A Guide to Grantor Retained Annuity Trusts (Grat Trust)
A grantor retained annuity trust (GRAT) can be used to transfer assets to your beneficiaries with little or no gift or estate tax cost.
A GRAT is a special type of trust which can allow you to transfer to your beneficiaries with little or no gift and estate tax, that portion of the appreciation on the value of the assets contributed to the trust in excess of an assumed growth rate required by Internal Revenue Code Section 7520, which is announced monthly by the Internal Revenue Service.
It is also possible to structure a GRAT so that some or all of the assets themselves pass to your beneficiaries. We suggest that you discuss with your tax and legal advisors whether a GRAT is appropriate for you.
Below, we provide some items to consider during these discussions.
This tax-efficient wealth planning strategy can be accomplished by transferring assets to the GRAT but retaining the right to receive a series of annuity payments from the GRAT for a specified term of years. Each annuity payment, customarily, is based on a percentage of the fair market value of the assets transferred to the GRAT determined at the time of transfer. The annuity payments would be satisfied by paying you the income earned by the assets owned by the GRAT and, if the income proved to be insufficient, by returning to you a portion of those assets. Any property remaining in the GRAT after all of the periodic annuity payments have been made would be distributed to your beneficiaries, either outright or in continuing trust (for ease of reference, referred to herein as beneficiaries).
You would treat the transfer of assets to the GRAT as a gift in the amount of the fair market value of the assets less the actuarial present value of your annuity interest.
The actuarial present value of the annuity interest is the sum of the annuity payments discounted by the interest rate required by Internal Revenue Code Section 7520 in effect for the month in which the GRAT is funded.
Because the value of the gift on which gift tax would be imposed is determined by subtracting the actuarial present value of the annuity payments from the value of the assets contributed to the GRAT.
If the GRAT provides for sufficiently large annuity payments, then the present value of your annuity interest can approximate the fair market value of the assets transferred to the GRAT, in which case the gift tax will be minimized or potentially eliminated.
This is known as “zeroing out” a GRAT.
By using the interest rate required by Internal Revenue Code Section 7520 when valuing your retained annuity interest, the IRS assumes that the assets contributed to the GRAT will produce a total return equal to such interest rate over the period that the annuity will be paid to you.
As a result, when the actual total return earned by the assets in the GRAT (including both ordinary income and capital appreciation) during such period exceeds the Internal Revenue Code Section 7520 rate used to calculate the present value of your annuity, the IRS will have undervalued the gift. The amount of the undervaluation will pass to your beneficiaries free of any gift tax.
Example 1:
Example 1 illustrates a GRAT designed to pass appreciation on assets to your beneficiaries. Although the IRS changes the interest rate required by Internal Revenue Code Section 7520 every month, this example will assume that such rate is 2.0%. Also, for purposes of this example, assume assets having a value of $1 million are contributed to the GRAT and that the assets in the GRAT generate income of 3% per year and capital appreciation of 4% per year (for a total return of 7% per year). Lastly, assume the GRAT’s annuity term is three years and is a level annuity. (A GRAT annuity can increase by up to 20% each year, but this example uses a level annuity.) Based on the assumptions in Example 1, at the end of the GRAT annuity term, over $111,000 passes to the beneficiaries of the GRAT. Although not illustrated here, on these assumptions, the value of the gift for gift tax purposes is $0.18. Accordingly, your beneficiaries, on these assumptions, would receive over $111,000 without gift tax being incurred. Further, the appreciation on those assets (from the end of the annuity term until your death) are removed from your estate as you would no longer own them.
Example 1
| Year | Beginning Principal | 4.00% Growth | 3.00% Annual Income | Required Payments | Remainder |
|---|---|---|---|---|---|
| 1 | $1,000,000.00 | $40,000.00 | $30,600.00 | $346,752.60 | $723,847.40 |
| 2 | $723,847.40 | $28,953.90 | $22,149.73 | $346,752.60 | $428,198.43 |
| 3 | $428,198.43 | $17,127.94 | $13,102.87 | $346,752.60 | $111,676.64 |
| Summary | $86,081.84 | $65,852.60 | $1,040,257.80 | $111,676.64 |
Example 2:
Example 2 illustrates a GRAT in which the annuity payments are tied to cash flow derived from the asset contributed to the GRAT, which could ultimately pass the asset itself to the beneficiaries of the GRAT. In this example, assume the asset is an apartment building having a value of $3 million with a stable $210,000 per year rent roll. Using a hypothetical interest rate under Internal Revenue Code Section 7520 of 2.0%, you could set the annuity term so that the amount of the annuity approximates the annual rent roll. (For ease of illustration, this Example does not show growth in the value of the real property.) In this case, a 17-year annuity term (using a level annuity) would set the annuity payment at $200,909.10 per year. The annuity would be fully funded by the rent roll, and after 17 years the asset (the apartment building) would pass to the beneficiaries free from gift tax. See Example 2 (note that intermediate years are omitted from the illustration).
If the GRAT’s actual total return does not exceed the interest rate required by Internal Revenue Code Section 7520, then using the GRAT produces little detriment, for in that case, the GRAT will simply return all of its assets to you.
Although this means there would be no assets remaining in the GRAT for distribution to the beneficiaries, your only cost will have been the gift tax incurred upon creating the GRAT (which, if the GRAT was “zeroed out”, would be minimal or none) and the transaction costs of creating and administering the GRAT. Thus, from a gift tax perspective, the use of a GRAT presents only a minimal downside while creating the potential for significant benefits.
