rules.

 

The Advantages of GRATs in Shifting Market Conditions

GRATs are a particularly good option for individuals or families with assets with the potential for high growth, such as shares in a start-up pre-IPO, shares in a family-owned business, or assets that are currently devalued but anticipated to have strong long-term appreciation.

Whether interest rates are low or there’s uncertainty in the market, a GRAT can be a tool that allows you to protect your assets and yet have some flexibility and control.

While a GRAT is an irrevocable trust, you can exchange assets or substitute cash for assets that are not appreciating as quickly as you anticipated.

There’s also flexibility in payment structure, so you can minimize payments early in the GRAT term to allow for greater appreciation. You can increase the payment over time up to a maximum of 20% per year.

There are also tax advantages for your heirs, since you report gains and losses in your GRAT on your personal tax return. The GRAT also removes assets from your estate, so your heirs don’t have to pay estate taxes on those assets.

 

Mitigating the Downsides of GRATs

While GRATs can be an effective estate planning tool for asset protection, there are some disadvantages to establishing one. However, there are also some options that can reduce the impact of these shortcomings.

The major downside is that GRATs are irrevocable. You must feel confident that the annuity stream you establish during your specified term will be achievable and that the internal growth within the GRAT will exceed your interest rate.

In addition, the grantor must survive the GRAT's term – whether it be 2, 3, or 5 years – for the gift to be considered “completed" and for the assets in your GRAT to be removed from your estate.

If you do not survive the GRAT term, the assets will be returned to your estate as if the gift was never made.

There are, however, a variety of ways to structure a GRAT to maximize the tax planning and estate planning benefits.

For example, you can:

Set Up GRAT Annuity Payments to Match IRS Interest/Hurdle Rate

If the assets appreciate and fail to generate an income that's large enough to pay the annuity, the annuity payment must be made from the principal value of the asset.

This is fine because the annuity payment can be made “in kind" from the assets held within the GRAT. Income is only secondary. What you are looking for is to transfer the appreciation within the trust to your heirs.

Set up a GRAT Annuity with Increasing Annual Payments

IRS regulations allow you to increase your annuity payment by as much as 20% per year.

Knowing this, you can give the assets in the GRAT time to increase in value by taking a smaller annuity payment at the beginning.

Establish a Rolling GRAT

While most GRATs are established for a 2- or 3-year term to avoid the risk of the grantor passing away during the GRAT term, a Rolling GRAT sets up several short-term GRATs, usually within a 10-year period. This mitigates the risk of the GRAT assets reverting to the grantor.

If you, the grantor, pass away during one of the Rolling GRAT terms, you will have received the benefits of the earlier GRATS, and the future GRATs will not be funded. Only the assets remaining in the active GRAT would revert back to your estate.

 

Make the Most of GRATs

The ultimate goal of a GRAT is to transfer only those assets that are likely to increase in value.

This way, the grantor can both:

• Receive the annuity payments.
• Provide a large gift and estate tax-free remainder interest to the trust's beneficiaries – your heirs.

Your wealth planner can provide more custom guidance on the types of assets to gift or transfer to a GRAT.

Assests to include in a GRAT might include:

• stocks that you expect to appreciate.
• hedge fund investments.
• closely held business interests.
• real estate.

 

Learn More About Setting Up a GRAT

If you do not have an estate plan in place and are interested in setting up a GRAT, this may be a good time to start that process with your wealth management team.

Your wealth planner, estate planner and tax advisor may want to consult collaboratively to establish a GRAT that meets your needs now and provides for your heirs in the context of the market.