Beyond the basic fundamentals of your estate plan, are there any additional steps you could take to further reduce potential estate taxes? This article outlines the grantor retained annuity trust (GRAT). A GRAT is a unique trust strategy that could help individuals and families reduce their potential estate-tax liability by freezing a portion of their estate’s value today while shifting the appreciation of those assets to beneficiaries potentially free of estate and gift taxes. 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.
Why use a GRAT?
The goal of a GRAT strategy is to freeze a portion of an estate's value today, allowing future appreciation on those assets to pass to heirs estate-tax-free. Over the term of the trust, the individual, also known as the grantor, receives a stream of income (in the form of an annual distribution). So, if individuals or families own assets that they expect to appreciate in value, but that they don't necessarily want to gift away outright, it may make sense to shift the potential future growth of those assets to heirs using a GRAT. GRATs tend to be particularly effective in low-interest-rate environments, so for those who hold the view that interest rates will rise from here, now may be a good time to explore GRATs and whether this strategy could make sense.
How does a GRAT work?
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. The initial transfer plus some interest would be returned to the grantor over the term of the trust and, at the end of the period, the balance of the trust would be passed on to heirs, either outright or in a further trust.
The annuity payments to the grantor during the term of the trust are calculated using the IRS Section 7520 rate, or hurdle rate.1 At the conclusion of the GRAT term, any assets remaining in the trust (any appreciation above the hurdle rate) would pass to heirs free of gift and estate taxes, if the trust is structured properly. This hurdle rate is based on an IRS-prescribed rate that changes monthly, based on a variety of economic factors, and has been at historic lows in recent years, but has risen recently. (The rate was 0.8% in March 2021.) Therefore, for a GRAT established now to be considered a success, the assets in the trust must appreciate by more than the hurdle rate in place when the trust was funded. So, 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
Currently, the length of the GRAT term can vary, though generally it ranges from 2 to 10 years. A benefit to implementing a longer-term GRAT is that a hurdle rate can be locked in for a longer period of time. Identifying a preferable term length depends largely on how quickly one believes the trust assets may grow. Opting for a longer term gives 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 will pass to heirs gift and estate-tax free.
Rolling GRATs
Rather than establishing a single, longer-term GRAT, some individuals and families may wish to consider establishing 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). The initial distributions roll into subsequent trusts (rather than being returned to the grantor), and the grantor receives larger distributions in the final years of the cumulative term.
Single-GRAT example
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Further, multiple short-term GRATs increase the likelihood that one or more of the individual GRATs will be successful in beating the hurdle rate, compared to one longer-term GRAT. As the annuity payments are made from each of the shorter-term GRATs, these payments could be directed to, or rolled into, the successive GRATs that are established as the funding source.
Rolling GRATs may better account for market volatility, so for riskier investments, such as stocks, rolling GRATs may be preferred. 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. A stock market decline may have less of an impact on a rolling-GRAT strategy, because as new GRATs are funded each year and invested in the stock market at lower prices, those funds may be better positioned to take advantage of an eventual market rebound.
One disadvantage to rolling GRATs is that the hurdle rate is not locked in, and could increase over time as new GRATs are established. However, even if the hurdle rate rises, this strategy is still effective as long as the assets in the trust outperform the hurdle rate. It's also important to note that there may be added legal and administrative costs associated with setting up and administering several GRATs.
Rolling-GRAT example
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Funding the GRAT
As we've discussed, 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.
Separate, single-asset GRATs
When considering funding a GRAT with a diverse array of assets, such as shares of a family business and individual equities, consider whether it makes sense to set up separate GRATs for each asset class. If one of these assets performs well and another does not, the fact that they are in separate trusts may allow one GRAT to beat the hurdle rate while the other one might not. If the assets are in the same trust and one has a negative impact on the other, the blended rate of return for these may not beat the hurdle rate, resulting in an unsuccessful overall outcome.
The power of substitution
Once a GRAT has been funded, assets inside the GRAT may be exchanged for assets outside the GRAT. Naming the grantor as trustee could allow for this flexibility, or an attorney creating the trust document could include specific language allowing the grantor this specific authority. If the assets don't perform as the grantor expected, they could remove them from the trust and replace them with assets deemed more likely to appreciate. 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. 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.