Example 2
| Year | Beginning Principal | $210,000 Annual Income | Required Payments | Remainder |
|---|---|---|---|---|
| 1 | $3,000,000.00 | $210,000.00 | $209,909.10 | $3,000,090.90 |
| 2 | $3,000,090.90 | $210,000.00 | $209,909.10 | $3,000,181.80 |
| 3 | $3,000,181.80 | $210,000.00 | $209,909.10 | $3,000,272.70 |
| 16 | $3,001,363.50 | $210,000.00 | $209,909.10 | $3,001,454.40 |
| 17 | $3,001,454.40 | $210,000.00 | $209,909.10 | $3,001,545.30 |
| Summary | $3,570,000.00 | $3,568,454.70 | $3,001,545.30 |
***Years 4 through 15 and are omitted for ease of illustration***
If you survive the term of the annuity, then the value of the property remaining in the GRAT after all of the annuity payments have been made will have been removed from your gross estate and will not be subject to estate tax upon your later death. Of course, the annuity payments made to you return assets to your gross estate which could be subject to an estate tax at your death if not otherwise disposed of before then. As discussed above, a GRAT that is “zeroed out” for gift tax purposes will generally return the value of the initially contributed assets to you, passing only the appreciation thereon free of the estate tax. Thus, the use of a “zeroed out” GRAT serves only to pass the appreciation on those assets, and not their original value, free of estate tax.
If, however, you should die during the term of the annuity, then, generally (although, not always), the entire value of the assets (including the appreciation) held in the GRAT at your death will be included in your gross estate (and potentially subject to estate tax). This, however, would be the same result as if you had decided not to create the GRAT, choosing instead to continue to own those assets outright. Thus, from an estate tax perspective, the use of a GRAT presents little downside if you should die during the term of the annuity while creating the possibility of significant benefits if you survive.
For federal income tax purposes, during the term of the annuity, the existence of the GRAT will essentially be ignored, and the property held in the GRAT will be treated as if owned directly by you (note that this result may not apply for state income tax purposes, such as in Pennsylvania).
Thus, there will be no federal income tax imposed on the initial transfer of assets to the GRAT or on any later return of assets to you in satisfaction with the annuity payments. In addition, during the term of the annuity, any income attributable to assets owned by the GRAT will be includible in your gross income and you will be responsible for paying the income tax due thereon. However, you may be able to use the annuity payments that you receive to pay any income tax that is due.
Because the full advantages of a GRAT are realized only if the actual total return on the assets held in the GRAT exceeds the interest rate required by Internal Revenue Code Section 7520 and if you survive until the end of the annuity term, to mitigate this mortality risk, generally, short-term GRATs are preferable to long-term GRATs. A short-term GRAT lessens the chance that a period in which the actual rate of return earned by the assets in the GRAT exceeds the interest rate required by Internal Revenue Code Section 7520 will be offset by a period in which the rate of return earned by such assets is below that interest rate. Moreover, when the term of the annuity is relatively short it is less likely that you will die during that term, reducing the chance that your estate will be taxed on the appreciation in the GRAT’s assets. Of course, if the GRAT is relying on cash flow from its assets to carry the annuity the term of the annuity will, by necessity, in part depend upon that amount.
Asset selection can be important to the success of your GRAT strategy. Generally, assets that you believe will appreciate rapidly will likely produce a better end result for the remainder beneficiaries of the GRAT. As a corollary, contributing a diversified portfolio to a single GRAT may not produce the best result, because assets whose appreciation lags or is negative will offset the appreciation on assets that outperform or even simply have a positive return, thereby reducing the overall performance inside the GRAT. One way to avoid this result might be to use multiple identical GRATs, each one holding a different asset or market sector. Closely held assets (particularly interests in private companies that are likely to appreciate or be sold) may also be appropriate assets to transfer to a GRAT. It may be possible to leverage the power of the GRAT when valuing closely held assets due to the application of so-called valuation discounts.
Although the leverage of valuation discounts can produce great results for the remainder beneficiaries of a GRAT, a word of caution is necessary. If interests in the closely held business are used to pay the annuity, they must be valued at the time the annuity payment is made. If valuation discounts were used when the closely held asset was contributed to the GRAT, valuation discounts would generally be applied when the closely held asset is distributed from the GRAT to pay the annuity. There usually is a cost to obtain an appropriate valuation.
A final note about transfer taxation is appropriate. A GRAT may not be the most appropriate tool for making transfers in trust for multiple generations that may be subject to the Generation-skipping Transfer Tax (GSTT). The annuity term of a GRAT is an “Estate Tax Inclusion Period” (ETIP) for purposes of the GSTT. Allocation of your exemption from the GSTT is made only at the conclusion of the ETIP. Accordingly, careful analysis is necessary should you consider using a GRAT to fund a multi-generational wealth transfer.
As with any wealth transfer strategy, you should consult your personal attorney or other tax advisors to determine if that strategy is appropriate for your circumstances.
Chart 1: Granter Retained Annuity Trust (view image of chart 1)
- Gift of securities or other assets
- Annuity paid to the Grantor for a specified term
- Remaining assets (if any) distributed to the beneficiaries after all periodic annuity payments have been made.
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I am David, economist, originally from Britain, and studied in Germany and Canada. I am now living in the United States. I have a house in Ontario, but I actually never go. I wrote some books about sovereign debt, and mortgage loans. I am currently retired and dedicate most of my time to fishing. There were many topics in personal finances that have currently changed and other that I have never published before. So now in Business Finance, I found the opportunity to do so. Please let me know in the comments section which are your thoughts. Thank you and have a happy reading.
