For individuals or families seeking to pass assets to their heirs who may be concerned with estate tax liability, a grantor retained annuity trust (GRAT) can be a powerful option. As with any estate planning tool, it's important to consult your attorney and tax advisor to determine if this strategy makes sense for you.
What is a GRAT?
A GRAT is a trust created so that individuals and families can move wealth to heirs while using little, if any, of their lifetime federal gift and estate-tax exclusion. An individual would work with an attorney to set up an irrevocable trust and transfer assets into it. In return, the grantor would receive an annuity payment at least annually for a certain number of years.
How does a GRAT work?
A GRAT essentially freezes a portion of an estate’s value today while shifting the appreciation of those assets to beneficiaries potentially free of estate and gift taxes. The initial transfer, plus some interest, are returned to the grantor over the term of the trust. At the conclusion of the GRAT term, assuming the trust is structured properly, any assets remaining in the trust would pass to heirs free of gift and estate taxes. The annuity payments made back to the grantor will be included in the estate, but the growth on the assets would pass to heirs free of estate tax.
The annuity payments to the grantor during the term of the trust are calculated using the IRS Section 7520 rate, or hurdle rate.1 The hurdle rate is based on an IRS-prescribed rate that changes monthly, based on a variety of economic factors. A GRAT is considered a success when the assets in the trust appreciate by more than the hurdle rate in place when the trust was funded. When the hurdle rate is low relative to historical levels, the likelihood that the assets will exceed the hurdle rate may be higher and could mean significant potential estate-tax savings and increased wealth transferred to heirs.
Choosing the length of the GRAT term
The length of the GRAT term can vary, though generally it ranges from 2 to 10 years. Identifying a preferable term length depends largely on how quickly one believes the trust assets may grow. A benefit to implementing a longer-term GRAT is that a hurdle rate can be locked in for a longer period of time, giving the trust assets more time to grow (assuming favorable market conditions) and potentially exceed the hurdle rate, versus betting that the assets will appreciate enough to beat the hurdle rate in a shorter time frame. Of course, the more the trust assets can grow over a longer period of time, the higher the remaining balance that may pass to heirs gift and estate-tax free.
Rather than a single, longer-term GRAT, some individuals and families establish a series of shorter-term GRATs, often referred to as "rolling GRATs." The main advantage of a rolling-GRAT structure is that the principal remains in a trust for a longer period of time (albeit not in the same one it started in). Because the hurdle rate is established when the GRAT is funded, shorter-term GRATs can also provide more planning flexibility in an environment where the hurdle rate is expected to decrease.
Advantages of using a GRAT
A GRAT provides unique planning options as well as a potential income stream for the grantor. Families may choose a GRAT to pass on assets expected to appreciate in value, but that they don't necessarily want to gift away outright. GRATs are particularly helpful for families that have fully utilized their available estate-tax exclusion. Here are some benefits of a GRAT to consider:
Flexibility
Once a GRAT has been funded, assets inside the GRAT may be exchanged for assets outside the GRAT. If the assets don't perform as the grantor expected, they can be removed from the trust and replaced with assets with a greater potential for appreciation. This could help a grantor navigate risks such as creating a GRAT when the stock market is trading near historic highs, which could increase the likelihood of a potential decline in stock prices during the term of the GRAT.
Alternatively, if the assets within a GRAT appreciate rapidly, they could be removed and substituted with cash, or another asset expected to experience minimal volatility. This approach could enable the grantor to lock in the rapid appreciation that could then be transferred to heirs at the end of the GRAT term. Finally, should a grantor need access to liquid assets, it may be possible to remove liquid assets from a GRAT and replace them with illiquid assets, although appropriate valuation of such assets would need to be considered, among other factors.
Removing high-growth assets from an estate
GRATs are most useful when funded with assets that may appreciate significantly over time, such as shares of a family business, pre-IPO stocks, or other investable assets. Funding the GRAT with investable assets or cash makes valuing the transfer and investing a relatively simple process. The trustee can then invest or reallocate the assets based on the terms of the trust. Funding a GRAT with more complex assets, such as shares of a family business, is more complicated and expensive, as appraisals and valuations may be required if the price for the shares is not readily discernible.
Options for payments
While most people associate the term "annuity" with receiving a payment of a fixed amount, the annual payment from a GRAT can increase by up to 20% each year. By increasing the amount each year, lower payments would be received at the beginning of the GRAT term and higher payments toward the end, leaving more assets in the trust during the earlier years to potentially generate higher returns.
Income tax benefits
A GRAT is treated as a grantor trust, which means that all income, gains, and losses will flow through to the grantor and be included on the grantor's personal income tax return. The benefits to this tax treatment are twofold: First, this effectively allows more wealth to shift to heirs, because neither they nor the trust will bear the responsibility of these payments. Second, the IRS has ruled that when the grantor pays the income taxes, there is no additional gift made to the GRAT.
Risks of using a GRAT
As with most estate-planning techniques, there are risks to consider before deciding whether this strategy is appropriate.
Mortality risk
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.
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. The good news in this scenario is that the grantor would experience minimal, if any, adverse tax consequences; however, they would have incurred fees and expenses to establish and administer a trust that did not perform successfully.
Potential changes in estate-tax laws
The GRAT is such a powerful wealth transfer tool that over the years the Treasury and Congress have proposed various restrictions on GRATs, though these restrictions have not yet been implemented.
Generation-skipping transfer tax
GRATs present several attractive qualities, but it does not minimize or eliminate the generation-skipping transfer tax (GSTT), an additional tax that could apply to transfers made to heirs more than one generation below them. 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.Should you get a GRAT?
A GRAT may be an effective wealth transfer strategy to consider, but depending on many factors, it may or may not be right for your family. If you think a GRAT might be appropriate for you, contact your attorney or tax advisor to discuss how it may fit within your overall estate plan.