Proper receipt of annuity payments is critical
It is important to ensure that the annuity payments are valued correctly and made on time. Incorrect or untimely GRAT annuity payments could be treated as additional contributions to the GRAT by the grantor. This could disqualify the GRAT and render this wealth transfer technique invalid. The trustee should keep accurate records, including account statements, valuations, and appraisals.
There are several options available when setting up required annuity payments. A grantor could elect to receive cash or a portion of the assets in kind.
Fixed versus increasing payments
While most people associate the term "annuity" with receiving a payment of a fixed amount, the annual payment from a GRAT can also 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.
Tax implications
Gift and estate tax
When implementing a GRAT strategy, individuals typically seek to reduce potential gift-tax consequences. With a "zeroed out" GRAT structure, the actuarial value of the annuity equals (or nearly equals) 100% of the initial transfer and, as a result, no federal gift tax is due and little, if any, of the lifetime estate and gift tax exclusion is used. This can be a significant benefit for those who have already exhausted their lifetime exclusion or choose to preserve what remains. 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.
Income tax
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.
What happens when the GRAT terminates?
At the end of the GRAT period, the assets remaining in the GRAT can either pass outright to heirs or remain in trust for the benefit of heirs. If a series of rolling GRATs has been established, the grantor may wish to have the balances consolidated into one trust, for ease of administration. This trust can also be treated as a grantor trust for income tax purposes, meaning the grantor would continue to pay the income taxes and further reduce their taxable estate.
It may also be possible to exchange or purchase assets or receive distributions without realizing income or capital gains. This trust can be structured to make assets available to heirs with as much or as little restriction as preferred. While GRATs are typically intended to benefit descendants, a grantor's spouse may also be included as a beneficiary. Doing so would ensure that the funds are available if the need for them arose, while allowing the assets to be passed on to heirs outside of the surviving spouse’s estate, if access to the funds is not needed.
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. A significant advantage of setting up a series of rolling GRATs instead of a single GRAT is that several of those GRATs would likely have already reached maturity, and the grantor would have received the satisfactory result of transferring the growth on at least some of the assets outside of their estate.
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. Because the grantor used little to no lifetime federal gift and estate tax exclusion (assuming the GRAT was structured as a "zeroed out" trust) and continued to pay income taxes as if the assets were still in their name, the grantor would experience minimal, if any, adverse tax consequences. Rather, the grantor would have incurred fees and expenses to establish and administer a trust that did not perform successfully.
IRS concerns
The IRS permits GRATs, provided the terms of the trust adhere to applicable Department of the Treasury regulations intended to benefit descendants and a grantor's spouse.3 However, it is such a powerful wealth transfer tool that over the years the Treasury, and more recently Congress and the current administration, has proposed various restrictions on GRATs, though these restrictions have not yet been implemented. These proposed restrictions include requiring a term of at least 10 years and a remainder interest greater than zero, and prohibiting a decrease in the annuity amount during the term of the GRAT.4
Note: Recent proposals by Congressional legislators and the current administration have targeted GRATs with proposals that would significantly impact the viability of GRATs.
Generation-skipping transfer tax
GRATs present several attractive qualities, but minimizing or eliminating the generation-skipping transfer tax (GSTT) is not one of them. If GSTT is allocated to the full value of the GRAT when it is set up and funded, it will in effect be "wasted" as the annuity payments come back into the estate. If the grantor leaves the assets outright or in trust for the benefit of their children only, rather than for the benefit of multiple generations, GSTT will not be a concern. However, 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.
Summary
Even as we are unable to predict whether the administration’s proposals will ever be implemented, or if other estate-tax law changes will arise, a GRAT strategy may be an effective wealth transfer strategy to consider while interest rates are low. Although GRATs are often considered useful only when assets appreciate significantly over the term of the trust, they can still be successful with more modest growth, providing the growth outpaces the hurdle rate. Whether a GRAT is used independently in its simplest form or alongside other estate planning strategies, the strategy can enhance the effectiveness of an overall wealth plan.
If you think this strategy might be appropriate for you, contact your attorney or tax advisor to discuss your specific situation. Your Fidelity Wealth Management Advisor is available to discuss how a GRAT may fit within your overall wealth plan.
With uncertainty about the direction of future policy, changes to federal estate-tax law could be on the horizon. Working with your attorney and tax advisor to revisit and update your estate plan regularly can help ensure that your plan aligns with current laws.